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Government Holmes Econ 10

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Changes A government exists –Taxes –Spending –Monetary Policy Consumers pay taxes

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Definitions G: Government purchases of goods and services Examples: Aircraft carriers, national parks, USPS wages (Stuff that would be I if gov’t was a firm) T: Net taxes = taxes- transfers Transfers: income redistribution, entitlements Example: social security, AFDC, food stamps, Medicaid Compare and contrast the two accounts. Rule of thumb: if the gov’t gets something back, then it is G.

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T Note how we compute T: taxes - transfers Thus, suppose we increase taxes by $50: T increases $50. Suppose we increase AFDC by $30: T decreases $30 T= taxes - transfers = = -30 Suppose we increase taxes on diamonds by $50 and increase AFDC payments $50. T is not affected. ( T = = 0). Get familiar with these operations; they are tricky but important.

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T/ Y Income tax revenues increase Bigger houses--> more property taxes Sales taxes Excise taxes Luxury taxes SS taxes Unemployment falls --> Unemp. Ins falls AFDC falls Fewer qualify for Medicaid Food stamps fall If Y goes up, then….. Thus, T/ Y > 0. We call T/ Y the tax rate. Thus, taxes >0 and transfers taxes - transfers >0

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Disposable Income Given your income (your paycheck), do you get to decide between C and S for every dollar? You get to spend your NET income, what you get after taxes. Same for the economy as a whole. Y D =Y-T = gross income - net taxes = disposable income Thus, we need a new MPC: C/ Y D

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Aside Why do we lump taxes and transfers together? On a 1040 tax return, there are various tax credits. For example, this year parents get a $400 credit for children. This is a tax reduction, but can also be viewed as a transfer. Suppose you get $100 a month from Social Security but pay $150 in SS taxes. Does that mean that you are only paying $50 in SS taxes or does it mean you pay $150 but get $100? The two views are hard to distinguish, so we lump them together. This is probably how must people behave anyway.

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Check Suppose the government increases the social security benefit. What account is affected? Which way? Suppose HCFA (Medicare) hires a new economist. What account? Suppose government increases the pension for armed services retirees. What account?

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Computing MPS Suppose you are given C/ Y D. Can you compute the MPS directly? A: no. We must convert to C/ Y. How to do? Suppose C/ Y D =.6, T/ Y=.3 Y T YDYD C Pick a number for Y (100) *.3 = = *.6 = 42 So C/ Y= 42/100 =.42 (Recall Y D =Y-T)

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Getting the multiplier... C/ Y =.42. Suppose I/ Y=.33. Proceed just as before =.75 ==> mult=4 Note: if you ever get a multiplier of , then you probably did something wrong. I’ll give you “nice” ones.

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Investment The last wrinkle in this model. Suppose you are thinking about buying a car. What are some important considerations? Yeah, those are good, but what about your choice between “You have done well in Econ 10. Your reward is an interest -free loan to buy a car.” “My name is LegBreaker Malone. I charge 20 percent interest.” Which would you prefer?

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The interest rate r We’ll assume there is one interest rate r for all transactions. Suppose you are GM trying to decide whether to build a new Saturn plant. (What account would that be?) Do you pay cash for such a transaction? No. Most firms issue bonds (equivalent to taking a loan). How does r affect their decision to invest? If r is high, then investing is more expensive. Will firms be more or less likely to invest as r increases? A: less I/ r < 0

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A story You are trying to decide whether to buy a new pizza oven for your pizzeria, and you know the oven will increase your revenue by $250 a month. The oven will last 4 years, the length of time you have to repay the loan. If the oven costs $10,000 then your payments would be... At 7 percent, you would probably do it. At 11 percent, you wouldn’t.

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Check Suppose C/ Y D =. 5, T/ Y=.4, and I/ Y =.2. Find the multiplier. Why does I/ r have the sign it does? Tell a story.

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The new model

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Multiplier Why?

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The flow chart Multiplier YY CC II SS -( S A )= C A IAIA DADA YDYD SATSAT CATCAT YDTYDT TATA IArIAr GAGA rArA TT Does this part look familiar?

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Other points Multiplier YY CC II SS -( S A )= C A IAIA DADA YDYD SATSAT CATCAT YDTYDT TATA IArIAr GAGA rArA TT Why is there no G on this side? What’s the relationship here? T A = - Y D T Autonomous Induced Note the three C’s.

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Sample Problem Suppose C/ Y D =.6, T/ Y=.2, I/ Y =.32, I/ r= Suppose C A =10, G A =20, T A =30, r = 2. Compute Multiplier, total Y, total C, S, I, T Step one: C/ Y. Y T YDYD C *.2 = = *.6 = 48 C/ Y=.48

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Step Two: Multiplier D/ Y = C/ Y + I/ Y + G/ Y = =.8 D A =20 Y=100 Y/ D A =5 1/(1-MPS) =1/(1-.8) =1/.2 =1/(1/5) =5

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Step Three: Run the Model Multiplier YY CC II SS -( S A )= C A IAIA DADA YDYD SATSAT CATCAT YDTYDT TATA IArIAr GAGA rArA TT Suppose C/ Y D =.6, T/ Y=.2, I/ Y =.32, I/ r= Suppose C A =10, G A =20, T A =30, r = 2. -(-10) *.6 = = *.2 = *

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Totals Multiplier YY CC II SS -( S A )= C A IAIA DADA YDYD SATSAT CATCAT YDTYDT TATA IArIAr GAGA rArA TT -(-10) *.6 = = *.2 = *

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Another Suppose C/ Y D =.7, T/ Y=.3, I/ Y =.26, I/ r= Suppose we want to balance the budget. G=100, T=100 C/ Y =.49 Multiplier = 4

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Flow chart Multiplier YY CC II SS -( S A )= C A IAIA DADA YDYD SATSAT CATCAT YDTYDT TATA IArIAr GAGA rArA TT Deficit falls by 36? I thought we balanced it!

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What happened? Some of the tax hike came out of savings… Thus, overall D increased. This - via the multiplier - created an increase in tax revenue.

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Interest Rate How does the interest rate change? Alan Greenspan is the chair of the Federal Reserve. The Fed is the bank of banks, or lender of last resort. If Nationsbank needs cash, they call Alan up and get a loan. What interest rate? Federal Funds Rate. Suppose Federal Funds rate goes up. What happens to r?r?

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The Fed The Fed has a two main functions: bank of banks monetary policy We’re focusing more on the second right now. By controlling r (more to come), the Fed-and Greenspan-control the course of the economy. Many say Greenspan is the second most powerful man in America [trivia: he is married to Andrea Mitchell, dated Baba Wawa, and was one of the programmers most to blame for Y2K]. I say maybe higher. The Fed wants to limit inflation and keep the economy stable.

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Another scenario Suppose Greenspan sees that C= -60. What could he do to keep Y=0? Suppose C/ Y D =.7, T/ Y=.3, I/ Y =.26, I/ r= Greenspan’s tool here is the interest rate. Answer: r = -2

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One (well, two) for the road Suppose C/ Y D =.8 T/ Y=.25 I/ Y =.15 I/ r= You have a 100 budget surplus. Suppose you can either cut taxes 100, raise transfers 100, or increase spending 100. Which has the bigger impact on Y? 2. Suppose Congress increases G by 100 and autonomous C is up 50. Suppose Greenspan raises r by 5. What is the effect on the deficit?

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