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Econ 208

Econ 208. Marek Kapicka Lecture 4 The Effects of Gov’t Spending. Where are we?. Introduction: A model with no Government The Effects of Government Spending Government Taxation and Government Debt Fiscal and Monetary Policy Optimal Monetary Policy Financial Intermediation. Roadmap.

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Econ 208

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  1. Econ 208 MarekKapicka Lecture 4 The Effects of Gov’t Spending

  2. Where are we? • Introduction: A model with no Government • The Effects of Government Spending • Government Taxation and Government Debt • Fiscal and Monetary Policy • Optimal Monetary Policy • Financial Intermediation

  3. Roadmap • Government Expenditures • A) Data on Govt Expenditures • B) Changes in Gov’t Spending in a frictionless world • C) Changes in Gov’t Spending in a world with frictions • D) Social Security

  4. A1) Government Expenditures

  5. A2) Government Purchases

  6. A3) Transfers

  7. B) The Effects of Government Spending • Questions: • How do changes in government purchases affect • Consumption, output (fiscal multiplier), capital stock? • Interest rates? • Crowding out?

  8. B) The Effects of Government Spending • Start by answering the question in a world without frictions • We will assume that government purchases are completely unproductive • They may add utility (e.g. public parks) • The model can be easily extended for a case of productive government purchases (roads)

  9. B1) The Effects of Government SpendingConsumers • Preferences • Lump-sum Taxes each period • Flow Budget Constraint • is real wage

  10. B1) The Effects of Government SpendingFirms • Hire labor to produce output • Production Function • Profits

  11. B1) The Effects of Government SpendingGovernment • Budget Constraint • Assume balanced budget each period (will show later that this assumption does not matter here)

  12. B1) The Effects of Government SpendingPareto Problem • Instead of solving for the Competitive Equilibrium solve for the efficient allocations subject to

  13. B1) The Effects of Government SpendingFirst order conditions • Consumption and hours worked satisfy • Substitute in and to obtain

  14. B1) The Effects of Government Spending Solving for the effect on output • Assume , and • is the Frisch elasticity of labor supply • Obtain • The fiscal multiplier is • Positive • Less than one

  15. B1) The Effects of Government Spending Implications • There is crowding out of consumption • But not one on one… • Hours worked increase • Wages decrease (why?)

  16. B1) The Effects of Government Spending Implications: Interest rate • Equilibrium interest rate • Assume that in period and in all other periods, • Then , and in all other periods • Consistent with wartime experience

  17. B1) The Effects of Government Spending Extension: Productive government spending • Assume now that government spending is productive: • Where measures the efficiency of government spending • Typically we would have • Total production of the economy:

  18. B1) The Effects of Government SpendingExtension: Productive government spending • Planning problem: subject to • Obtain

  19. B1) The Effects of Government SpendingExtension: Productive government spending • Putting together • The multiplier is now larger, but is still smaller than one

  20. What have we learned? • Effects of government spending in a frictionless world: • Increase in output • Crowding out of consumption • Decrease in wages • The effect depends on • How responsive is labor supply • Efficiency of public spending

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