1. Unit 6: Fiscal Policy

2. KEYNES Criticisms of Classical Theory:
The Great Depression
KEYNES Criticisms of Classical Theory:
C and I move together
KCM = 1/MPS
Liquidity Trap

3. KEYNES KEY QUESTIONS:
WHERE ARE WE?
WHERE WERE WE?
WHERE SHOULD WE BE?

4. NATIONAL INCOME ACCOUNTING
Total production and wealth of a nation in a given period in monetary terms.
Recorded
NOT black market, under table
Productive
NOT transfers
This country
NOT imports
This year
NOT used items or subtractions from inventory
Final value
NOT value-added

5. Adding It Up: GDP = C + Ig + G + Xn
Measuring GDP
The four categories of expenditures that provide a measure of the market value of total output in a particular year include:
Personal consumption expenditure (C)
Gross Private Domestic Investment (Ig)
Government Purchases (G)
Net Exports (Xn)
Adding It Up: GDP = C + Ig + G + Xn

6. Measuring GDP
The four categories of income that provide a measure of the market value of total output in a particular year include:
Wages (W)
Rent (R)
Interest (r)
Profit (Pf)
Adding It Up: NY = W + R + r + Pf

7. NY (W + R + r + Pf) + KCA + IBT = C + Ig + G + XN
Measuring GDP
Adding It Up
NY (W + R + r + Pf) + KCA + IBT = C + Ig + G + XN
income = expenditures
Y = C

8. Measurement of Unemployment
The total U.S. population is divided into three groups.
People “not counted”: under 16 years of age, over 65, institutionalized, house spouses
Adults in the labor force; those who SHOULD BE working
Employed, working over 32 hours a week
unemployed and seeking work

9. Measurement of Unemployment
The unemployment rate is the percentage of the labor force unemployed.
Unemployment rate = x100
unemployed
labor force

10. Types of Unemployment Structural Unemployment Frictional Unemployment
ACCEPTABLE UNEMPLOYMENT: those searching for jobs or waiting to take jobs in the near future.
Cyclical Unemployment
is unemployment associated with the business cycle; Actual Unemployment – Frictional Unemployment = Cyclical Unemployment.
Structural Unemployment
is unemployment that is associated with technological change; obsolete workers. Not Counted for Employment purposes.

11. – Frictional Unemployment Cyclical Unemployment
Types of Unemployment
Actual Unemployment
– Frictional Unemployment
Cyclical Unemployment

12. Definition of Full Employment
Full employment occurs when the economy experiences only frictional; there is no cyclical unemployment.
The level of real GDP that would occur if there was full employment is called potential output.

13. Economic Cost of Unemployment
If actual GDP is above or below potential GDP, the result is a GDP gap.
When actual GDP is less than potential GDP, there is a negative GDP gap accompanied with a higher unemployment rate and foregone income.
When actual GDP is greater than potential GDP, there is a positive GDP gap accompanied with a high inflation rate and overfull employment.
GDP gap = actual GDP – potential GDP

14. OKUN’S LAW GDP gap = actual GDP – potential GDP
GDP gap = Cyclical Unemployment x 2.5

15. Inflation
It is difficult to compare values over time without correcting them for inflation or deflation.
Nominal GDP, or unadjusted GDP, is gross domestic product in terms of the price level at the time of measurement.
Real GDP, or adjusted GDP, is gross domestic product measured in terms of the price level in a base period (or reference year).
It is a GDP that has been deflated or inflated to reflect changes in the price level.

16. Inflation
Inflation is a rise in the general level of prices in an economy.
When there is inflation, each dollar of income buys fewer goods and services; the purchasing power of money declines.

17. Measurement of Inflation
Inflation is a rise in the general level of prices in an economy.
When there is inflation, each dollar of income buys fewer goods and services; the purchasing power of money declines.
The main measure of inflation in the U.S. is the Consumer Price Index, or CPI.
The CPI is an index that compares the price of a market basket of goods and services in one period with the price of the same (or highly similar) market basket in a base period, currently
The CPI includes some 300 products that are presumably purchased by the typical consumer.

18. Types of Inflation
Demand-pull inflation is increases in the price level caused by excessive spending beyond the economy’s capacity to produce.
Excess demand from expanding output bids up the prices of the limited output.
Cost-push inflation is increases in the price level caused by sharp rises in the cost of key resources.
Supply shocks are the main source of cost-push inflation.

19. Measurement of Inflation
CPI for any particular year equals:
price of the market basket of the particular year
price of the same market basket in the base year

20. The Multiplier

21. The Multiplier
The Multiplier: -- The view that a change in autonomous expenditures (e.g. investment) leads to an even larger change in aggregate income.
An increase in spending by one party increases the income of others. Thus, an increase in spending can expand output by a much larger amount.
The multiplier is the number by which the initial change in spending is multiplied to obtain the total amplified increase in income.
The size of the multiplier increases with the marginal propensity to consume (MPC).

22. The Multiplier Principle
Expenditure Stage
Additional Income (Dollars)
Marginal Propensity To Consume
Additional Consumption (Dollars)
For simplicity (here) it is assumed that all additions to income are either spent domestically or saved.
Round 1
Round 2
Round 3
Round 4
Round 5
Round 6
Round 7
Round 8
Round 9
Round 10
3/4
1,000,000
750,000
750,000
562,500
562,500
421,875
421,875
316,406
316,406
237,305
237,305
177,979
177,979
133,484
133,484
100,113
100,113
75,085
75,085
56,314
All Others
225,253
168,939
Total
4,000,000
3,000,000
3/4
The multiplier concept is fundamentally based upon the proportion of additional income that households choose to spend on consumption: the marginal propensity to consume (here assumed to be 75%  3/4).
Here, a $1,000,000 injection is spent, received as payment, saved and spent, received as payment, saved and spent … etc. … until . . .
effectively, $4 million is spent in the economy.

23. A Higher MPC Means a Larger Multiplier
SIZE OF MULTIPLIER
9/10
10.0
4/5
5.0
3/4
4.0
2/3
3.0
1/2
2.0
1/3
1.5
As the MPC increases more and more money of every injection is spent (and so received as payment and then spent again, received as payment and spent again, etc.).
The effect is that for higher MPCs, higher multipliers result, specifically the relationship follows this equation:
M = 1
1 - MPC

24. The Keynesian View of Fiscal Policy

26. The Keynesian View of Fiscal Policy
When an economy is operating below its potential output, the Keynesian model suggests that the government should institute expansionary fiscal policy -- it should either:
increase the government’s purchases of goods & services, and/or,
cut taxes.

27. Expansionary Fiscal Policy to Promote Full-Employment
Goods & Services (real GDP)
Price level
LRAS
AD1 Y F P 1
SRAS1 e1
AD2
SRAS3 P 2 E2
Expansionary fiscal policy stimulates demand and directs the economy to full-employment P 3 E3
Keynesians believe that allowing for the market to self-adjust may be a lengthy and painful process. Y F Y F
We begin in the short run at Y1, below the economy’s potential capacity (YF). There are 2 routes to long-run full-employment equilibrium.
Classic theory would wait for both lower wages and resource prices to reduce costs, increase supply to SRAS3 and restore equilibrium at YF.
Keynesians would use expansionary fiscal policy to stimulate aggregate demand (shift AD1 to AD2) and guide the economy back to E2, at YF.

28. The Keynesian View of Fiscal Policy
When inflation is a potential problem, the Keynesian analysis suggests a shift toward a more restrictive fiscal policy:
reduce government spending, and/or,
raise taxes.
Keynesians challenged the view that the government’s should always be balance its budget.
Rather than balancing the budget annually, Keynesians argued that counter-cyclical policy should be used to offset fluctuations in aggregate demand.

29. Restrictive Fiscal Policy to Combat Inflation
Goods & Services (real GDP)
Price level
LRAS Y F P 1
SRAS1
AD1 e1
SRAS3
AD2 P 3 E3
Restrictive fiscal policy restrains demand and helps control inflation. P 2 E2 Y F Y F
Strong demand such as AD1 will temporarily lead to an output rate beyond the economy’s long-run potential (YF).
Classic theory says the high level of demand will lead to the long-run equilibrium E3 at a higher price level (as SRAS shifts back to SRAS3).
Keynesian restrictive fiscal policy would restrain demand from expanding to AD2 in the first place and guide the economy to a non-inflationary equilibrium (E2).

31. Fiscal Policy: Examples of Automatic Stabilizers:
Automatic Stabilizers: without any new legislative action, they tend to increase the budget deficit (or reduce the surplus) during a recession and increase the surplus (or reduce the deficit) during an economic boom.
Examples of Automatic Stabilizers:
Transfer Payments
Unemployment Compensation
Welfare
A Progressive Income Tax

32. Budget Deficits and Surpluses
Budget deficit: -- Present when total government spending exceeds total revenue from all sources.
When the money supply is constant, deficits must be covered with borrowing.
The U.S. Treasury borrows funds by issuing bonds.
Budget surplus: -- Present when total government spending exceeds total revenue from all sources.
Surpluses reduce the size of the government’s outstanding debt.

33. Budget Deficits and Surpluses
Changes in the size of the federal deficit or surplus are often used to gauge whether fiscal policy is adding additional demand stimulus or imposing additional demand restraint.
Changes in the size of the budget deficit or surplus may arise from either:
A change in the state of the economy, or,
A change in discretionary fiscal policy -- that is, through either government spending and/or changes in taxation.

34. 11/17/2018
End Unit 5