Econ 208

1. Econ 208 MarekKapicka Lecture 7 The Effects of Gov’t Spending

2. Announcements • Today’s lecture is based on Hall (2009) and Ramey (2009). Look at Hall’s paper. • PS3 will be posted today, due next week.

3. Empirical Evidence • Main question: • How does output, consumption and wages respond to an increase in government spending?

4. Empirical EvidenceHall 2009 • Hall (2009): • is GDP • are government military expenditures • is noise (includes nonmilitary expenditures) • is fiscal multiplier • Assumption: changes in are uncorrelated with

5. Empirical EvidenceHall 2009 • Similarly, estimate a consumption multiplier : • is consumption

6. Empirical EvidenceHall 2009

7. Empirical EvidenceHall 2009 • What’s driving the results? • Write the regression coefficient as • where is a weight of each observation

8. Empirical EvidenceHall 2009

9. Empirical EvidenceVector Autoregressions (VAR’s)

10. Empirical EvidenceVector Autoregressions (VAR’s) • Advantage: include additional factors (e.g. taxes, dynamics of govt spending) • Earlier studies typically find positive multiplier on consumption

11. Empirical EvidenceRamey (2009) • Ramey (2009): a positive consumption multiplier is mostly because of incorrect timing: • Military spending typically becomes known in advance • e.g. 9/11: higher military spending was expected in October 2001. However, Iraq invaded only in March 2003

12. Empirical EvidenceRamey (2009) • Why does this matter? • The negative wealth effect causes immediate drop in consumption and increase in labor supply • Lower consumption means higher investment • When G increases, consumption does not change much (consumption smoothing) • Missing the anticipated effect can lead to a misleading conclusion!

13. Ramey (2009): The effects on GDP

14. Ramey (2009): The Effects on Consumption and Wages

15. 2009 Stimulus (Hall 2009)

16. Summary • The frictionless model seems to get it qualitatively • However, quantitatively, it predicts a fiscal multiplier that is too small • Taking into account frictions like sticky prices provides a better explanation

17. 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

18. Reading • DLS, chapter 12.3

19. Transfers

20. Social Security • Two Types of SS • PAYG • Fully Funded • 2 periods: young and old • N old people, N’ young people

21. PAYG • Young pay SS taxes t • Old receive benefits b • Balanced budged each period • PAYG introduced in period T

22. PAYG for Consumers Who Are Old in Period T

23. PAYG for Consumers Born in Period T and Later

24. PAYG for Consumers Born in Period T and Later • Change in wealth depends on r and n • Better off if n>r • Worse offif n<r

25. Fully Funded Social Security • Essentially a mandated savings program where assets are acquired by the young, with these assets sold in retirement. • Either ineffective or decreases welfare

26. Fully Funded Social Security When Mandated Retirement Saving Is Binding

27. What’s missing in the model? • Costs of having no social security • Procrastination • Idiosyncratic risk • Costs of fully funded social security • Transition costs • Risky investment • Costs of PAYG system • Distortions of labor supply • Fertility declines

28. US Social Security

29. US Social Security