Transcript document

Economic
Environment
Lecture 2
Joint Honours 2003/4
Professor Stephen Hall
The Business School
Imperial College London
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Revision
from last week
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The circular flow of income, expenditure and
output
I
C
S
C+I
Households
Firms
Y
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Government in the circular flow
I
C+I+G
C
S
G
Households
C + I + G - Te
Te
Government
Firms
B - Td
Y + B - Td
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Y
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National income accounting: a summary
NYA
G
GNP
(and
GNI)
at
market
prices
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I
X-Z
C
NYA
Deprec'n
Indirect
taxes
GDP
NNP
at
market at basic National
prices prices income
Profits,
rents
Selfemployment
Wages
and
salaries
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This Lecture
• We begin to develop the basic demand
side model
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Demand-Side Models
The “Keynesian” approach to modelling the
economy is to focus solely on domestic demand.
This is because John Maynard Keynes’s “General Theory
...” (1936) was developed during the Great Depression,
when supply constraints were not a problem. (Indeed, the
real problem was to get people back to work!)
• Recall the equality
C+S+T+M = C+I+G+X
• This can be re-written as
C+S+T = C+I+G+(X-M)
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Demand-Side Models
• The term (X-M) is simply “net exports”. The right-hand
side of this equation is domestic demand for goods and
services. In equilibrium, this must equal the domestic
supply of goods and services (which is the left-hand
side). Denoting this supply by “Y”, we have
Y = C+I+G+(X-M)
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National Income Determination
• For an economy to be in equilibrium, it must be
that the supply of goods equals the demand for
goods. Stated another way, whatever is
produced must be used by someone. From the
previous section, this equality was written as
Y = C+I+G+(X-M)
• (In some books, aggregate demand, the right
hand side of this equality, is denoted by the term
“AD”)
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National Income Determination
Before proceeding, it is useful to review the various
components of aggregate demand
C = is households’ personal consumption
I = is business firms’ real investment
G = is the government’s expenditure, and
(X-M) = is net exports to the foreign sector
(*For now, we will assume that net exports are zero,
and will omit them from the analysis)
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The Keynesian assumption
• If we assume as did Keynes that supply (or
identically income) “Y” is unconstrained, then
its equilibrium value will be determined solely
by the right-hand side of the equation. That
is, income will be wholly demand-determined.
• The following models of national income
determination will focus solely on demand.
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National Income Determination
• In this model, then, AD = C+I+G+(X-M).
• As it is assumed (for now) that (X-M) = O,
• AD=C+I+G. Therefore, in equilibrium
Y = C+I+G
• Our objective is to find the equilibrium value of
income, “Ye”, that will satisfy our the equilibrium
condition; i.e., Ye solves
Ye = C+I+G
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How to proceed
• To solve this, we must make some
assumptions about the functional forms of the
right hand variables C, I, G. Indeed, the only
differences between the simplest model and
other, more complicated models are in
• (i) the inclusion of a foreign sector, and
• (ii) the assumptions we make about these
functional forms.
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Simplest Model 1
In the simplest model we will use, we make the following
assumptions regarding functional forms:
• C is positive - and a positive function of income;
• I is positive - but independent of income, because firm’s
investment decisions depend upon other factors (like
profit levels)
• G is positive - but independent of income.
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Consumption demand
• Households allocate their income between
CONSUMPTION and SAVING
• Personal Disposable Income
– income that households have for spending or
saving
– income from their supply of factor services (plus
transfers less taxes)
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Consumption and income in the UK
at constant 1995 prices, 1989-1998
Household consumtpion
expenditure (£bn.)
500
475
450
425
400
375
350
400
425
450
475
500
525
550
Real disposable income (£bn.)
Income is a strong influence on consumption
expenditure – but not the only one.
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The consumption function
The consumption function shows desired aggregate
consumption at each level of aggregate income
With zero income,
C = 8 + 0.7 Y desired consumption
is 8 (“autonomous
consumption”).
8
{
0
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The marginal propensity
to consume (the slope of
the function) is 0.7 – i.e.
for each additional £1 of
income, 70p is consumed.
Income
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The saving function
The saving function shows
desired saving at each
income level.
S = -8 + 0.3 Y
0
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Income
Since all income is either
saved or spent on
consumption, the saving
function can be derived
from the consumption
function or vice versa.
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The aggregate demand schedule
AD = C + I
I
C
Aggregate demand is
what households plan
to spend on consumption
and what firms plan to
spend on investment.
The AD function is
the vertical addition
of C and I.
(For now I is assumed
autonomous.)
Income
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Equilibrium output
45o
E
o line shows the
The
45
line
points at which desired
spending equals output
AD or income.
Given the AD schedule,
equilibrium is thus at E.
Output, Income
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This the point at which
planned spending equals
actual output and income.
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Simplest Model 1: Example 1
Suppose:
C = 400 + 0.75Y
I = 600
G = 1,000
Then by definition:
AD = 2,000 + 0.75Y
And, in equilibrium:
Ye = 2,000 + 0.75Ye
which solves as
(1 - 0.75)Ye = 2,000 or Ye = [1/(1 - 0.75] x 2,000
or Ye = 4 x 2,000 = 8,000
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Simplest Model 1: Example 1 cont.
AD=C+I+G=2000+.75Y
AD
D
C+I=1000+.75Y
C=400+.75Y
Y
• It is common to illustrate such simple examples with diagrams, with
(the components of) aggregate demand graphed as a function of Y:
• As the equilibrium is where Y = AD, it must lie somewhere along a
45 degree line on the diagram.
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Simplest Model 1: Example 1 cont.
• Graphically:
AD=C+I+G=2000+.75Y
ADD
C+I=1000+.75Y
C=400+.75Y
Y
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The Expenditure Multiplier
• In the previous example, the slope of the AD curve is 0.75, (the
mpc). More generally, as the diagram demonstrates, the slope
of AD has important consequences for the (relatively large)
change in Ye resulting from any (relatively small) change in C, I
or, most importantly, G.
AD’ (if G increases)
AD
Increase in Y
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The Expenditure Multiplier
•
Suppose in the previous example that the government decides to increase its
spending from G = 1,000 to G1 = 1,100 (an increase of 100).
Mathematically, AD1 = 2,100 + 0.75Y.
•
•
The new equilibrium condition is Y1e = 2,100 + 0.75Y1e which solves for
Y1e = 8,400, an increase of 400.
•
Thus a 100 increase in G has lead to a 400 increase in Ye . This is what is
known as the multiplier effect.
•
The expenditure multiplier is the amount by which equilibrium output will
change relative to the amount by which autonomous spending changes.
•
In the previous example, the expenditure multiplier equals 4.
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• Recall that we solved for Ye = [1/(1 - 0.75)] x 2,000.
More generally, this can be written
• Ye = [1/(1 - mpc)] x expenditure.
• The change in equilibrium income will equal [1/(1 mpc)] times the change in expenditure. Therefore, in
the simplest model [1/1-mpc)] is the expenditure
multiplier. In this example it equals 1/(1-.75)] or 4.
• The expenditure multiplier can be written in different
ways, and will become a more complicated term as
the model becomes more complex.
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Comments
• The increase in output that resulted from the
increase in government expenditure would seem
to suggest that the government can induce the
economy to grow - or grow more than it
otherwise would - simply by increasing its
expenditure. However, this result is a function of
the naive model we are now employing. As the
model becomes more complicated, this result
becomes more dubious.
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An alternative approach
S
An equivalent view of
equilibrium is seen by
equating
planned investment (I)
E
I
Output, Income
to planned saving (S)
again giving us
equilibrium at E
The two approaches are equivalent.
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Questions You Should Be Asking Yourself
are:
• According to the model, there are no constraints on
supply. What happens when such constraints exist?
• If supply constraints exist, there is an “opportunity
cost” associated with government expenditure. In
particular, the resources used by the government
could instead be used by private businesses for
capital investment. What are the associated
implications?
• What, exactly, is the nature of government
expenditure? Does it matter if the government builds
roads or missiles? (The term “G” doesn’t make such
a distinction.)
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Questions You Should Be Asking
Yourself are:
• What are the side-effects of increased
government expenditure? What happens, for
example, to interest rates and inflation?
• How does the government pay for the
additional expenditure? (Indeed, how is it
financing G?). What happens as a result?
• Can the increased expenditure and output
(and jobs!) last forever, or will the economy
eventually suffer an economic hangover?
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Model 2: Income Taxes
• Let us now suppose that the government is financing itself
through income taxes. The tax scheme it has adopted is
T = 100 + 0.20Y
• In words, this means that the government is collecting 100 from
everyone (a kind of “poll tax”) plus 20 percent of everything
earned by households.
• As this new tax applies only to households, we need to change
the consumption function to solve for the new equilibrium. We
must also, however, change our interpretation of the
consumption function Consumption is now written as a function
of disposable income “Yd”, where Yd is simply gross income
less income taxes.
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Model 2: Income Taxes
Now,
C = 400 + 0.75Yd = 400 + 0.75 (Y - (100 + 0.20Y ))
or C = 325 + 0.6Y
I = 600 (as before)
G = 1,000 (as before)
(*In this example, the mpc out of disposable income is still
0.75. And a new term, the marginal propensity to tax
“mpt” is 0.20.)
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Then by definition:
AD = 1,925 + 0.60Y
And, in equilibrium:
Ye = 1,925 + 0.60Ye
which solves as
Ye = [1/(1 - 0.60)] x 1,925
or Ye = 2.50 x 1,925 = 4,812.5
(The expenditure multiplier is thus 2.50).
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Model 2 cont.
• Comparing the equilibrium values in the two previous
examples is not really useful, since the problems are
entirely different. (In particular, the government’s budget
deficit has shrunk) However, it is useful to look again at
the expenditure multiplier.
• From the equations above, the new expenditure multiplier
is 2.50. If you work backwards through the algebra,
you’ll find that in this slightly more complicated model,
E=multiplier = [1/(1-mpc (1-mpt))]
(to verify, [1/(1-0.75 (1.0-.20))] = [1/(1-0.60)] = 1/0.40 =
2.50)
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• If you were to work through a diagrammatic
analysis once again, you would get the
anticipated result: an upward-sloping AD
curve with slope equal to 0.60.
• Question: Why, intuitively, does an income tax
reduce the expenditure multiplier and, in this
model, the government’s ability to boost
equilibrium output?
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Deflationary & Inflationary Gaps
• It is possible that the equilibrium output level
Ye is less than the full employment output
level “Yf “ meaning there are unused
resources (i.e. unemployment). In the simple
model, this happens if aggregate demand is
too low. Keynes called this a “deflationary
gap”. The converse can also happen, and is
called an “inflationary gap”.
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Deflationary & Inflationary Gaps
Deflationary Gap
Deflationary Gap
Y
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Yf
Inflationary Gap
Inflationary Gap
Yf
Y
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Deflationary & Inflationary Gaps
• As Keynes was writing during the Depression, he
lived in a time of a “deflationary gap”. His proposed
solution was for the government to take action to
increase aggregate demand. Specifically, he urged
government to spend more (i.e. increase “G”) to
make up for insufficient private demand.
• At a most general level, the “Keynesian” remedy to
unemployment is for the government to spend more
money on public works projects like bridge and road
construction.
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