QUICK REVIEW. PRICE LEVEL REAL GDP AD SRAS LRAS Qn Q1

QUICKQUICKREVIEWREVIEW

PRICE LEVEL

REAL GDP

AD

SRAS

LRAS

QnQ1

PRICE LEVEL

REAL GDP

AD

SRASLRAS

Qn

Price Level

NaturalReal GDP

SRAS

0

AD

QN

LRAS

Long-runequilibrium

Short-runequilibrium

Answer the following:Answer the following:

What is Say’s law? What three things must be flexible in the

Classical model? What is the Classical solution for too much

unemployment? How does the self-regulating economy get

out of a recessionary gap?

Self-Regulating Economy Self-Regulating Economy Self-Regulating Economy Self-Regulating Economy

KEYNESIAN ECONOMICSKEYNESIAN ECONOMICS

J. M. Keynes wrote during the Great Depression

Keynes focused on the demand side of the economy

Keynes did not believe that the economy was necessarily self-correcting

KEYNES ON WAGES AND PRICESKEYNES ON WAGES AND PRICES

Keynes believed that wages and prices were STICKY DOWNWARD

The lack of wage and price flexibility suggested that the economy might get STUCK in a recessionary gap.

Keynes tended to focus on the short run because

“IN THE LONG RUN WE ARE ALL DEAD”

KEYNES AND INCOMEKEYNES AND INCOME

Keynes focused his analysis on Total Expenditures in the economy

In particular, he focused on Consumption CONSUMPTION is a function of

DISPOSABLE INCOME SAVING is also determined by

DISPOSABLE INCOME

CONSUMPTION AND CONSUMPTION AND SAVING TERMSSAVING TERMS

Autonomous Consumption - the portion of consumption that is not related to income (it is the amount of Cons. when income is 0).

MPC - marginal propensity to consume (it is change in C / change in Y)

MPS - marginal propensity to save (it is the change in saving / change in Y)

CONSUMPTION AND CONSUMPTION AND SAVING TERMSSAVING TERMS

Break-even income - the level of disposable income where consumption spending is just equal to disposable income.

C = Yd

S must be zero

EQUATION FOR C AND SEQUATION FOR C AND S

C = a + b(Yd) Consumption = autonomous consumption +

the MPC * (disposable income)

S = -a + (1-b)(Yd) Saving = negative autonomous

consumption + MPS * ( disposable income)

EXAMPLEEXAMPLE

C = 100 + .75 (Yd) Find Aut. Cons., MPC, MPS, and C and S

when Yd=1000. Aut. Cons. = 100 MPC = .75 MPS = .25 C = 100 + .75 (1000) = 100 + 750 = 850

CONSUMPTION FUNCTIONCONSUMPTION FUNCTION

INCOME CONS. SAVING0 100 -100100 180 -80200 260 -60300 340 -40500 500 0600 580 20

Find MPC Find MPS Find Autonomous Consumption Give the equation for consumption Give the equation for saving Find breakeven income Find C and S when income is 700

CONSUMPTION FUNCTIONCONSUMPTION FUNCTION

A change in Disposable Income causes a MOVEMENT ALONG the Consumption Function

A change in Autonomous Consumption causes a SHIFT of the Consumption Function

SAVINGSAVING

SAVING is the unspent portion of a consumer’s income.

SAVING = Income - Consumption Exp.

INVESTMENTINVESTMENT2 components2 components

Capital goods (producer durables) - goods used by businesses to produce other goods and services. They have an expected service life of more than one year.

Inventory investment - changes in the stocks of finished goods, goods in process, and in raw materials a firm keeps on hand.

TOTAL EXPENDITURESTOTAL EXPENDITURES

Total Expenditures = C + I + G + (X-M) C depends on Disp. Y S depends on Disp. Y Disp. Y = C + S I depends on the interest rate ( not Y ) G is assumed to be autonomous

EQUILIBRIUMEQUILIBRIUM

TOTAL EXPENDITURES are equal to TOTAL PRODUCTION is equal to INCOME

DISEQUILIBRIUMDISEQUILIBRIUMTOTAL OUTPUT < TOTAL EXPENDITURESTOTAL OUTPUT < TOTAL EXPENDITURES

unplanned inventories production employment Real GDP income

DISEQUILIBRIUMDISEQUILIBRIUMTOTAL OUTPUT > TOTAL EXPENDITURESTOTAL OUTPUT > TOTAL EXPENDITURES

unplanned inventories production employment Real GDP income

C = 200 + .80(Yd)C = 200 + .80(Yd)I = 300I = 300

Find Autonomous Cons., MPC, and MPS Find breakeven income Find equilibrium income In Qn=3000, identify the following: type of

gap, size.

THE MULTIPLIERTHE MULTIPLIER

A dollar injected into the economy (i.e. investment) has an impact beyond the initial expenditures. The dollar continues to be spent multiplying its impact on the economy. The number of times it circulates through the economy is known as THE MULTIPLIER.

THE MULTIPLIER cont.THE MULTIPLIER cont.

The rate of circulation is related to the MPC and MPS. The larger the MPC, the more consumption rises as a result of an increase in income. This will result in a larger MULTIPLIER.

Autonomous Government Autonomous Government Spending & the Multiplier Spending & the Multiplier

Exhibit 12Exhibit 12

Autonomous Government Autonomous Government Spending & the Multiplier Spending & the Multiplier

Exhibit 12Exhibit 12(1)EXPENDITUREROUND

(2)CHANGE INAUTONOMOUSGOVERNMENTSPENDING

(3)CHANGE IN REALNATIONAL INCOMEOR REAL GDP($ millions)

(4)MPC

(5)CHANGE INCONSUMPTION($ millions)

Round 1

Round 2

Round 3

Round 4

$60.00 $ 60.00

48.00

38.40

30.72

.80

.80

.80

.80

$ 48.00

38.40

30.72

24.57........

.

.

.

.

..

.

.

..

.

.

.

.

.

.

.

.

.

.

..

.

.

All other 122.88 .80 98.88

TOTAL $300.00 $240.00(Approx.

THE FORMULATHE FORMULA

MULTIPLIER = 1 or 1

1 - MPC MPS

EXPANSIONARY FISCAL EXPANSIONARY FISCAL POLICYPOLICY

TO ADDRESS A RECESSIONARY GAPTO ADDRESS A RECESSIONARY GAP

policy aimed at increasing economic activity through increasing G &/or

decreasing T to increase AD or increase SRAS

CONTRACTIONARY FISCAL CONTRACTIONARY FISCAL POLICYPOLICY

TO ADDRESS AN INFLATIONARY GAPTO ADDRESS AN INFLATIONARY GAP

policy aimed at decreasing economic activity through decreasing G &/or

increasing T to decrease AD or decrease SRAS

Fiscal Policy in Keynesian Theory: Ridding the Fiscal Policy in Keynesian Theory: Ridding the Economy of Recessionary Gaps Economy of Recessionary Gaps

Fiscal Policy in Keynesian Theory: Ridding the Fiscal Policy in Keynesian Theory: Ridding the Economy of Inflationary Gaps Economy of Inflationary Gaps

Exhibit 2 (2 of 2)Exhibit 2 (2 of 2)

THE MULTIPLIER EFFECTTHE MULTIPLIER EFFECT

both G and T are subject to the multiplier effect SO a change in

either will lead to an even greater change in equilibrium real output

(which is equilibrium Y)

THE EXPENDITURE THE EXPENDITURE MULTIPLIERMULTIPLIER

1 / 1- MPC or 1 / MPS Change in Real GDP =

multiplier x (change in G)

COMMON MULTIPLIERSCOMMON MULTIPLIERS

MPC .9 .8 .75 .66 .5

EXPMULT

10 5 4 3 2

EXAMPLEEXAMPLE

Qe = 800 while Qn = 1000 MPC = .75 find the G necessary to bring the economy

to natural real GDP

THE TAX MULTIPLIERTHE TAX MULTIPLIER

- MPC / MPS or ( 1 - exp. mult.) Change in Real GDP

= tax multiplier x (change in T)

EXAMPLEEXAMPLE

Qe = 1200 while Qn = 800 MPC = .66 find the T necessary to bring the economy

to full employment GDP

BALANCED BUDGET BALANCED BUDGET MULTIPLIERMULTIPLIER

if both G & T increase (or decrease) by the same amount, then equilibrium real GDP will increase by the amount

of the increase (or decrease) in G

C = 200 + .80(Yd)C = 200 + .80(Yd)I = 300I = 300

Find equilibrium income

In Qn=3000, identify the following: type of gap, size, fiscal policy options to close it.

Should Fiscal Policy be Used?Should Fiscal Policy be Used?

NOT NECESSARILY

Crowding Out Lags

CROWDING OUTCROWDING OUT

increases in G may lead to decreases in private sector spending ( C or I )

CROWDING OUT CROWDING OUT may occur due to:may occur due to:

direct substitution more on public libraries fewer books at bookstores

interest rate effects more on social programs and defense budget

deficit increases government’s demand for credit rises interest rate rises investment drops

Lags and Discretionary Fiscal Lags and Discretionary Fiscal PolicyPolicy

The data lag: not aware of changes in the economy as soon as they happened

The wait-and-see lag: adopt a more cautious attitude

The legislative lag The transmission lag: take time to be put into

effect The effectiveness lag: take time to affect the

economy

KEYNESIAN PERSPECTIVEKEYNESIAN PERSPECTIVE

fiscal policy is effective crowding out is relatively small lags are short

CLASSICAL PERSPECTIVECLASSICAL PERSPECTIVE

fiscal policy is ineffective crowding out is significant lags are long

FISCAL POLICYFISCAL POLICY

Discretionary Fiscal Policy

DISCRETIONARY FISCAL DISCRETIONARY FISCAL POLICYPOLICY

deliberate changes in G and/or T to achieve particular objectives

requires new action by Congress

FISCAL POLICYFISCAL POLICY

Discretionary Fiscal Policy Automatic Stabilizers

AUTOMATIC STABILIZERSAUTOMATIC STABILIZERS

changes in G and/or T that occur automatically as economic conditions change

these changes do not require new action by Congress

Four Types of Fiscal Policy Four Types of Fiscal Policy

Automatic

Discretionary

Expansionary Contractionary

Policy Makers Gor Tor both

Policy Makers Gor or both

UnemploymentCompensation

Welfare Payments

UnemploymentCompensation

Welfare Payments

(1) (2)

(3) (4)

The New Classical View Of The New Classical View Of Fiscal PolicyFiscal Policy

crowding out does occur as people save more in anticipation of higher taxes

these adjustments cause expansionary fiscal policy to be ineffective.

SUPPLY SIDE POLICYSUPPLY SIDE POLICY

dislike demand side policies because increases in AD means growth comes with higher prices

prefer to focus on tax issues which alter incentives to work, save, and invest

What Are the Major Federal What Are the Major Federal Taxes?Taxes?

What Are the Major Federal What Are the Major Federal Taxes?Taxes?

Personal income tax Corporate income tax Social security tax

Exhibit 1Major Federal Taxes

SOURCE: Council of Economic Advisers, Economic Report of the President, 1999.

MARGINAL TAX RATEMARGINAL TAX RATE

tax rate applied to additional income change in tax payment divided by the

change in taxable income

Three Three Income Income

Tax Tax Structures Structures

Three Three Income Income

Tax Tax Structures Structures

MARGINAL TAX RATES AND MARGINAL TAX RATES AND FISCAL POLICYFISCAL POLICY

decreasing marginal tax rates leads to an increase in SRAS

b/c increases the incentive to work if the tax change is permanent, then the

change in AS is too the LRAS will shift to the right

Laffer Curve Laffer Curve

TX

Tax Rate (percent)

Tax Revenues

0

A

Laffer Curve

C

X

B

TZ TY

Y

Z

100

B to C: Tax rateand tax revenuesinversely related.

A to B: Tax rateand tax revenuesdirectly related.

What are the Major Federal What are the Major Federal Government Spending Government Spending

Programs?Programs?

What are the Major Federal What are the Major Federal Government Spending Government Spending

Programs?Programs?

National defense Income security Health Medicare Social security Net interest on the National Debt

Exhibit 3Major Federal Spending Programs

SOURCE: Council of Economic Advisers, Economic Report of the President, 1999.

DEBT AND DEFICITSDEBT AND DEFICITSDEBT AND DEFICITSDEBT AND DEFICITS

BUDGET DEFICITS occur when government expenditures exceed tax receipts

A BUDGET SURPLUS occurs when tax receipts exceed government expenditures

CYCLICAL DEFICITSCYCLICAL DEFICITSCYCLICAL DEFICITSCYCLICAL DEFICITS The portion of the deficit that is a result of

an economic downturn many economists (Keynes) believe that

deficits are natural and necessary during recessions because tax revenues fall and benefit payments rise

Our problem is that we have continued to run deficits in expansionary periods

STRUCTURAL STRUCTURAL DEFICITSDEFICITS

The structural deficit is the portion of a budget deficit which exists when the economy is operating at full employment

Total Budget Deficit = structural deficit + cyclical deficit

National DebtNational Debt NATIONAL DEBT is the total sum of what

the federal government owes its creditors (the sum of past deficits)

Exhibit 5 Public Debt for 1987–1999

The 1999 amount is for November 1999.

SOURCE: Bureau of the Public Debt.

NATIONAL DEBTNATIONAL DEBTNATIONAL DEBTNATIONAL DEBT

As the debt grows, interest on the debt grows in its share of the budget.

The portion of the budget that can be cut in order to balance the budget is SHRINKING

PORTION OF THE BUDGET PORTION OF THE BUDGET THAT IS CONSIDERED THAT IS CONSIDERED

UNTOUCHABLEUNTOUCHABLE

PORTION OF THE BUDGET PORTION OF THE BUDGET THAT IS CONSIDERED THAT IS CONSIDERED

UNTOUCHABLEUNTOUCHABLE

Interest on the Debt 14% Social Security 22% untouchable total 36% National Defense 20% Total 56%

WHO BEARS THE BURDEN WHO BEARS THE BURDEN OF THE DEBT?OF THE DEBT?

WHO BEARS THE BURDEN WHO BEARS THE BURDEN OF THE DEBT?OF THE DEBT?

CURRENT GENERATION - if crowding out occurs then households are giving up consumption to pay for increases government spending

FUTURE GENERATIONS - will have to pay higher taxes to pay off the bonds when they come due. They bear the cost while the bondholders receive the payoffs.

COUNTERPOINTCOUNTERPOINTCOUNTERPOINTCOUNTERPOINT

WE-OWE-IT-TO -OURSELVES - if American taxpayers make payments to American bondholders, money is simply shifted from one pocket to another.

Only works if debt is held domestically (currently 14-18% is held by foreigners)