Economics 104B - Lecture Notes - Professor Fazzari Topic V: Demand-Side acroeconomic T!

eor": #e"nesian Economics

(Final Version, April 13, 2011)

$% E&ui'i(rium of )utput and $**re*ate Demand

Over the past several weeks in the class, we have looked at the components of the economy that ca se them to chan!e" #e saw how ho seholds and firms make cons mption and investment decisions $ased on a variety of factors s ch as the interest rate and income" #e e%plored the determination of international trade and talked $riefly a$o t how !overnment activity infl ences the economy" &here is now a shift in the class" #e will now look in some detail and systematically at how vario s chan!es in the economy affect $ siness cycles, inflation, and !rowth" ('emem$er the main macro iss es disc ssed in the very $e!innin! of the class") &o meet this !oal, we will se models" &hese are a$stractions that hopef lly capt re the ma(or feat res that are most important in drivin! macroeconomic activity" &hese models will $e $ ilt pon the components we have st died in recent weeks" &he first model we disc ss e%plains how the demand side operates, that is, the model descri$es )*eynesian+ macroeconomics" On that note, here we !o,"

1. The Keynesian Cross (income-expenditure diagram) a) Firms produce what they expect to sell Firms prod ce what they e%pect to sell" As we disc ssed while s mmari-in! demand.side theory, prod ction is motivated $y sales e%pectations" &his o$servation leads to the $ehavioral ass mption that firms produce what they expect to sell" &herefore, if we !raph /%pected 0ales vers s 1rod ction (2), we will !et the a!!re!ate s pply c rve (A0), a line with a slope of 31" ()0 pply+ is another piece of (ar!on economists se for the concept of prod ction") A slope of 31 means that for every point on the A0 c rve, prod ction e4 als e%pected sales" A slope of 31 is e4 ivalent to sayin! the A0 line makes a 56 de!ree an!le with either a%is"

(1) The ! degree line as the aggregate supply cur"e. 7ere is the pict re8 /%pected A9 A0

56o O tp t (2) #) The aggregate demand cur"e$ positi"e slope and the %&C #e will derive the a!!re!ate demand c rve from the cons mption f nction" &he cons mption f nction shows one component of A9 (:) as a f nction of income" ('emem$er income and o tp t are concept ally the same thin! at the macro level") &o !et to the A9 c rve from the :ons mption F nction, simply add the other components of A9" &his will res lt in a shift upwards" ;ote that theoretically the A9 c rve co ld $e $elow the cons mption f nction if <mports was lar!e eno !h, $ t in reality this wo ld not happen" &he slope of the A9 c rve is the same as the slope of the :ons mption F nction $eca se we are ass min! that <, =, /%, and <m do ;O& vary with income>they are p rely e%o!eno s varia$les (at this point)" &herefore, the slope of the A9 c rve is still the ?1:" (@ater on, we will make the model more complicated, however")

A9 A9 A :3<3=3/%.<m

:ons Fn" (:) <3=3/%.<m

<ncome (2) c) 'etermination o( macroeconomic e)uili#rium #hen we derived the A0 and A9 c rves separately, the %.a%es were la$eled 1rod ction and <ncome, respectively" #hen we com$ine the !raphs, we ( st la$el it 2, which we can do $eca se income A prod ction" 0imilarly, the y.a%es were la$eled A9 and e%pected sales" #hen we p t the !raphs to!ether, we ( st la$el the y.a%is )A9,+ which co ld stand for either e%pected or act al A9" Also, $eca se the slope of the A9 c rve A ?1:, which m st $e less than 1, the A0 and A9 c rves will intersect" 7ere is the pict re8

A9

A0 A9 *

20

&he concept of e4 ili$ri m is sed in the analysis of most economic models" <n the *eynesian cross model, e4 ili$ri m occ rs when A0 e4 als A9, point * in the a$ove !raph" /4 ili$ri m is a Bstate of restB where there is no endo!eno s process that chan!es thin!s" 7owever, the economy need not always $e in e4 ili$ri m $eca se thin!s chan!e (via e%o!eno s shocks)"

/4 ili$ri m is a point when e%pectations are reali-ed" Firms e%pect to sell 20, they prod ce 20, and act ally they sell 20" <f the e4 ili$ri m is to $e a meanin!f l state for the real.world economy, it is necessary that there $e some endo!eno s forces in the system that p sh the economy toward the e4 ili$ri m" &hen, we can view the e4 ili$ri m as a kind of Bcenter of !ravityB that attracts the act al economy to it" 0 ppose we start off o t of e4 ili$ri m, meanin! a level of prod ction where A0 does not e4 al A9" &hink a$o t a level of o tp t prod ced a$ove the e4 ili$ri m" :all this level 27 (the 7 stands for hi!h) where 27 C /4" 20" At 27, A0 is !reater than A9" (0how this for yo rself on the !raph a$ove or refer to yo r class notes") &herefore, prod ction is !reater than sales" &he amo nt of this difference e4 als the vertical distance $etween the A0 and A9 c rves at 27" #hen firms are not sellin! what they prod ce, they will lower prod ction" &his res lts in lower o tp t and a movement down the A0 c rve" As we know, lowerin! prod ction will lower income" &his leads to a movement down the A9 c rve" &herefore, $oth prod ction and sales drops ntil we reach e4 ili$ri m, point *" ;ote that while $oth prod ction and sales drop, sales will drop $y a lesser amo nt $eca se the slope of the A9 c rve is less than the slope of the A0 c rve" 0ymmetrically, if we start from a level of o tp t $elow the e4 ili$ri m, A9 e%ceeds A0 (show this yo rself on the !raph)" Firm sell more than they prod ce" &hey will raise sales e%pectations and therefore increase prod ction" O tp t rises and income rises ntil the economy conver!es a!ain to e4 ili$ri m" &his )dynamic process+ (dynamic means that it happens thro !h time) p shes the economy to e4 ili$ri m" <f we ass me that the conver!ence to e4 ili$ri m takes place rather 4 ickly, the e4 ili$ri m point is a !ood prediction for where the economy act ally operates" Dy analy-in! how the e4 ili$ri m points chan!e, we can predict the effect of vario s kinds of shocks on the model" &his is an a$straction a!ain" &he economy is not always e%actly at e4 ili$ri m, $ t the chan!e in e4 ili$ri m provides a !ood appro%imation to what act ally happens in the economy" <n most of what follows, we will not disc ss the ad( stment to e4 ili$ri m in detail" #e will ( st ass me the economy always operates at e4 ili$ri m

(1) +ales expectations decrease i( output a#o"e e)uili#rium , lower production

(-) +ales expectations increase i( output #elow e)uili#rium , higher production

(.) /)uili#rium where demand expectations are reali0ed

d) +hi(ts o( aggregate demand and changes in e)uili#rium output (1) Changes in the consumption (unction

A cons mption shock will ca se a shift in the a!!re!ate demand c rve s ch as the one ill strated in the !raph $elow" &he E0 economy was e%periencin! a recession leadin! to the events of 0eptem$er 11" After the attacks there were concerns that the economy wo ld weaken f rther" <nstead, cons mption act ally increased ca sin! a $oost to the a!!re!ate demand as pict red $elow" ?arketin! efforts $y =? and other a tomakers and a sense of comin! to!ether as a co ntry may have contri$ ted to a rise in a tonomo s cons mption" A0 A9 D A9 (0 mmer 2001) A A9 (@ate Fall 2001)

20

21

&he fall in cons mption after the poppin! of the ho sin! $ $$le in 200F likely led to a lar!e ne!ative cons mption shock that wo ld p sh down the A9 c rve and ca se a red ction in e4 ili$ri m o tp t that $ecame the =reat 'ecession"

(-) Changes in in"estment #hen the hi!h.tech $oom of the late 1GG0s came to an end, there was a dramatic drop in $ siness investment spendin!" @etHs consider the effect of the decline in investment spendin! that took place $etween 2000 and 2001" @ower investment red ces a!!re!ate demand for any income level" &h s, the A9 c rve shifts downward" &he e4 ili$ri m point moves from * to 1" /4 ili$ri m o tp t falls from 20 to 218

 A0 A9 A A9 (@ow <nvestment) D A9 (7i!h <nvestment)

21

20

(.) /conomic (luctuations due to changes in aggregate expenditure &his model !ives )*eynesian+ macroeconomic predictions" &hat is, in this model, shifts in A9 (or, in more modern lan! a!e )a!!re!ate demand shocks+) drive macroeconomic fl ct ations" 0hort.term !rowth and recessions are the res lt of shifts in the A9 c rve" &his is clearly a )demand.side+ model" An endo!eno s varia$le is one that is e%plained $y the model" An e%o!eno s varia$le is one that is determined o tside the model $y e%ternal forces" Dein! e%o!eno s does not mean that the varia$le is constant, $ t that it is determined o tside of the model" <n the *eynesian :ross model, 2 and : are endo!eno s" 2 is clearly endo!eno s $eca se it is determined $y e4 ili$ri m levels of A9 and A0" #hile it is more s $tle, it is also tr e that : is endo!eno s $eca se : is a f nction of 2" <f 2 is determined $y the model, then : m st $e too" 0ales is also endo!eno s" <n simplest version of the *: model, all other varia$les are e%o!eno s (ta%es I&J, interest rate IrJ, =, < , /%, <m, the ?1:, the a tonomo s component of cons mption IaJ, etc")"

e) /ndogenous "s. exogenous "aria#les in economic models

More humor from former TA and the original note-taker Jamie Kucher, suggesting a sad commentary on the typical economist: A $oy was crossin! a road one day when a fro! called o t to him and said, B<f yo kiss me, <Kll t rn into a $ea tif l princess"B 7e $ent over, picked p the fro! and p t it in his pocket" &he fro! spoke p a!ain and said, B<f yo kiss me and t rn me $ack into a $ea tif l princess, < will stay with yo for one week"B &he $oy took the fro! o t of his pocket, smiled at it, and ret rned it to his pocket" &he fro! then cried o t, B<f yo kiss me

and t rn me $ack into a princess, <Kll stay with yo and do A;2&7<;= yo want"B A!ain the $oy took the fro! o t, smiled at it and p t it $ack into his pocket" Finally, the fro! asked, B#hat is the matterL <Kve told yo <Km a $ea tif l princess, that <Kll stay with yo for a week and do anythin! yo want" #hy wonKt yo kiss meLB &he $oy said, B@ook, <Km an economist" < donKt have time for a !irlfriend, $ t a talkin! fro! is cool" -. /)uili#rium output and potential output a) 'e(inition o( potential output &h s far we have learned that the e4 ili$ri m level of o tp t depends on shifts in the A9 c rve" As we have drawn it, the A0 c rve will !o p at a 56M an!le indefinitely" 7owever, in reality there is a prod ction capacity limit" 0 ppose, for e%ample, that all of a s dden there was an A9 shock and A9 do $led" Firms wo ld not $e a$le to s pply that m ch immediately" &herefore, there is a limit as to how m ch prod ction can $e s pplied" &his limit comes from the s pply side of the economy, that is, potential output" As disc ssed earlier in the co rse, potential o tp t (represented with the sym$ol 2N) is what the economy can prod ce when all la$or and capital reso rces are fully utilized with the pre ailing technology" o All la$or reso rces f lly tili-ed means the economy operates at f ll employment" D t, as disc ssed earlier in the co rse, the nemployment rate will not $e -ero" o F ll tili-ation of capital reso rces implies hi!h capacity tili-ation, $ t for technical reasons the act al meas re of capacity tili-ation will not !et to 100 percent" o 2N co ld (and does) increase" &his is where the phrase )with prevailin! technolo!y+ comes in" #hen technolo!y advances, 2N will $e !reater, meanin! it is possi$le for the economy to prod ce more" <n the short term, it is pro$a$ly possi$le for the economy to prod ce $eyond 2N" 9 rin! #orld #ar <<, the Enited 0tates prod ced more o tp t than what was s staina$le in the lon! term" ?ore people were in the la$or force than wo ld have normally wanted to work" <n o r analysis, we will ass me 2N is in fact the ma%im m level of o tp t" A!ain, this ass mption is an a$straction" /ven tho !h the economy mi!ht prod ce a $it a$ove 2N sometimes, this sit ation is n s al and not a ma(or concern" A!ain, as disc ssed earlier in the co rse, potential o tp t is a tar!et for !ood economic performance" <f we accept the typical )more is $etter+ ass mption, we want the economy to prod ce as m ch as possi$le" &his tar!et is reached if o tp t e4 als 2N" ?ost economists think that the E"0" was at 2N in the late 1GG0s and the first half of 2000" &his is primarily $eca se of the very low nemployment level $y historical

standards" 1rior to the =reat 'ecession in 200O and 200F most economists tho !ht that the economy was operatin! at, or at least close to, 2N" #) &otential output as a limit to expansion induced #y higher expenditure &he concept of potential o tp t can $e incorporated into the *eynesian :ross !raph $y limitin! A0 once it reaches 2N8 *' * *'2 *+ A9N

1 32 34 3

/4 ili$ri m o tp t cannot e%ceed 2N in this dia!ram, altho !h e4 ili$ri m can $e at a lower level of o tp t than 2N if A9 is $elow A9N A9 hi!her than A9N will leave some desired sales nf lfilled (demand e%ceeds s pply)" &his sit ation is likely to $e inflationary"

c) 5o necessary reason (or aggregate expenditure to #e su((icient to purchase potential output$ a (undamental macroeconomic pro#lem As mentioned a$ove, 2N is the tar!et level of o tp t" &h s, we want an e4 ili$ri m like point A in the !raph a$ove" &here is no ! arantee, however, that A9 will $e consistent with the level A9N needed to !ive e4 ili$ri m at point A with o tp t 2N" <f A9 is not hi!h eno !h, e4 ili$ri m may $e at a point like D with o tp t $elow 2N" <n this case, reso rces are wasted and social welfare is red ced, as disc ssed earlier in the co rse when we talked a$o t nemployment" &his is the key dilemma noted $y *eynes as he wrote his seminal $ook in the midst of the =reat 9epression" *eynes $elieved that the 9epression was ca sed $y low a!!re!ate demand" <n his theory, A9 mi!ht $e hi!h eno !h to p sh e4 ili$ri m o tp t to 2N, $ t this wo ld happen only in a special case" &he more )!eneral+ case, he predicted, wo ld $e e4 ili$ri m o tp t $elow 2N" &his is the reason he entitled his $ook the !eneral &heory of /mployment, <nterest, and ?oney"

.. The %ultiplier a) 6raphical demonstration o( the multiplier e((ect *' 1 *'2 *+ *'1

32

31 34

<n the !raph a$ove, the vertical do $le.headed arrow represents the si-e of the initial positive demand shock" &he vertical distance of the shift pward indicates the amo nt demand initially rises holdin! income constant" D t o tp t and income rise m ch more than the si-e of the initial demand shock" &he chan!e in o tp t is indicated $y 21 P 20, also show $y the hori-ontal do $le.headed arrow in the !raph a$ove" &he fact that 2 rises more than the si-e of the initial demand shock represents the m ltiplier" &hat is, the 4 antitative effect of a demand shock on e4 ili$ri m o tp t is lar!er than the si-e of the shock" &he e%istence of a m ltiplier e%plains why the effects of an A9 shock are lar!er than the si-e of the ori!inal A9 shock" For e%ample, a Q10 $illion positive investment shock will have more than a Q10 $illion effect on e4 ili$ri m o tp t" @etHs consider the int ition $ehind the m ltiplier" 0 ppose that there is a positive A9 shock" &his ca ses sales, e%pected sales, and o tp t to rise" 7i!her o tp t raises employment and income" 7i!her income ca ses hi!her cons mption, which raises A9 even more and the cycle contin es a!ain" &h s, the effect on o tp t is lar!er than the si-e of the ori!inal demand shock" One co ld say that the m ltiplier process )ma!nifies+ the effect of any initial demand shock" ;ote that the m ltiplier works in $oth directions" <f the initial shock is ne!ative, it will also $e ma!nified"

#) 7ntuition #ehind the multiplier

c) *lge#raic analysis o( the multiplier phenomenon ;ow we will se a simple al!e$raic version of the *eynesian :ross model to demonstrate the m ltiplier model with e4 ations" De!in with the cons mption f nction8 o : A a 3 (?1:)2 &he definition of a!!re!ate demand is8 A9 A : 3 < 3 = 3 /% P<m <n e4 ili$ri m, o tp t e4 als a!!re!ate demand, so 2 A A9 7ence, 2 A : 3 < 3 = 3 /% P <m or s $stit tin! the cons mption f nction for : !ives 2 A Ia 3 (?1:)2J 3 < 3 = 3 /% P<m ;ow, solve this e4 ation for 2, the e4 ili$ri m level of o tp t8 o 2 P (?1:)2 A a 3 < 3 = 3/% P <m o 2 (1 P ?1:) A a 3 < 3 = 3/% P <m o 2 A I 1 R (1.?1:) J Ia 3 < 3 = 3 /% P <mJ &he e%pression 1R(1.?1:) is called &he ? ltiplier" &he m ltiplier is a meas re of $y how m ch an initial A9 shock is ma!nified to !et the total effect of the shock on e4 ili$ri m o tp t" 0ince the ?1: is always $etween 0 and 1, the m ltiplier is always !reater than or e4 al to 1" :oncept ally, this means that the val e of the initial shock is m ltiplied $y a n m$er !reater than one to !et the total effect of the shock (ie8 total effect C initial shock)" <f, however, the ?1: e4 als 0, then we !et a m ltiplier of 1" o 2o can show from the !raph, that if the ?1: is -ero, the A9 c rve is hori-ontal" #hen A9 shifts p in this special case e4 ili$ri m o tp t rises ( st as m ch as the si-e of the initial shock, and no more" &h s, the !raph !ives the same answer as the al!e$ra" o <nt itively, if the ?1: is -ero we wo ld not e%pect any )ma!nification effect+ $eca se there is no feed$ack in the circ lar flow model after the economy ad( sts to the initial demand shock" /%ample8 0 ppose that investment rises from <0 to <1" o <nitial e4 ili$ri m o tp t, 20 is8 20 A I1R(1.?1:)J N (a 3 <0 3 = 3 /% P <m) o Final e4 ili$ri m o tp t, 21 is8 21 A I1R(1.?1:)J N (a 3 <1 3 = 3 /% P <m) o 0 $tract the 20 e4 ation from 21 e4 ation to o$tain8 o S2 A 21 P 20 A I1R(1.?1:)J N (<1 P <0) A I1R(1.?1:)J S<

o As we can see, as lon! as 0 T ?1: T1, the m ltiplier will $e !reater than 1" ? ltiply the m ltiplier $y the si-e of the initial shock, S<, and yo will !et the si-e of the total effect of the A9 shock on e4 ili$ri m o tp t, S2 d) The in"estment accelerator 445ote$ The material in this topic (8.*. .d)was not co"ered in class (spring9 -211) in the interest o( time. 1ut it pro"ides a use(ul and realistic example o( the models we are wor:ing with. +tudents should study this material on their own. 7t will li:ely appear in some (orm or other on the homewor: or (inal exam. 44 <n o r disc ssion of investment earlier in the co rse we emphasi-ed the volatility of investment" <n partic lar, we disc ssed how investment is hi!hly procyclical, risin! when o tp t is hi!h and fallin! when o tp t is low" &herefore, the ass mption in the $asic *eynesian :ross model that investment is e%o!eno s is not very realistic" #e can improve the model $y incorporatin! an investment e4 ation that allows investment to vary with o tp t" /conomists call the positive link $etween investment and o tp t )the accelerator+ &he accelerator meas res the additional < !enerated from an increase in 2" &he $asic investment accelerator e4 ation (which looks very similar to the cons mption f nction) is < A $ 3 (A::)N2 # is determined e%o!eno sly, and is similar to a in the cons mption f nction" &he accelerator, A::, is always $etween 0 and 1 (like the ?1:) $ t it typically is low (possi$ly a$o t 0"1) $eca se < is a relatively small percenta!e of 2" #ith a positive A:: in this model, < will rise when 2 rises and < will decline when 2 falls, ( st as o r theory predicts and the data demonstrate" Esin! the followin! e4 ations, we will calc late e4 ili$ri m 2 : A a 3 (?1:)2 < A $ 3 (A::)2 A9 A : 3 < 3 = 3 /% P <m 2 A A9 (which is tr e in e4 ili$ri m8 2 A A0 A A9) 2 A Ia 3 (?1:)2J 3 I$ 3 (A::)2J 3 = 3 /% P<m 2 P (?1:)2 P (A::)2 A a 3 $ 3 = 3 /% P <m 2 (1 P ?1: P A::) A a 3 $ 3 = 3 /% P <m /4 ili$ri m 2 A I 1 R (1 P ?1: P A::) J Ia 3 $ 3 = 3 /% P <mJ

(1) *n e)uation capturing in"estment "olatility

(-) /((ect on the multiplier

&his is the e4 ation for e4 ili$ri m o tp t, takin! into consideration the endo!eno s effects a chan!e in 2 has on cons mption and investment" As we can see al!e$raically, an increase in the A:: will increase the val e of the m ltiplier" &his sho ld make sense concept ally also" <f we have any A9 shock (chan!e in the stock market, chan!e in !overnment spendin!, etc), we will see an increase in <" &his is another way of sayin! that < is procyclical8 any increase in 2 will have an increase in <" <n addition, in this model < rises ( st like : when income !oes p, which makes the m ltiplier effect lar!er" /ffect of the accelerator on the *: model !raph8 *' *+ *'1 (*CC ; 2)

*'2 (*CC < 2) 1

* 32 31 34 3

o &he accelerator effect raises the slope of the A9 c rve" #hen A:: C 0, an increase of 2 not only raises cons mption, $ t it also raises investment" o As we have seen $efore, if the A9 c rve is steeper, the m ltiplier is lar!er" &h s, the !raph a$ove is consistent with o r al!e$raic analysis of the accelerator"

B% Fisca' Po'ic" in t!e #e"nesian Frame+or,

1. 6o"ernment spending sta#ili0ers (or demand-induced (luctuations a) +pending increases to o((set recession <n the *eynesian framework, hi!her !overnment spendin! will stim late the economy" <n this sense, a short term increase in deficit spendin! may $e $eneficial as it co ld lead the economy o t of the recession" #hen yo increase =, this res lts in a shift pward of the A9 c rve" &herefore, e4 ili$ri m 2 !oes p" /ffect of the ? ltiplier o S2 A I1 R (1.?1:J N S=

#) The multiplier and pump priming

o &herefore, the effect on 2 is lar!er than the chan!e in =" &herefore, if S= C 0 then S2 C 0 and S2 C S= o <f yo do not see this relationship $etween S2 and S= ri!ht away, write o t the e4 ations for e4 ili$ri m 2 !iven =0 and =1" &hen s $tract 20 from 21 to !et S2" (#e did the same thin! for S< earlier in these notes)" o <f the model had an accelerator effect in it, the m ltiplier wo ld $e even lar!er" &he )p mp primin!+ metaphor comes from what it takes to !et a p mp !oin!" #hen the p mp is dry, yo have to p t a little water into it to )prime+ it" #hen this water is p mped thro !h, it creates a vac m that s cks water o t of the well" &hen yo can p mp lots of water" &he increase in = is like )primin! the p mp+ of A9 creation and the m ltiplier <n response to the =reat 9epression, there was a lot of !overnment spendin! on p $lic works pro(ects to $oost the economy" 1ro!rams incl ded the #1A (#orks 1ro!ress Administration) that employed 3,500,000 people at its peak in 1G3O to $ ild roads, $rid!es, p $lic $ ildin!s, parks, etc" &he &ennessee Valley A thority $ ilt dams for flood control and hydroelectric power" &he :ivilian :onservation :orps (:::) created (o$s devoted to conservation pro(ects, incl din! development of the national parks" &hese activities may have $een ( stified $y the specific o tcomes they created (roads, parks, etc") D t these );ew 9eal+ pro(ects also were ( stified a macroeconomic o$(ective to stim late the $road economy" &h s, this set of policies is consistent with *eynesian fiscal policy" 9 rin! #orld #ar << (as yo may have noticed, ##<< is a common historical e%ample), the chan!e in o tp t was h !e" &here is little do $t that the dramatic rise in o tp t was d e in lar!e part to the massive increase in !overnment spendin! associated with the war effort" #hen :linton was first elected in 1GG2, the economy was doin! poorly (end of the recession)" 7e proposed a Q30 $illion stim l s packa!e to $oost the economy" &his packa!e incl ded transportation and research pro!rams that may have $een ( stified on their own merits" D t it was clear that part of the o$(ective was $road macroeconomic stim l s" &he packa!e was not passed $y :on!ress, $ t the lo!ic of this policy was related to principles of *eynesian fiscal policy" &he wars in <ra4 and Af!hanistan d rin! the =eor!e #" D sh administration were certainly not )desi!ned+ to stim late the economy" D t hi!her spendin! of Q100 to Q160 $illion per year for these wars ndo $tedly raised A9" 0ome of this spendin! was sed for services p rchased a$road, which co ld $e viewed as imports that donHt raise E"0" A9" <n a nearly Q15 trillion economy, this additional amo nt of A9 is not h !e (itHs a$o t a one percent shock)" ;onetheless, especially with some m ltiplier effect, the additional war spendin! co ld have a non.trivial effect on year.to.year economic !rowth"

c) =istorical examples

9 rin! the =reat 'ecession, vario s fiscal )stim l s+ policies were implemented in a variety of co ntries" &he effect of these policies on o tp t and employment have $een widely de$ated amon! economists and politicians" &he *eynesian perspective presented here s pports the idea that hi!her !overnment spendin! stim lates the economy, and that the total effect on o tp t e%ceeds the val e of the rise in spendin! d e to the m ltiplier" o &he economists in the O$ama administration in early 200G estimated that the m ltiplier was a$o t 1"6" &hey sed this fi! re to forecast the effect of the )American 'ecovery and 'einvestment Act+ (A''A), that was si!ned into law soon after 1resident O$ama took office" o &he e%pectation was that the A''A stim l s wo ld create or save several million (o$s and red ce the increase in the nemployment rate" o As it t rned o t, the nemployment rate and associated (o$ losses in 200G and 2010 were s $stantially worse than the administration forecast" &his o tcome led many critics of the O$ama economic policies to la$el the A''A stim l s a fail re" o &he co nter ar! ment is that the employment crisis wo ld have $een e en worse witho t the stim l s" ?ore people wo ld have $een laid off and the decline in (o$s wo ld have $een even more severe" <t is the case that the early 200G forecasts of O$ama economists were too optimistic" D t nearly all economists were makin! similar forecasts at the time that nderestimated the serio sness of the =reat 'ecession" a" <t is the case that people were employed in new (o$s financed $y A''A f ndin!" Also, a $i! part of A''A was !rants to states to help them offset the decline in their ta%es" &he states laid off a lar!e n m$er of p $lic employees d e to their fiscal crisis" <t seems likely these layoffs wo ld have $een even lar!er if not for the A''A money comin! from the federal !overnment" o Other co ntries also sed fiscal stim l s" <n partic lar, :hina implemented a massive pro!ram" :omparisons are tricky, $ t relative to the si-e of the economy, :hinaHs stim l s looks to $e fo r to five times as lar!e as the E"0" A''A plan" After declinin! sharply early in the =reat 'ecession, :hinaHs economy $o nced $ack 4 ickly"

-. Tax policy$ Consumption and taxes 7ere is a version of the al!e$raic *: model that incorporates ta%es8 o @et cons mption depend on disposa$le income, denoted $y 2.&, where & stands for e%o!eno s ta%es8 o : A a 3 (?1:)N(2 . &) o Ass min! < is e%o!eno s (no accelerator for the moment), we can solve for e4 ili$ri m o tp t as follows8

2 A A9 A : 3 < 3 = 3 /% P <m 2 A Ia 3 (?1:)N(2.&)J 3 < 3 = 3 /% P <m 2 (1 P ?1:) A a P ?1:(&) 3 < 3 = 3 /% P <m 2 A I 1 R (1.?1:) J Ia P ?1: (&) 3 < 3 = 3 /% P <mJ From this form la we can write e%pressions for the chan!e in 2 ca sed $y either a chan!e in !overnment spendin! or a chan!e in ta%es8 S2 A I 1 R (1.?1:) J N S= S2 A I 1 R (1.?1:) J N (?1:)N(.S&) &he form la for the chan!e in ta%es has a similar form to the one that predicts the effect of a chan!e in !overnment spendin!, $ t there are some important differences" o First, there is a ne!ative si!n on the chan!e in ta% term" &his ne!ative si!n !ets the direction of chan!e ri!ht" <f ta%es fall (a ne!ative S&) then o tp t rises (a positive S2)" &hat is, S& and S2 move in the opposite direction" (;otice that no ne!ative si!n is needed in the e4 ation predictin! the effect of S= on S2 $eca se these two varia$les move in the same direction") o #hy do we have the )e%tra+ ?1: term in the S2 e4 ation when the fiscal stim l s nder consideration takes the form of a ta% c tL &his is $eca se if we c t ta%es, the entire ta% c t will not show p in the initial A" shock" 0 ppose the ?1: is 0"G and we have a shock of a Q1,000 ta% c t, then the initial shock to cons mption is only QG00" <t is this n m$er, not Q1,000 that then !ets ma!nified $y the m ltiplier" 0o, what will have a lar!er effect on 28 a Q1,000 increase in = or a Q1,000 ta% c tL &he answer is a Q1,000 increase in =, $eca se the initial A9 shock in this case will $e Q1,000" &he initial A9 shock in the case of the Q1,000 ta% c t will $e Q1,000 N ?1:" =overnment 9eficit A = P &" (<f ta%es C !overnment spendin!, then the !overnment deficit is ne!ative, meanin! there is a !overnment s rpl s")

.. Can go"ernment de(icits #e good>

a) Con"entional "iew on dangers o( go"ernment de(icits Fiscal policy in a recession can $e implemented either $y increasin! = or lowerin! &" 7owever, either one (or especially if $oth policies are p rs ed) will increase the deficit (or lower the s rpl s)" &his is a criticism of *eynesian policy>it creates deficits" =overnment de$t is s ally considered a $ad thin!" &he national de$t is $ad $eca se the E"0" has to pay interest on the de$t" &he interest payments are transfer payments that !o to E"0" $ondholders" &hese people tend to $e richer citi-ens" &herefore, a criticism of the national de$t is that the !overnment payments are !oin! to the rich in

the form of interest payments where it co ld $e !oin! towards a variety of other activities to $enefit other classes (s ch as a ta% c t, spendin! on ed cation, social sec rity, etc) if the !overnment did not have to pay this interest every year" <n addition, there is a concern that $eca se the interest and principal payments on the de$t m st $e made in the f t re, the deficit places a $ rden on f t re !enerations of ta%payers" &he si!nificant increase in the !overnment deficit d rin! the D sh administration was stron!ly critici-ed for these reasons" &he potential pro$lems with the deficit were a key iss e in the 2005 presidential election" After the =reat 'ecession, the E"0" deficit e%panded a!ain to levels not seen since #orld #ar 2" As of the sprin! of 2011, these h !e deficits have $ecome a serio s political iss e" <f the economy is operatin! $elow f ll employment, then fiscal stim l s can $e !ood" Fiscal stim l s, whether it comes from hi!her = or lower & almost certainly will raise the deficit" <f the !overnment !enerates o tp t, employment, and income, then they may make more ta% reven es in the f t re" &herefore, while the *eynesians do not think that a !overnment deficit is !ood in and of itself, they do $elieve that if the economy is weak, the $enefits of the deficit can o twei!h the disadvanta!es" &his perspective s !!ests that the D sh ta% c ts co ld have $een helpf l for the E"0" economy in the early part of the 2000s" &he recession of 2001 and slow, )(o$less+ recovery from it led to hi!h nemployment" &o the e%tent that the ta% c ts stim lated demand, they wo ld have helped to solve the nemployment pro$lem" One can certainly critici-e the detailed str ct re of the D sh ta% c ts from a *eynesian perspective, however" <f more of the ta% c ts went to lower and middle income people, they mi!ht have raised A9 even more and provided more economic stim l s" o &o make this point more formally, s ppose the cons mption f nction is as follows8 : A a 3 ?1:' (2' P &') 3 ?1:O (2O P &O)" o <n this model, the )'+ s perscripts denote the ?1:, income, and ta%es for )rich+ people and the )O+ s perscripts refer to everyone else" &he standard ass mption is that ?1:' T ?1:O, that is, the rich spend a smaller portion of their disposa$le income" o 2o can derive the e4 ili$ri m for the model with this cons mption f nction as follows8 2 A : 3 < 3 = 3 /% P <m

#) The Keynesian criti)ue$ de(icits to stimulate a wea: economy

2 A Ia 3 ?1:' (2' P &') 3 ?1:O (2O P &O)J 3 < 3 = 3 /% P <m 2 P ?1:' (2') P ?1:O(2O) A a P ?1:' (&') P ?1:O (&O) 3 < 3 = 3 /% P <m 2 (1 P ?1:AV=) A a P ?1:' (&') P ?1:O (&O) 3 < 3 = 3 /% P <m where ?1:AV= A ?1:' (2'R2) 3 ?1:O(2OR2), the )wei!hted avera!e+ mar!inal propensity cons me for the entire economy" &he )wei!hts+ are the shares of income earned $y the rich !ro p and the other !ro p" o 0o, the effect of a ta% c t on o tp t is8 S2 A I 1 R (1.?1:AV=) J I(?1:')N(.S&') 3 (?1:O)N(.S&O)J o <f ?1:' T ?1:O then a dollar of ta% c t to the rich !ro p will have a smaller effect on o tp t than a dollar of ta% c t to the other !ro p" &his res lt also helps e%plain why many economists $elieve that ta% c ts for lower and middle income families wo ld provide more effective at stim l s in the aftermath of the =reat 'ecession" <n partic lar, the O$ama administration has p rs ed red ctions in the payroll ta% (the ta% that f nds 0ocial 0ec rity and part of ?edicare)" &his ta% is imposed at a flat rate on all wa!es p to a ann al cap (the cap is a$o t Q10F,000 for 2010)" : ts in this ta% rate tend to $e more $roadly distri$ ted than c ts to income ta% rates $eca se the income ta%es are skewed m ch more toward wealthy people" &his perspective also helps e%plain why some people $elieve that allowin! the D sh ta% c ts to e%pire for hi!h income people (ro !hly the top 2 percent of the income distri$ tion) wo ld not have a very lar!e effect on e4 ili$ri m o tp t" o &o see this res lt formally, look a!ain at this e4 ation8 S2 A I 1 R (1.?1:AV=) J I(?1:')N(.S&') 3 (?1:O)N(.S&O)J 0 ppose that the elimination of the hi!h.income D sh ta% c ts implies a positive val e of S&' and the val e of ?1:' is fairly small" &hen, the ne!ative effect on S2 will $e relatively small" o D t as lon! as ?1:' is not -ero, even an increase in ta%es on well.to.do people will still red ce o tp t"

. ?estraining a demand-led #oom with (iscal policy$ in(lation concerns 'estrainin! inflation is necessary when there is a sit ation of e%cess demand" *'1 *' C *'4 1 *'2 * *+

32

34

<t is desira$le to stim late the economy to point D" Deyond 2N, however, f rther increases in A9 will not $e met $y hi!her o tp t $eca se the economy has reached its potential capacity" 1olicy m st $e sed caref lly not to stim late A9 so m ch that we !et to point :" 1oint : is $ad $eca se it leads to inflation" #henever A9 C 2N, inflation will likely occ r, $eca se if demand e%ceeds what firms can prod ce, they will likely raise prices" Fiscal 1olicy to fi!ht inflationL o <f inflation is a concern in the economy, we co ld se fiscal policy to help c r$ inflation" /ither decreasin! = or increasin! & co ld shift the A9 c rve down, hopef lly to point D" 7owever, in practice, it is s ally monetary policy (raisin! interest rates) that is sed to slow down inflation" o <n the late 1GO0s when the economy was very stron! and inflation $e!an to rise, a temporary )s rta%+ was imposed on income ta%es" &he e%plicit o$(ective of this ta% increase was to red ce inflationary press re"

!. Choice o( spending policy "ersus tax policy to reach (iscal goals <f we are at point A in the !raph a$ove, wo ld the $etter fiscal policy $e to lower ta%es or to increase !overnment spendin!L #e saw that al!e$raically, increasin! = has a lar!er effect" 7owever, there are other factors that policymakers consider in choosin! the partic lar str ct re of economic stim l s plans"

a) Conser"ati"e criticism o( Keynesian (iscal policy as leading to #ig go"ernment$

*eynesian macroeconomics is often considered politically li$eral" <t is interventionist in nat re8 if the economy is not at potential o tp t, then the !overnment can intervene in an attempt to $rin! nemployed reso rces into se" <f we se the c rrent E"0" economic sit ation as an e%ample, the !overnment co ld stim late the economy $y increasin! its spendin!" D t, yo canHt increase !overnment spendin! witho t increasin! the power of the !overnment" :onservatives often ar! e that increased !overnment spendin! wo ld lead to the implementation of pro!rams that will not $e eliminated once we ret rn to potential o tp t" <f *eynesianism is considered politically li$eral, then why did =eor!e #" D sh p rs ed ta% c ts so a!!ressively sin! *eynesian stim l s as a rationaleL *eynesian stim l s thro !h ta% c ts rather than increased !overnment spendin! do not lead to a lar!e !overnment" :onservative *eynesianism can $e characteri-ed $y the followin! policies8 <f yo are at point A and want to stim late the economy, do so $y c ttin! ta%es" <f yo are at point : and want to slow down the economy, do so $y decreasin! !overnment spendin! (tho !h remem$er that monetary policy, not fiscal policy, is typically sed for controllin! inflation)" &he *eynesian feat re of this policy mi% !oes $eyond the typical conservative approach $y emphasi-in! timin!" &he *eynesian approach implies that ta% c ts sho ld $e made at the ri!ht time, when the economy is in a recession, or at least operatin! $elow 2N" <f spendin! c ts are made, they sho ld occ r in an otherwise stron! macro environment" &he latter point is partic larly relevant to fiscal de$ates in early 2011" ?any conservatives ar! e that E"0" federal !overnment spendin! is too lar!e in the lon! term" &hese ar! ments often rely on two $asic premises" First, !overnment is cons min! too many reso rces and the overall welfare of society wo ld $e $etter served $y reallocatin! reso rces away from p $lic ses to private ses" 0econd, the E"0" does not have ade4 ate ta% reven es to s pport the c rrent level of !overnment spendin! (incl din! promised )entitlements+ like 0ocial 0ec rity and ?edicare in the f t re)" &he res lt is lar!e, ndesira$le !overnment deficits" o ?any moderate economists and politicians a!ree with some aspects of these ar! ments" D t they also accept the $asic *eynesian idea that lower !overnment spendin! will red ce demand, weaken the economy, and increase nemployment" From this perspective, even if c ts in !overnment spendin! are necessary in the lon! r n, it is a $ad time to make s ch c ts when the economy s ffers from a very hi!h level of nemployed reso rces, like the sit ation in the aftermath of the =reat 'ecession" o &his ar! ment e%tends to ta% policy" A widely held ar! ment amon! moderates, and even li$erals, is that the co ntry needs a stron! social safety

#) * conser"ati"e Keynesian policy$ use tax cuts and spending cuts

net, $ t sho ld not pay for it $y r nnin! deficits" 1eople with this view often ar! e that ta%es need to rise to cover the risin! cost of the social safety net, especially health care costs that are affected $y the a!in! of the $a$y $oom, lon!er life spans, and the risin! relative price of medical care" D t, a!ain, the time to raise ta%es may not $e when the economy s ffers from so many slack reso rces" <t may $e $etter to tolerate lar!e deficits ntil a ro$ st recovery eliminates nemployment" @. &ractical challenges o( managing (iscal policy O r disc ssion of fiscal policy makes it seem pretty easy" #e see points A and D on the !raph a$ove, know the concept of the m ltiplier, etc" <t seems like !ettin! o t of a recession is a pretty simple task" 7owever, there are many reasons why sin! fiscal policy to !et to 2N can $e diffic lt" <t is diffic lt to know how lon! it will take to !et from point A to point D" o <t takes some time to reco!ni-e that the economy is in recession, or even $elow potential o tp t" /conomic data are prod ced with a la! and the fi! res $o nce aro nd from month to month, even 4 arter to 4 arter" o Once a pro$lem of o tp t $elow potential (or nemployment) is identified, it takes a lon! time for the political process to a!ree on a fiscal stim l s plan" 0ho ld spendin! rise or ta%es $e c tL <f ta%es are to $e c t, which ones sho ld $e c tL O$vio sly, there will $e a lot of political pro$lems associated with these policies that will take time to work o t, especially in a hi!hly partisan political environment" #) Ancertainty a#out the +i0e o( the %ultiplier$ /conomists do not know the e%act val e of the ?1: or the e%act val e of the A::" *eynesians have si!nificantly different estimates of the m ltiplier" #itho t knowin! the val e of the m ltiplier, policymakers do not know the necessary si-e of a ta% c t or increases in =" #hen decidin! on the si-e of a ta% c t or an increase in !overnment spendin!, it is necessary to know the tar!et level of prod ction" 7owever, knowin! 2N is diffic lt $eca se it co ld $e constantly chan!in! d e to new technolo!ies" <f policy makers overshoot 2N, it will lead to inflation" *nowin! the e%act level of stim l s that will !et the economy to 2N $ t will not $e inflationary is a challen!e task"

a) Time lags and Forecasting &ro#lems$

c) Ancertainty a#out the le"el o( potential output$

d) Concerns that stimulati"e policy will #e in(lationary$