Economics for CED

Economics for CED Noémi GiszpencSpring 2004Lecture 11: Macro: Government Policyand the Keynesian Model June 21, 2004

Government Fiscal Policy 45o C+I+G expenditure C+I • “Fiscal policy” is when national government makes decisions on taxation and spending to influence the level of production and employment. • Increasing the autonomous spending, G, increases Ye by multiplier. • If Ye too low, can increase G to combat unemployment • If Ye too high, can decrease G to combat inflation • What about taxes? C G I C0 Ye income/production Economics for CED: Lecture 11, Noémi Giszpenc

Don’t forget taxes! • Consumption depends on disposable income Yd = Y - T = Y - (Yt + TX - TR) • T is net taxes: sum of income taxes Yt and non-income taxes TX, minus transfers TR •  T  Yd C  Ye • by a “tax multiplier”: MPC/(1-MPC) • A cut in taxes and increase of transfers have same effect on equilibrium aggregate demand • But they have different effects in many other ways, and are likely to affect different people. • And have smaller (indirect) effect than changes in G. Economics for CED: Lecture 11, Noémi Giszpenc

Trygve Haavelmo(b. 1911), 1989 Nobel laureate Bonus: Balanced Budget multiplier • Suppose government increases G and T by same amount, B. •  G  Ye by B*1/(1-MPC) •  T  Ye by B*MPC/(1-MPC) • Net increase in Ye is B*(1-MPC)/(1-MPC) = B*1 = B • “balanced budget multiplier” is 1 • This means that increasing the “size” of government, all else being equal, increases equilibrium output by the exact amount of the increase. Economics for CED: Lecture 11, Noémi Giszpenc

Government deficits & debt • Deficits mean gov’t must borrow--and pay interest • The burden of interest payment (debt service): • Means taxes later to pay interest • Taxes less wealthy people to pay more wealthy people • If not sustainable, leads to a crisis • “Crowds out” private borrowing for investment purposes • Probably only realistic kind of balanced budget would be “cyclically balanced budget”: • government deficits in recession periods offset by government surpluses in booms. • Government spending is also automatically anti-cyclical: • progressive income taxes rise with income and slow down growth; welfare and unemployment transfers rise as incomes drop and slow down recessions. Economics for CED: Lecture 11, Noémi Giszpenc

Government Monetary Policy • “Monetary policy” is when the national government makes changes in central bank policy or in bank reserves to influence the interest rate and thus investment, production and employment. • To understand the effects of these changes on the macroeconomy, we need to go back to the workings of the Federal Reserve system. • Then we need to relate the movements in money supply and interest rate to economic activity. • It will help to remember the way businesses decide to invest. Economics for CED: Lecture 11, Noémi Giszpenc

A closer look at investment • In the last class, I was given as exogenous. • Let us now say that I has an autonomous component (I0) and partly depends on the real interest rate (r) : I = I0 + I(r) • (real interest is nominal interest minus inflation) • I(r) goes down when r goes up. Why? • Remember the figure we drew in class of the investments a business chooses based on the return from each investment and the cost of capital • If (some) capital is more costly (comes at a higher interest rate), some investments will not be made. Economics for CED: Lecture 11, Noémi Giszpenc

Figure from lecture 5: returns & costs Annual costs/returns per $100 Cost of capital funds Investment 1 Investment 2 Investment 3 Investment 4 Investment projects 0 $ Quantity of funds Economics for CED: Lecture 11, Noémi Giszpenc

Effect of r on I (and Y) • Lenders, too, look for the highest-return projects to lend to first. • These ideas lead to a diminishing marginal efficiency of investment (MEI): • The more is invested, the less return there will be on investment • Investors quit investing when marginal return equals marginal cost: when MEI = r • If r is low, it takes a while for the MEI to diminish down to r • If r is high, people’s MEI hits r faster. • Since investment is a component of aggregate demand, if I goes up, aggregate demand (Yd) and thus equilibrium output (Ye) go up. Economics for CED: Lecture 11, Noémi Giszpenc

IS Ye r Let’s see that graphically • Based on what we’ve just said, if we graph interest rate on one axis and equilibrium output on the other, we’d expect a bigger Ye for a lower r and a smaller Ye for a higher r. • Let’s call the line “IS” because it has to do with investment and savings. • Every point on the line is a possible equilibrium between interest rate and output. • Where do we end up? Economics for CED: Lecture 11, Noémi Giszpenc

Back to the financial markets Ye went up… so  Md went up… but Ms stayed the same, so  r went up. • Remember how the Fed sets interest rates? Their method is based on people’s liquidity preference: • A high rate of interest (on, say, bonds) induces me to part with some liquidity of money • A low rate of interest makes me abandon bonds in favor of money • When output rises people demand more money • because people need money to conduct more transactions r r’ Md’ r Md Ms M Economics for CED: Lecture 11, Noémi Giszpenc

The liquidity-money (LM) equilibria • With a fixed money supply, an increase in output will shift money demand up and result in a higher rate of interest at equilibrium. • Let’s graph all of the possible equilibria between output and interest rate--this time from the financial markets. • We can call that line of equilibria LM • As Ye goes up, r goes up r LM Ye Economics for CED: Lecture 11, Noémi Giszpenc

LM r IS Ye Put ’em together and whaddya get? • A shortcut to understanding much of Keynes’s theory. • Below the IS curve, low interest rates induce more investment:  more Y. • Above IS, high interest rates inhibit investment:  less Y. • Meanwhile… • Below LM, a high Y (and steady money supply Ms) boost interest rates:  higher r • Above LM, a lower Y reduces demand for money:  r falls • We end up at the intersection. The “IS-LM” graph is sometimes called the “Keynesian cross” Economics for CED: Lecture 11, Noémi Giszpenc

Are we nailed to the cross? I.e, can the government move the economy away from the Ye and r determined by these forces? • Main method: expanding or contracting money supply to affect interest rates--basically, shifting LM curve • Control is limited: • Late 70s, Fed tried to limit money, so banks created new forms of money (checking accounts) • Early 90s, Fed created more reserves, but banks were afraid to lend, so little new money created • Analogy: using monetary policy to try to stimulate economy is like pushing on a string--it is easier to slow down economy • Also, decision to invest depends on more than just interest rate • And indirect effect may take a long time to kick in • Slower (more political) method: fiscal policy--shifting IS curve by changing G or T (once it kicks in, faster effects) • Needs to be “accommodated” anyhow by monetary policy • If demand increases but Ms remains constant, only change is in r Economics for CED: Lecture 11, Noémi Giszpenc

The problem of inflation • Inflation is a rise in the average price level • Some prices rise faster than average and others slower, so inflation redistributes income haphazardly • This uncertainty makes it unpopular • Inflation hurts creditors (but benefits debtors) • (And all businesses run on credit) • What causes inflation? • Keynesian view: 2 kinds of inflation: demand pull & cost push • If demand for output exceeds capacity of economy to produce it, inflation speeds up. • If costs of production rise, increase is passed on to consumers. • Second more dangerous--price increase can lead to further increases in cost, and so to spiraling inflation • Monetarist view: changes in the money supply don’t affect output or the “velocity” of money--only the price level (inflation). • In the long run, real potential output remains unchanged: monetary policy can have no effect except inflation. Economics for CED: Lecture 11, Noémi Giszpenc

Expectations and surprises LAS long run aggregate supply • When inflation continues over years, people come to expect it • If price rise is a surprise, businesses will increase production to reap profit • This would be in the macroeconomic short run • If price rise is expected, input costs will rise at the same time, leading to unchanged production • This would be in the macroeconomic long run p SAS short runaggregatesupply price level RGDP Economics for CED: Lecture 11, Noémi Giszpenc

The policy ineffectiveness proposition • Assumption: Rational Expectations • make efficient use of all available information • Expectations can be rational and still not be very accurate. • Given a population with rational expectations, • Any consistent government policies designed to influence the economy to a level of production other than the long-run potential output will be ineffective. • Because people will expect the policies and counteract them • However, output tends to be permanent. • This year’s level of output will resemble last year’s • Thus, a sudden big change in output can cause a change in people’s rational expectations--output is path dependent Economics for CED: Lecture 11, Noémi Giszpenc

Now what do we do? • One reason to study macroeconomics is to try to see what is possible and what’s not. • After that, “politics is the art of the possible” • The Keynesian model shows that some government action is possible. • But some things are impossible • For example, every country having a trade surplus • Watch out for fallacies of composition! • But have we accounted for all of the effects of government action? • And what important factors have we left out? Economics for CED: Lecture 11, Noémi Giszpenc

Time lags • 3 types of lags: • Recognition that there is something to respond to • Implementation of a policy • Response by economic actors; changes in behavior • One possible remedy to insufficient data: “triggers” (automatic adjustments) • E.g., tax cuts that only go into effect during recession, or only when government can afford them Economics for CED: Lecture 11, Noémi Giszpenc

Inequality… • In the model, a cut in taxes (TX) has the same effect as a rise in transfers (TR) • But different people are affected • An increase in government debt means more taxes to pay interest • Generally redistributes money from those with less to those who already have lots • But what effect does unequal wealth or income have on the broader economy? Economics for CED: Lecture 11, Noémi Giszpenc

…and its effects • “Trickle-down” “theorists” say inequality is good. • The wealthier you are, the more you save • Therefore, more money in the hands of rich people means more is available for investment, which is good for growth, which is good for everybody. • Assumption: increase in rate of saving across few people compensates for decrease of saving among many people • Assumption: rich people invest domestically • Assumption: investment leads to growth • Assumption: “growth” is good for everybody • (A better trick: investment tax credits--only kick in if investment is made) Economics for CED: Lecture 11, Noémi Giszpenc

Effect of inequality, continued • Others say inequality is bad • In and of itself, but also instrumentally • To see why we need a broader theory of output, or a more detailed one • Ford? Demand lagging supply? Economics for CED: Lecture 11, Noémi Giszpenc

Then there’s the international problem • Makes national policy making difficult Economics for CED: Lecture 11, Noémi Giszpenc

Jane Jacobs recommendations • “Development” replaces “growth” as goal • Image of “tangled bank” of interdependent processes • Diversity feeds development of cities • 4 conditions are necessary for diversity: • Several primary functions close together • Residence, work, entertainment: people outdoors on different schedules using many facilities in common • Short blocks (frequent corners) • Closely mingled buildings of varying age and condition • For variation in economic yield they must produce • Sufficiently dense concentrations of people • Capital put to work locally (not completely mobile) • Local currency (responds to local econ. conditions) Economics for CED: Lecture 11, Noémi Giszpenc

Herman Daly recommendations • “Development” replaces “growth” as goal • “optimal scale” joins distributive justice, full employment, and price level stability as goal • Hicksian definition of income: • Income is what you can consume now that will leave you able to consume same amount next period • Means can’t count consumption of natural capital as income • Tax labor & income less, and tax resource throughput more • Bluntly, encourage employment & discourage throughput • Maximize productivity of natural capital in the short run • And invest in increasing its supply in the long run • Move away from globalization toward domestic (national and local) economies • Less inequality  population will control itself Economics for CED: Lecture 11, Noémi Giszpenc

Amartya Sen recommendations • Commitment to freedom (as individual capability), especially: • Political (representation, free speech) • Economic • Social Opportunities (health, education) • Political (accountability, transparency) • Security • “Freedoms are not only the primary ends of development, they are also among its principal means.” Development as Freedom, p. 10 • For true development, attention to inequality (of freedoms) at the same time as efficiency Economics for CED: Lecture 11, Noémi Giszpenc

Dollars & Sense recommendations • Productivity growth through worker cooperation: • More job security, portable health benefits, minimum wage • Worker involvement in production • Moderate inflation OK • As long as cost-of-living-adjustments are made to fixed incomes, or these are automatically indexed • “Shoe-leather costs” relatively small • Provides needed flexibility in wage-setting, since it is hard to adjust nominal wages down. Economics for CED: Lecture 11, Noémi Giszpenc

Economics for CED