Introduction to Macro Policy and Models

1. Introduction to Macro Policy and Models Fiscal Policy: Government Taxation, Spending and Deficit Impacts on the Macroeconomy

2. Focus Today • Setting up the questions regarding fiscal policy • Understanding preliminary answers and their basis • Applying this knowledge to a contemporary issue, the emergence of a budget surplus following huge deficits

3. The Central Model • The Key Behavioral Actors: • Domestic Households, buying consumer goods and housing • Domestic Businesses, buying machines or building factories & offices or stocking goods in inventory • Foreign buyers and suppliers • Some Government Agencies Whose Behavior is “Regular”

4. The Central Model • The Key Exogenous Influences • Domestic Government tax, transfer and purchasing decisions (that change on an irregular basis) • Domestic Central Bank “control” of the money supply and interest rates • The International Counterparts to these • International Commodity Markets and Cartel Behavior

5. A First Model • 7 Endogenous/ Behavioral Variables (Including ID’s) and 7 Equations • Consumer Spending : C=f ( YD, i ) • Business Spending : I = f ( d GNP, i) • Imports : M = f ( C, I , i ) • Exports : X = f ( GNPW, i ) • Total Output=Spending : • GNP = C+I+X-M+G • After-tax Income : YD = GNP - T • Inflation : R P = f ( GNP )

6. A First Model • 4 Exogenous/Policy Variables • Government Purchases : G • Taxes (Net of Transfers) : T • Interest Rate : i • Rest-of-World Demand : GNPW • Omitted Variables • Wealth • Supply Capacity

7. The Reduced Forms of the 7 Behavioral Equations • C=C ( G, T, i, GNPW ) • I = I ( G, T, i, GNPW ) • M = M ( G, T, i, GNPW ) • X = X ( G, T, i, GNPW ) • GNP = C+I+X-M +G • = GNP ( G, T, i, GNPW ) • YD = GNP - T • RP = RP ( GNP) = RP( G, T, i, GNPW )

8. The GNP Reduced Form Equation is a Useful Summary • GNP = C+I+X-M +G= GNP ( G, T, i, GNPW ) GNP1= GNP(G1,T1) i= INTEREST RATE GNP2= GNP(G2,T1) GNP=NATIONAL SPENDING/OUTPUT

9. The GNP Reduced Form Equation is a Useful Summary • GNP = C+I+X-M +G= GNP ( G, T, i, GNPW ) • Why does GNP=GNP(i) slope down? • Both Consumers (C) and Businesses (I) spend less if credit costs are higher. • Higher interest rates tend to boost the exchange rate, which cuts Exports (X) and boosts Imports (M) • How do changes in G, T shift GNP(i)? • For any given C or I , less G subtracts from GNP, and sets up multiplier, feedback effects • Extra T reduces YD which reduces C and thus cuts GNP.

10. If interest rates are fixed at i1, reducing G cuts GNP by a “multiple” of G • GNP = C+I+X-M +G= GNP ( G, T, i, GNPW ) GNP1= GNP(G1,T1) i= INTEREST RATE GNP2= GNP(G2,T1) i1 GNP2 GNP1 GNP=NATIONAL SPENDING/OUTPUT

11. What if lower GNP implies lower i due to Fed or market reactions? i= INTEREST RATE i=i(GNP) GNP2= GNP(G2,T1) GNP=NATIONAL SPENDING/OUTPUT

12. What if lower GNP implies lower i due to Fed or market reactions? i1 i2 GNP2 GNP1

13. What if the Fed has a strict inflation target and thus a fixed GNP target? i1 i2 GNP2 GNP1

14. Deficit ReductionWill Change the Economy • But it might not boost unemployment. • What sectors will offset lower G? • What does the Fed need to do? • What might change the equilibrium level of GNP? • Who gains and loses, considering incomes, wealth, skill-building? • Is a constitutional amendment necessary?

15. Build a Model

16. Build a Model

17. Build a Model

18. Build a Model

19. Build a Model Now, let interest rates respond to GDP, dropping from 5% to 4%: