QUICK REVIEW

PRICE LEVEL REAL GDP AD SRAS LRAS Qn Q1

PRICE LEVEL REAL GDP AD SRAS LRAS Qn

Price Level Natural Real GDP SRAS 0 AD Q N LRAS Long-run equilibrium Short-run equilibrium

Answer the following: l What is Say’s law? l What three things must be flexible in the Classical model? l What is the Classical solution for too much unemployment? l How does the self-regulating economy get out of a recessionary gap?

Self-Regulating Economy

KEYNESIAN ECONOMICS l J. M. Keynes wrote during the Great Depression l Keynes focused on the demand side of the economy l Keynes did not believe that the economy was necessarily self-correcting

KEYNES ON WAGES AND PRICES l Keynes believed that wages and prices were STICKY DOWNWARD l The lack of wage and price flexibility suggested that the economy might get STUCK in a recessionary gap. l Keynes tended to focus on the short run because l “IN THE LONG RUN WE ARE ALL DEAD”

KEYNES AND INCOME l Keynes focused his analysis on Total Expenditures in the economy l In particular, he focused on Consumption l CONSUMPTION is a function of DISPOSABLE INCOME l SAVING is also determined by DISPOSABLE INCOME

CONSUMPTION AND SAVING TERMS l Autonomous Consumption - the portion of consumption that is not related to income (it is the amount of Cons. when income is 0). l MPC - marginal propensity to consume (it is change in C / change in Y) l MPS - marginal propensity to save (it is the change in saving / change in Y)

CONSUMPTION AND SAVING TERMS l 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 S l C = a + b(Yd) l Consumption = autonomous consumption + the MPC * (disposable income) l S = -a + (1-b)(Yd) l Saving = negative autonomous consumption + MPS * ( disposable income)

EXAMPLE l C = (Yd) l Find Aut. Cons., MPC, MPS, and C and S when Yd=1000. l Aut. Cons. = 100 l MPC =.75 MPS =.25 l C = (1000) = = 850

CONSUMPTION FUNCTION

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

CONSUMPTION FUNCTION l A change in Disposable Income causes a MOVEMENT ALONG the Consumption Function l A change in Autonomous Consumption causes a SHIFT of the Consumption Function

SAVING l SAVING is the unspent portion of a consumer’s income. l SAVING = Income - Consumption Exp.

INVESTMENT 2 components l 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. l Inventory investment - changes in the stocks of finished goods, goods in process, and in raw materials a firm keeps on hand.

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

EQUILIBRIUM l TOTAL EXPENDITURES l are equal to l TOTAL PRODUCTION l is equal to l INCOME

DISEQUILIBRIUM TOTAL OUTPUT < TOTAL EXPENDITURES l unplanned inventories l production l employment l Real GDP l income

DISEQUILIBRIUM TOTAL OUTPUT > TOTAL EXPENDITURES l unplanned inventories l production l employment l Real GDP l income

C = (Yd) I = 300 l Find Autonomous Cons., MPC, and MPS l Find breakeven income l Find equilibrium income l In Qn=3000, identify the following: type of gap, size.

THE 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 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 Spending & the Multiplier Exhibit 12 (1) EXPENDITURE ROUND (2) CHANGE IN AUTONOMOUS GOVERNMENT SPENDING (3) CHANGE IN REAL NATIONAL INCOME OR REAL GDP ($ millions) (4) MPC (5) CHANGE IN CONSUMPTION ($ millions) Round 1 Round 2 Round 3 Round 4 $60.00$ $ All other TOTAL$300.00$ (Approx.

THE FORMULA MULTIPLIER = 1 or MPCMPS

EXPANSIONARY FISCAL POLICY TO ADDRESS A RECESSIONARY GAP policy aimed at increasing economic activity through increasing G &/or decreasing T to increase AD or increase SRAS

CONTRACTIONARY FISCAL POLICY TO 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 Economy of Recessionary Gaps

Fiscal Policy in Keynesian Theory: Ridding the Economy of Inflationary Gaps Exhibit 2 (2 of 2)

THE 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 MULTIPLIER l 1 / 1- MPC or 1 / MPS l Change in Real GDP = multiplier x (change in G)

COMMON MULTIPLIERS

EXAMPLE l Qe = 800 while Qn = 1000 l MPC =.75 l find the G necessary to bring the economy to natural real GDP

THE TAX MULTIPLIER l - MPC / MPS or ( 1 - exp. mult.) l Change in Real GDP = tax multiplier x (change in T)

EXAMPLE l Qe = 1200 while Qn = 800 l MPC =.66 l find the T necessary to bring the economy to full employment GDP

BALANCED BUDGET MULTIPLIER 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 = (Yd) I = 300 l Find equilibrium income l In Qn=3000, identify the following: type of gap, size, fiscal policy options to close it.

Should Fiscal Policy be Used?  NOT NECESSARILY l Crowding Out l Lags

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

CROWDING OUT may occur due to: l direct substitution more on public libraries  fewer books at bookstores l 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 Policy l The data lag: not aware of changes in the economy as soon as they happened l The wait-and-see lag: adopt a more cautious attitude l The legislative lag l The transmission lag: take time to be put into effect l The effectiveness lag: take time to affect the economy

KEYNESIAN PERSPECTIVE l fiscal policy is effective l crowding out is relatively small l lags are short

CLASSICAL PERSPECTIVE l fiscal policy is ineffective l crowding out is significant l lags are long

FISCAL POLICY l Discretionary Fiscal Policy

DISCRETIONARY FISCAL POLICY l deliberate changes in G and/or T to achieve particular objectives l requires new action by Congress

FISCAL POLICY l Discretionary Fiscal Policy l Automatic Stabilizers

AUTOMATIC STABILIZERS l changes in G and/or T that occur automatically as economic conditions change l these changes do not require new action by Congress

Four Types of Fiscal Policy Automatic Discretionary ExpansionaryContractionary Policy Makers  G or  T or both Policy Makers  G or  or both Unemployment Compensation Welfare Payments Unemployment Compensation Welfare Payments (1)(2) (3)(4)

The New Classical View Of Fiscal Policy l crowding out does occur as people save more in anticipation of higher taxes l these adjustments cause expansionary fiscal policy to be ineffective.

SUPPLY SIDE POLICY l dislike demand side policies because increases in AD means growth comes with higher prices l prefer to focus on tax issues which alter incentives to work, save, and invest

What Are the Major Federal Taxes? l Personal income tax l Corporate income tax l Social security tax

Exhibit 1 Major Federal Taxes SOURCE: Council of Economic Advisers, Economic Report of the President, 1999.

MARGINAL TAX RATE l tax rate applied to additional income l change in tax payment divided by the change in taxable income

Three Income Tax Structures

MARGINAL TAX RATES AND FISCAL POLICY l decreasing marginal tax rates leads to an increase in SRAS b/c increases the incentive to work l if the tax change is permanent, then the change in AS is too l the LRAS will shift to the right

Laffer Curve T X Tax Rate (percent) Tax Revenues 0 A Laffer Curve C X B T Z T Y Y Z 100 B to C: Tax rate and tax revenues inversely related. A to B: Tax rate and tax revenues directly related.

What are the Major Federal Government Spending Programs? l National defense l Income security l Health l Medicare l Social security l Net interest on the National Debt

Exhibit 3 Major Federal Spending Programs SOURCE: Council of Economic Advisers, Economic Report of the President, 1999.

DEBT AND DEFICITS l BUDGET DEFICITS occur when government expenditures exceed tax receipts l A BUDGET SURPLUS occurs when tax receipts exceed government expenditures

CYCLICAL DEFICITS l The portion of the deficit that is a result of an economic downturn l many economists (Keynes) believe that deficits are natural and necessary during recessions because tax revenues fall and benefit payments rise l Our problem is that we have continued to run deficits in expansionary periods

STRUCTURAL DEFICITS l The structural deficit is the portion of a budget deficit which exists when the economy is operating at full employment l Total Budget Deficit = structural deficit + cyclical deficit

National Debt l NATIONAL DEBT is the total sum of what the federal government owes its creditors (the sum of past deficits)

Exhibit 5Public Debt for 1987–1999 The 1999 amount is for November SOURCE: Bureau of the Public Debt.

NATIONAL DEBT l As the debt grows, interest on the debt grows in its share of the budget. l The portion of the budget that can be cut in order to balance the budget is SHRINKING

PORTION OF THE BUDGET THAT IS CONSIDERED UNTOUCHABLE l Interest on the Debt 14% l Social Security 22% l untouchable total 36% l National Defense 20% l Total 56%

WHO BEARS THE BURDEN OF THE DEBT? l CURRENT GENERATION - if crowding out occurs then households are giving up consumption to pay for increases government spending l 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.

COUNTERPOINTCOUNTERPOINT l WE-OWE-IT-TO -OURSELVES - if American taxpayers make payments to American bondholders, money is simply shifted from one pocket to another. l Only works if debt is held domestically (currently 14-18% is held by foreigners)