© Stephen Hall, Imperial College LondonPage 1 Economic Environment Lecture 3 Joint Honours 2003/4 Professor Stephen Hall The Business School Imperial College.

© Stephen Hall, Imperial College LondonPage 3 The consumption function Income Consumption C = 8 + 0.7 Y The consumption function shows desired aggregate consumption at each level of aggregate income 0 With zero income, desired consumption is 8 (“autonomous consumption”).{ 8 The marginal propensity to consume (the slope of the function) is 0.7 – i.e. for each additional £1 of income, 70p is consumed.

© Stephen Hall, Imperial College LondonPage 4 The aggregate demand schedule Income Aggregate demand C Aggregate demand is what households plan to spend on consumption and what firms plan to spend on investment. AD = C + I I The AD function is the vertical addition of C and I. (For now I is assumed autonomous.)

© Stephen Hall, Imperial College LondonPage 5 Equilibrium output Output, Income Desired spending 45 o line The 45 o line shows the points at which desired spending equals output or income. AD Given the AD schedule, This the point at which planned spending equals actual output and income. equilibrium is thus at E. E

© Stephen Hall, Imperial College LondonPage 7 Introduction to Prices, Policy and Theoretical Issues The reason for the names given to the two dis- equilibrium conditions is that their existence is expected to lead to price decreases (i.e. deflation) or price increases (i.e. inflation), respectively. As we will see later, in a free market economy, prices (including the wage rate, which is the price of labour) are the main equilibrating mechanism, serving to match supply to demand. Therefore, when considering “dis- equilibrium” conditions, we need to address prices and price-adjustment mechanisms explicitly.

© Stephen Hall, Imperial College LondonPage 8 Keynes believed that prices - in particular, the wage rate - would not always respond correctly to market conditions. This is the basis for his call for government intervention. By contrast, “classical economists” (or now neo-classical economists) believe that prices do adjust to equate supply to demand and put markets in equilibrium. This is why they are also known as “equilibrium theorists”. (Included in this family are “monetarists”, whose beliefs and policy recommendations will be discussed later). In general, “equilibrium theorists” believe that government “meddling” in the economy only worsens the state of affairs. They believe that the best government policy - even in times of high unemployment - is to leave things to the market.

© Stephen Hall, Imperial College LondonPage 9 The way forward We now need to begin to make the simple model a little more realistic by thinking about; What determines investment A little more on consumption

© Stephen Hall, Imperial College LondonPage 10 n Investment spending includes: – fixed capital n Transport equipment n Machinery & other equipment n Dwellings n Other buildings n Intangibles – working capital n stocks (inventories) n work in progress n and is undertaken by private and public sectors

© Stephen Hall, Imperial College LondonPage 12 The demand for fixed investment Investment entails present sacrifice for future gains –firms incur costs in the short run –but reap gains in the long run Expected returns must outweigh the opportunity cost if a project is to be undertaken so at relatively high interest rates, less investment projects are viable.

© Stephen Hall, Imperial College LondonPage 13 The investment demand schedule … shows how much investment firms wish to undertake at each interest rate. Investment demand Interest rate II At relatively high interest rates, less investment projects are viable. At r 0, I 0 projects are viable. r0r0 I0I0 but if the interest rate rises to r 1, desired investment falls to I 1. r1r1 I1I1

© Stephen Hall, Imperial College LondonPage 14 The Accelerator Principle of Investment If the economy is growing at a constant rate Then firms will find a level of investment, I, compatible with that growth rate. However, if aggregate demand begins to increase at a faster rate because of, say, an increase in household consumption, then I must also increase. After all, firms must invest in extra machinery in order to produce the additional goods demanded by households.

© Stephen Hall, Imperial College LondonPage 15 But investment is itself a component of aggregate demand. Therefore, if investment increases, this will provide an additional boost to the economy, i.e. cause Ye to grow further still. The accelerator principle of investment, which can be expressed as I = aY for some constant a > 0 suggests that government- or consumer-lead economics growth will be enhanced, or accelerated, by increased corporate investment. (Of course, the opposite is also true in economic downturns).

© Stephen Hall, Imperial College LondonPage 16 The Accelerator Principle of Investment The accelerator principle provides one explanation for economic fluctuations (i.e. the “business cycle”). Of course, investment is also determined by the price of borrowing, i.e. the interest rate. Therefore, it is important to explicitly introduce interest rates into our model.

© Stephen Hall, Imperial College LondonPage 17 Consumption revisited Income is a key determinant of consumption but other factors shift the consumption function –household wealth –availability of credit –cost of credit These create a link between the financial and real sectors –because interest rates can be seen to influence consumption.

© Stephen Hall, Imperial College LondonPage 18 The permanent income hypothesis A modern theory of consumption developed by Milton Friedman –argues that people like to smooth planned consumption even if income fluctuates Consumption depends upon permanent not transitory income.

© Stephen Hall, Imperial College LondonPage 19 Savings occur during middle age and dissaving in youth and old age. The life-cycle hypothesis A theory of consumption developed by Ando and Modigliani. Age 0 Income, consumption Death Individuals try to smooth their consumption, based on expected lifetime income. Permanent income Thus wealth and interest rates may influence consumption. Income varies over an individual's lifetime. Actual income

© Stephen Hall, Imperial College LondonPage 20 Ricardian equivalence Individuals will react to a shock such as a tax change in different ways, depending on whether changes are seen to be temporary or permanent. If the government cut taxes today, but individuals realise this will have to be balanced by higher taxes in the future, then present consumption may not adjust.

© Stephen Hall, Imperial College LondonPage 21 Interest rates and aggregate demand The position of the AD schedule is now seen to depend upon interest rates through the effects on –consumption –investment

© Stephen Hall, Imperial College LondonPage 22 Model 3: with Interest Rates Let us continue to characterise aggregate demand as consisting of demand from households (C), firms (I), and the government (G). (Therefore, AD = C+I+G as before). Now, however, let us make the functional forms of C, I, and G more complex. In particular, we will make them dependent upon a new variable, the interest rate “i”.

© Stephen Hall, Imperial College LondonPage 23 Model 3: with Interest Rates We make the following new assumptions: C is positive, and a positive function of income; But it is also a negative function of the interest rate. Because as the interest rate increases, households will try and save a bit more (and thus consume a bit less). I is positive but independent of income, (for simplicity). But “I” is a negative function of the interest rate. Essentially, if it costs firms more to borrow, then they will borrow less and thus invest less. G is positive but independent of income and the interest rate.

© Stephen Hall, Imperial College LondonPage 24 Model 3: Example 3 We have now added another variable, the interest rate “i”, to our analysis.This makes a visual presentation of the model more difficult, but a mathematical presentation is still straightforward. We will introduce an entirely new example.Keeping with our assumptions, suppose: C = 300 – 30i + 0.80Yd and T = 100 + 0.25Y (setting Yd = Y - T solves as C = 220 – 30i + 0.60Y) I = 250 – 20i G = 480

© Stephen Hall, Imperial College LondonPage 25 Then by definition: AD = 950 – 50i + 0.60Y And, in equilibrium: Y e = 950 - 50i + 0.60 Y e This can be reduced to: (1 - 0.60 ) Y e = 950 - 50i or Y e = [1/0.40] x (950 – 50i) or Y e = 2.5 x (950 – 50i) or Y e = 2,375 – 125i Note that we have one equation and two unknowns, which cannot be solved for a single equilibrium value of Y e (or i e ).

© Stephen Hall, Imperial College LondonPage 26 The IS Curve Y e = 2,375 – 125i Note that we have one equation and two unknowns, which cannot be solved for a single equilibrium value of Y e (or i e ). The example from Model 3 shows that with the introduction of the interest rate (and nothing else) there is no single equilibrium value Y e ; rather, there are many combinations of Y and I that are compatible with one another.

© Stephen Hall, Imperial College LondonPage 27 Definition: The IS-Curve shows all combinations of interest rate and income that put the commodities market in equilibrium; i.e., equate aggregate demand to income. Typically, the IS-curve is drawn in Y,i space. In the preceding example, the IS-curve would look as follows:

© Stephen Hall, Imperial College LondonPage 28 The IS schedule Income AD 45 o line Income r AD 0 r0r0 At a relatively high interest rate r 0, consumption and investment are relatively low – so AD is also low. Y0Y0 Y0Y0 Equilibrium is at Y 0. Y1Y1 Y1Y1 Equilibrium is at Y 1. IS The IS schedule shows all the combinations of real income and interest rate at which the goods market is in equilibrium. AD 1 At a lower interest rate r 1 Consumption, investment and AD are higher. r1r1

© Stephen Hall, Imperial College LondonPage 30 Model 3: Example 4 The preceding Example 3 solved for a commodity market equilibrium (i,Y combinations) for given levels of taxation (T) and government expenditure (G). This equilibrium set of i, Y combinations was embodied in the IS-curve. But what happens when one of these variables changes?

© Stephen Hall, Imperial College LondonPage 31 Example 4a: Government Spending Increase First, use all of the same equations as before (where the original IS-curve solved for Ye = 2,375 – 125i) except suppose now that government expenditure increases from G=480 to G1 = 580) Clearly, AD1 = C+I+G1 = 1,050 – 50i + 0.6Y Setting Ye = AD1 and solving gives the new IS- curve new IS-curve : Ye = 2,625 – 125i

© Stephen Hall, Imperial College LondonPage 32 Example 4a: Government Spending Increase Visually, the IS-curve has shifted rightward as a result of the increase in government spending.21i More generally, any increase in autonomous (i.e. Y-independent) expenditure - from C, I or G - will cause the IS-curve to shift rightward. On the other hand, any decrease in autonomous spending will cause the IS-curve to decrease leftward. 21 Y 19 23752625 i

© Stephen Hall, Imperial College LondonPage 33 Model 3: Example 4 (cont.) Recall again that the original IS-curve was Ye = 2,375 – 125i Example 4b: Tax Increase Now let us use the original equations from Example 3 (with G=480), but suppose now that the income tax code changes from T=100+0.25Y to T1 = 200+0.25Y. This tax increase affects demand through the consumption function, which is now:

© Stephen Hall, Imperial College LondonPage 34 C1=300-30i + 0.8Yd = 300 – 30i+ 0.8 (Y - (200+0.25Y)) which solves as: C1 = 140 – 30i + 0.6Y (so we have C1=140 – 30i + 0.6Y, I=250 – 20i, G = 480) clearly, AD1 = C1 + I + G = 870 -50i+0.6Y setting Ye = AD and solving gives the new IS-curve new IS-curve: Ye = 2,175 – 125i

© Stephen Hall, Imperial College LondonPage 35 Model 3: Example 4 (cont.) Visually, the IS-curve has shifted back leftward as a result of the increase in government spending.19i More generally, any increase in the personal income tax will cause the IS-curve to shift leftward. An income tax increase is effectively a consumption decrease, and works accordingly. On the other hand, any tax decrease in autonomous will cause the IS-curve to increase rightward. 19 Y 17.4 21752375 i

© Stephen Hall, Imperial College LondonPage 36 Fiscal Policy In Models 1 and 2, an equilibrium output level could be determined precisely and was a function of government expenditure. In particular, the more government spent, the higher was the output level. Importantly, however, the models were timeless models (with no future to worry about), and they assumed that there were no supply constraints. Essentially, the government could increase output without cost to anybody, because it was producing valuable goods, and creating jobs, by using economic resources that were simply lying about!

© Stephen Hall, Imperial College LondonPage 37 In real life, of course, those resources do have other uses; if not today, than in the future. In other words, there is an opportunity cost to government spending. “Fiscal Policy” is the term used to refer to a government’s taxation and expenditure policies designed to affect the state and evolution of the economy. Clearly, designing an appropriate fiscal policy is more complicated than the simple Keynesian models would suggest (Spend! Spend! Spend!) in part because government expenditure takes up resources that could be (perhaps better) employed elsewhere. However, before discussing “appropriate” fiscal policy, we must first enquire as to what the government is attempting to achieve.

© Stephen Hall, Imperial College LondonPage 38 Fiscal Policy Objectives Fiscal policy objectives can be several: Wealth re-distribution: a government may use its tax and spend policies to transfer wealth from rich to poor (or conversely!) Stabilisation: the government may attempt to “fine tune” the economy, pursuing growth policies during economic downturns, and attempting to slow down the economy when it is growing too rapidly. Growth: the government may attempt to induce economic growth, usually by spending more or taxing less.

© Stephen Hall, Imperial College LondonPage 39 Stabilisation and Growth Policy Problems Historically, governments have had a very difficult time fine-tuning their economies. The reasons are several: Timing problems: there is usually a long and uncertain time between when a government sees a problem, when the government reacts to it, and when the policy takes effect. Irreversibility: it is politically easy for governments to spend more money, but quite difficult to reduce it afterward. Taxes are also relatively easy to raise, but difficult to lower. Over-spending: it is difficult to keep costs of public projects under control (because the users of public money have little incentive themselves to keep costs down).

© Stephen Hall, Imperial College LondonPage 40 Stabilisation and Growth Policy Problems Historically, governments have also attempted to use wage and price policies to fine-tune the economy. Time and time again, these have proven so disastrous that one would expect governments to abandon them. Still, the true depth of government policy problems cannot be fully appreciated until (i) we begin to question where the government gets its money to spend, i.e. “public finance”, and (ii) prices are introduced.

© Stephen Hall, Imperial College LondonPage 41 Public Finance The government cannot spend money it doesn’t have. Essentially, it can finance itself in one of three ways: Tax - which is to take resources from private households Borrow - which is to take resources from future households Print money - which (because of its inflationary effect) is to take resources from everyone who is holding money. (*This is a monetary policy tool, to be discussed later).

© Stephen Hall, Imperial College LondonPage 42 Public Finance Before looking into the intricacies of public finance, the preceding list of financing methods should point out one very important fact: as a first approximation, The government cannot make the economy wealthy. Essentially, all the government can do is to take wealth from individuals and spends it on behalf of individuals. What the government can do, however, is to create an environment where individuals can make themselves wealthy.

© Stephen Hall, Imperial College LondonPage 43 Public Finance At an abstract level, the important questions are: Is the government spending money on behalf of individuals better than could those individuals themselves? There will always be winners and losers (and usually more of the latter). So, who, exactly, is benefiting and losing from government fiscal policies? “Fairness” pertains not only to today’s citizens but to tomorrow’s as well. Is the government adequately considering the welfare of future generations?

© Stephen Hall, Imperial College LondonPage 44 Public Finance Finally, it should be noted that the net wealth effect from government fiscal policy is zero only as a first approximation. The key to good fiscal policy is to identify the times and places at which the government can make a positive contribution to wealth.

© Stephen Hall, Imperial College LondonPage 45 Public Expenditure The UK government spends vast amounts of money; nationally, locally, and through public corporations. In 1988/89, public spending totaled £186 bil., or roughly £3,200 per every man, woman and child. Its growth over time can be seen below:

© Stephen Hall, Imperial College LondonPage 46 Taxation Government receives money from several sources: National Insurance “contributions” surpluses from public corporations rent, interest, and dividends proceeds from the sale of public assets direct user fees for government services But, by far, the most important source of government income is taxation.

© Stephen Hall, Imperial College LondonPage 47 Taxation Taxation is of two general types: Direct taxation: which is assessed on individuals and businesses and collected by Inland Revenue –The rates at which individuals are assessed can either be –progressives: higher earners pay a higher rate –proportional/constant: everyone pays the same rate (say, 25%) –regressive: higher earners pay a smaller rate Indirect taxation : which is assessed against transactions –(e.g. VAT) and is collect by Customs and Excise.

© Stephen Hall, Imperial College LondonPage 48 Taxation The primary function of taxation is to raise revenue for the government. However, taxes can have other purposes and implications: –To transfer wealth from rich to poor (or conversely!) –To protect domestic industries from foreign competition (or to price them out of international markets!) –To create incentives to behave in socially desirable ways; for example, to save more, to reduce smoking, etc.

© Stephen Hall, Imperial College LondonPage 49 Government Borrowing If the government does not raise enough revenue through taxation, it can meet its additional revenue needs either by printing money (to be discussed later) or by borrowing. The amount of money the government borrows during the fiscal year is known as the Public Sector Borrowing Requirement (PSBR). It is also possible for the government to have a balanced budget or even a budget surplus. But these are seldom seen. (They did, though, exist during the mid-1980’s. ).

© Stephen Hall, Imperial College LondonPage 50 Government Borrowing Mrs. Thatcher and other “Thatcherites” believed in a balanced budget as a matter of principle. But there are also economic reasons for maintaining one: Government borrowing drives up interest rates, and means that there are less financial resources available for private firm investment. This is known as “crowding out”. Borrowing is a politically easy trap to get into, because the costs are borne later, when the money must be paid back. But this is bad for future generations, who must pay for our debts.

© Stephen Hall, Imperial College LondonPage 51 Borrowing is quite difficult to reverse, because it is a painful exercise with no immediate visible benefit. The Bank of England may react to heavy government borrowing by increasing the money supply. But (as we will see) this will lead to inflation, which itself causes private investment to fall and so is bad for long-run economic prosperity.

© Stephen Hall, Imperial College LondonPage 1 Economic Environment Lecture 3 Joint Honours 2003/4 Professor Stephen Hall The Business School Imperial College.

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© Stephen Hall, Imperial College LondonPage 1 Economic Environment Lecture 3 Joint Honours 2003/4 Professor Stephen Hall The Business School Imperial College.

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