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Fiscal policy

Fiscal policy






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    Fiscal policy Fiscal policy Presentation Transcript

    • GT01003Macroeconomics
    • Learning Objectives1. Identify the key assumptions of the basic Keynesianmodel2. Explain how to develop a model of Planned AggregateExpenditure (PAE)3. Analyze how an economy reaches short-runequilibrium in the basic Keynesian model Do the analysis with both numbers and graphs
    • Learning Objectives4. Show how a change in planned aggregate expenditurecan cause a change in the short-run equilibriumoutput Explain how this is related to the income-expendituremodel5. Explain why the basic Keynesian model suggests thatfiscal policy is useful
    • John Maynard Keynes (1883 –1946) The idea that a decline in aggregatespending may cause output to fallbelow potential output was one of thekey insights of John Maynard Keynes. The goal of this lecture is to present atheory/model of how recession andexpansion may arise fromfluctuations in planned aggregateexpenditure or total plannedspending.
    • Keynesian Model Building block for current theories of short-run economicfluctuations and stabilization policies In the short run, firms meet demand at preset prices Firms typically set a price and meet the demand at that pricein the short run Menu price is the cost of changing prices Determining the new price Incorporating prices into the business Informing consumers of new prices Firms change prices when the marginal benefits exceed themarginal costsKeyAssumption
    • Keynesian ModelWill new technologies make the Keynesian theory lessrelevant to the real world?? Technology has reduced menu costs Bar codes and scanners reduce costs of changing prices in the store Online surveys Highly segmented airline pricing Internet mechanisms for setting price eBay ■ Priceline Other costs remain Competitive analysis ■ Deciding the new prices Informing consumers
    • New Technologies
    • New Technologies
    • New Technologies
    • Planned Aggregate Expenditure (PAE) Planned aggregate expenditure is planned spending onfinal goods and services Four components of planned aggregate expenditure Consumption (C) by households Investment (I) is planned spending by domestic firmson new capital goods Government purchases (G) are made by federal stateand local governments Net exports (NX) is exports minus imports
    • Planned Aggregate Expenditure (PAE) Actual spending equals planned spending for Consumption Government purchases of final goods and services Net exports Adjustments between actual and planned spendingare accomplished with changes in inventories The general equation for planned aggregateexpenditures isPAE = C + IP + G + NX
    • Develop a Model of PAE:Consumption Expenditures Consumption (C) accounts for two-thirds of totalspending Powerful determinant of planned aggregate spending Includes purchases of goods, services, and consumerdurables, but not houses Rent is considered a service C depends on disposable income, (Y – T)
    • Consumption, 1960 - 2007
    • Develop a Model of PAE:Consumption Function The consumption function is an equation relatingplanned consumption to its determinants, notablydisposable income (Y – T)C = C + (mpc) (Y – T)where C is autonomous consumption spendingmpc is the change in consumption for a givenchange in (Y – T) Autonomous consumption is spending not related to thelevel of disposable income A change in C shifts the consumption function
    • Develop a Model of PAE:Consumption FunctionC = C + (mpc) (Y – T) The wealth effect is the tendency of changes in assetprices to affect households wealth and thisconsumption spending This effect is included in C C also captures the effects of interest rates onconsumption Higher rates increase the cost of using credit to purchaseconsumer durables and other items
    • Develop a Model of PAE:Consumption FunctionC = C + (mpc) (Y – T) Marginal propensity to consume (mpc) is theincrease in consumption spending when disposableincome increases by $1 mpc is between 0 and 1 for the economy If households receive an extra $1 in income, they spendpart (mpc) and save part (Y – T) is disposable income Output plus government transfers minus taxes Main determinant of consumption spending
    • Develop a Model of PAE:Consumption FunctionDisposable income (Y – T)Consumptionspending(C)CC = C + (mpc) (Y – T)Δ (Y – T)Δ CCInterceptSlope = Δ C / Δ (Y – T)slope
    • Planned Aggregate Expenditure(PAE) Two dynamic patterns in the economy1. Declines in production lead to reduced spending2. Reductions in spending lead to declines in productionand income Consumption is the largest component of PAE Consumption depends on output, Y PAE depends on Y
    • Planned Spending ExamplePAE = C + IP + G + NXC = C + mpc (Y – T)PAE = C + mpc (Y – T) + IP + G + NX Suppose that planned spending components have thefollowing valuesPAE = 620 + 0.8 (Y – 250) + 220 + 330 + 20PAE = 960 + 0.8 YC = 620 mpc = 0.8 T = 250IP = 220 G = 330 NX = 20
    • Planned Spending ExampleC = 620 + 0.8 (Y – 250)PAE = 960 + 0.8 Y If Y increases by $1, C will increase by $0.80 PAE increases by 80 cents Planned aggregate expenditure has two parts Autonomous expenditure, the part of spending thatis independent of output $960 in our example Induced expenditure, the part of spending thatdepends on output (Y) 0.8 Y in our example
    • Planned Expenditure GraphOutput (Y)Plannedaggregateexpenditure(PAE)960PAE = 960 + 0.8YSlope = 0.84,800
    • Short-Run Equilibrium Short-run equilibrium is the level of output at whichplanned spending is equal to output No change in output as long as prices are constant Our equilibrium condition can be writtenY = PAE Using our previous example, PAE = 960 + 0.8 YY = 960 + 0.8 Y0.2 Y = 960Y = $4,800
    • Short-Run Equilibrium SearchOutput (Y) PAE = 960 + 0.8 Y Y – PAE Y = PAE?4,000 4,160 –160 No4,200 4,320 –120 No4,400 4,480 –80 No4,600 4,640 –40 No4,800 4,800 0 Yes5,000 4,960 40 No5,200 5,120 80 No Only when Y = 4,800 does planned spending equaloutput
    • Short-Run Equilibrium GraphOutput (Y)Plannedaggregateexpenditure(PAE)960PAE = 960 + 0.8Y45oY = PAE4,800Slope = 0.8
    • Output Greater than Equilibrium Suppose output reaches5,000 Planned spending isless than total output Unplanned inventoryincreases Businesses slow downproduction Output goes downPAEOutput (Y)960PAE = 960 +0.8Y45oY = PAE4,800 5,000
    • Output Less than Equilibrium Suppose output is only4,500 Planned spending ismore than totaloutput Unplanned inventorydecreases Businesses speed upproduction Output goes upPAEOutput (Y)960PAE = 960 +0.8YY = PAE4,8004,700
    • Planned Spending andthe Output GapOutput YPlannedaggregateexpenditure(PAE)960EPAE = 960 + 0.8Y45oY = PAE4,800Y*Recessionary gapPAE = 950 + 0.8Y950F4,750
    • Planned Spending andthe Output Gap Autonomous consumption, C, decreases by 10 Causes a downward shift in the planned aggregateexpenditures curve The economy eventually adjusts to a new lower level ofequilibrium spending an output, $4,750 Suppose that the original equilibriumlevel, $4,800, represented potential output, Y* A recessionary gap develops Size of the recessionary gap is 4,800 – 4,750 = $50 Entire decrease is in Consumption spending Same process applies to a decrease in IP, G, or NX–
    • Planned Spending andthe Output Gap Japanese recession in 1990s reduced Japanese imports East Asian economies developed by promotingexports The decrease in exports to Japan decreased plannedaggregate expenditures in these countries The decrease in planned spending caused the economiesto contract to a new, lower level of planned spending andoutput Japan exported its recession to its neighbors US recessions have similar effects on its major tradingpartners
    • Planned Spending andthe Output Gap: US Recession 2001 Robust investment spending, 1995 – 2000 High growth economy New technologies: internet, fiber optics, geneticengineering Not as promising as anticipated Recession caused by a decline in autonomousspending Less investment in 2001 Terrorist attack 9/11 Travel spending decreased Recovery began 2002
    • Income-Expenditure Multiplier The income – expenditure multiplier shows the effectof a one-unit increase in autonomous expenditure onshort-run equilibrium output Previous example Initial planned expenditure = 960 + 0.8 Y New planned expenditure = 950 + 0.8 Y Equilibrium changed from $4,800 to $4,750 A $10 change in autonomous expenditures caused a $50change in output Multiplier = 5 The larger mpc, the greater the multiplier
    • Stabilization Policy Stabilization policies are government actions toaffect planned spending with the intention ofeliminating output gaps Expansionary policies increase planned spending Contractionary policies decrease planned spending Two major stabilization tools are fiscal policy andmonetary policy Fiscal policy uses changes in governmentspending, transfers, or taxes Monetary policy uses changes in the money supply
    • Fiscal Policy and Recessions Government spending is part of planned spending Changes in government spending will directly affect plannedaggregate expenditures Suppose planned spending decreases $ 10 fromY = 960 + 0.8 Y toY = 950 + 0.8 Y Equilibrium Y decreases from $4,800 to $4,750 Recessionary gap is $50 Stabilization policy indicates a $10 increase in governmentspending will restore the economy to Y* at $4,800
    • How can the Government eliminatean Output Gap?Output YPlannedaggregateexpenditure(PAE)960PAE = 960 + 0.8Y45oY = PAEFPAE = 950 + 0.8Y9504,750E4,800Y*
    • Example: Japanese Spending In the 1990s Japan spent over $1 trillion on publicworks Highways, subways, and transportation projects Concert halls Re-laying cobblestone sidewalks
    • Taxes and Transfers Planned aggregate expenditures are affected by taxesand transfers The effect is indirect, channeled through the effects ondisposable income Lower taxes or higher transfers increase disposableincome Increases in disposable income lead to higher C
    • Fiscal Policy as a Stabilization Tool:Three Qualifications The use of fiscal policy to stabilize the economy ismore complicated than suggested by the basicKeynesian model. Three qualifications must be made to the use of fiscalpolicy as a stabilization tool.1. Fiscal policy may affect potential output as well aspotential spending2. Large and persistent government budget deficitsreduce national saving and growth3. The relative inflexibility of fiscal policy
    • Spending and Output in the ShortRunShort-Run Spending and OutputPlannedAggregateExpenditures(PAE)ConsumptionFunctionShort-RunEquilibriumChanges inEquilibriumOutput GapsMultiplierFiscal PolicyLimitationsKeynesian Model