RealApplic SL

8/13/2019 RealApplic SL

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2 Fiscal Policy

Goals:

Practice how the model works. Determine the e¤ects of government spending. Learn about the di¤erence between temporary andpermanent shocks.

Understand how expectations a¤ect current economicactivity.

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2.1 Temporary Increase in G

The experiment:

G " but G 0 stays unchanged. This must be …nanced to satisfy the government bud-get constraint.

Assume that T 0 " .

Important:

A policy experiment must specify an entire path of policy variables.

The path must satisfy the budget constraint. It does not make sense to ask: what are the e¤ectsof a change in G alone?

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2.1.1 E¤ect of G on Output Supply

Recall how Y s was derived:

G only a¤ects labor supply: G " ) N s " .

Y s curve shifts right.

The e¤ect should be small for a temporary G (smallchange in W ).

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2.1.2 E¤ect of G on Output Demand

Y d

= C d

+ I d

+ G .

No change in I d : …rm’s target K 0 stays the same.

C d # : income e¤ect due to lower W .

Most likely Y d " because the income e¤ect is small for atemporary G " .

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2.1.3 Equilibrium e¤ect of higher G

Unambiguously, Y " .

Likely: r " (because shift of Y s is small).

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2.1.4 Labor Market E¤ects of higher G

No change in N d

(MP N schedule).

Direct e¤ect on N s : positive (we already saw that).

Indirect e¤ect on N s : higher r ) higher N s (seeabove).

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2.1.5 Summary: E¤ects of G

Current period:

Output increases. Consumption and leisure fall ! utility loss for house-holds.

Investment falls.

Next period:

Taxes must rise to …nance higher government debt. K 0 is lower ! Y is lower.

Policy implication: Using …scal policy to pull an economyout of recession comes at a cost.

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2.2 Future Increase in G

Key point: Expectations of future shocks a¤ect today’sequilibrium.

Experiment: G 0 rises, …nanced by higher T 0.

2.2.1 Labor market

Labor supply: rises (for …xed w; r ) b/c of lower W . Labor demand: no change. Labor market clearing: N " and w #.

Employment

Real Wage N s

N d

w*

N*

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2.2.2 Goods market

Output supply: rises b/c of lower higher supply. C d falls b/c of lower W (not by much b/c changein G 0 is not permanent).

I d : no change in target capital stock. Output demand curve shifts left.

Y

r Y s

Y d

Total e¤ect: Y " ; r #.

This is not exactly right: I d will shift because …rms expecta change in w0 and therefore in N 0!

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2.3 Permanent Increase in G

Experiment: G and G0

increase by G . This is …nancedby T 0.

This is the "sum" of the previous two experiments.

Therefore, the total e¤ects are:

G G 0 G and G 0

N s " " ""N d

C d # # ##

I d

G " "Y d " # ?

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2.3.1 What happens to aggregate demand?

Direct e¤ect: G " .

Indirect e¤ect: C d # because of lower W .

Permanent income hypothesis suggests: C d should fallby the change in the present value of taxes.

Then: Y d curve una¤ected by …scal policy.

Surprise result: Permanent …scal stimulus raises GDPnot through aggregate demand, but through laborsupply!

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2.3.2 What happens to labor supply?

Direct e¤ect: Lower W increases N s

.

Indirect e¤ect: lower r reduces labor supply (higher W ).

How do we know labor supply does not fall overall?

If it did, output supply would decrease. This is not a circular argument. The shift of N s for…xed r is the shift in the Y s curve. The second shift(change in r ) is a movement along Y s .

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2.3.3 Summary: E¤ects of permanent G "

Goods market:

GDP rises due to higher supply. Interest rate falls ) I " ; C " (movement alongY d ).

Note: No crowding out, in contrast to temporaryG " .

Labor market:

Higher labor supply ) higher N and lower w .

Note: Doing more of the same (raise G for 2 periodsinstead of 1) does not simply magnify the e¤ects of G .

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3 Productivity Shocks

3.1 Temporary increase in z

Labor demand rises: higher MP N .

Labor supply: no direct e¤ect. w change is move alongthe N s curve.

Result: For …xed r , higher N and higher w . Y s curveshifts right.

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Indirect e¤ect on the labor market: r # shifts N s left.

But this e¤ect is empirically small, so that N rises.

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3.1.2 Business cycle implications

With productivity shocks: consumption, investment, em-ployment, wages, interest rates should be pro-cyclical.

This is true in the data.

This is the key idea of Real Business Cycle theory, whichwe study later.

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