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 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

A1) Government Expenditures

A2) Government Purchases

A3) Transfers

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

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)

B1) The Effects of Government Spending Consumers

B1) The Effects of Government Spending Firms Hire labor to produce output Production Function Profits

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

B1) The Effects of Government Spending Pareto Problem Instead of solving for the Competitive Equilibrium solve for the efficient allocations subject to

B1) The Effects of Government Spending First order conditions

B1) The Effects of Government Spending Solving for the effect on output

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

B1) The Effects of Government Spending Implications: Interest rate

B1) The Effects of Government Spending Extension: Productive government spending

Planning problem: subject to Obtain

B1) The Effects of Government Spending Extension: Productive government spending Putting together The multiplier is now larger, but is still smaller than one

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