1 Macroeconomics I Lecture 3

2 The determination of national income Output and demand

3 Equilibrium model of J. M. Keynes (1936) Simple model ( no government, the closed economy): AD = C + I 1.Sticky wages and prices of goods 2. factors of production not fully employed 3.Short run approach: output depends on demand only

4 Demand for consumption goods Determined by the personal disposal income Yd Consumption function: C= MPC. Yd + Ca (KSK=MPC)

5 M. Friedman and F. Modigliani consumption function Permanent income hypothesis of M. Friedman: consumption determined not by current income but by long term income expectations. Short term change in income have little effects on consumer spending behavior Life cycle hypothesis of F. Modigliani: close to PIH, consumers make consumption plans for the whole life. They dissave early and late in the life and save during their peak earnings years – consumption smoothening. It explains why students live at much better level than their incomes suggest.

6 Saving function S= MPS x Yd – Ca, KSO= MPS

Marginal propensity to consume: fraction of a dollar by which consumption increases when income rises by a dollar MPC = 0.75 means that 75 cents of every extra dollar in income is consumed The rest, remaining 25 cents is saved MPS (marginal propensity to save) = 0.25 MPS + MPC = 1 7

8 Investment demand investment plans do not depend on the level of income (autonomous character of I )

9 Equilibrium output Demand= AD aggregate demand Y = C + I at point E aggregate demand equals to output

adjustment to equilibrium Y, outputIC= 8+0.7Y AD= C+I Y-ADInventories are output ↓↑ ↓↑ No inventories (E) constant ↑↓ 10

11 actual and full employment output AD = Y (output) does not guarantee output at full employment level. At Ye unemloyment is possible, distance Yb- Ye = output gap, Yb = full employment output

12 Income determination C = MPC x Y, Y = C+I=MPC x Y + I Y(1-MPC)=I Y=I/1-MPC MPC + MPS =1 Y=I/1-MPC = I/MPS or if MPC=c, MPS=s Y=I/1-c=I/s

What is the equilibrium level of output? C = Y I = 13 C + I = Y Y = Y 21 = Y (1-0.7) Y = 21 : 0.3 Y = 70 13

The multiplier (M) M = ratio of the change in equilibrium output to the change in autonomous investment M > 1, because any given change in investment demand sets off further changes in consumption demand We should expect that that M related to the MPC M= 1/1- MPC M=1/MPS If MPC=0.7, M=1/1-0.7 or M=1/0.3 = 3.33 The source of multiplier: Increase of the consumption that takes place when autonomous investment goes up 14

adjustment to a shift in investment demand stepsYIC= 8+0.7YAd= C+I Y-ADinventorie s output step constantConstant step ↑↓ step ↑↓ step ↑↓ New equilibrium constant Change in investment equals 9Change inoutputequals 30Multiplier equals 30/9 15

Saving equals investment I = Y – C S = Y – C I = S In the economy firms are investing and households do the saving P lanned I=planned S only at the equilibrium level of output (unplanned inventory changes = 0) Out of the equilibrium level of output: actual saving = actual investment (change in inventories counts as investment) Actual means: planned + unplanned 16

The paradox of thrift Virtues of saving and spending: 1) the increase of consumption is good for a society, spending provides jobs 2) saving is a good thing, it enables to provide more consumption in the future Paradox of thrift (Keynesian model): If AD = Y, but there is no full employment level, the private virtue of saving is not a public virtue (the collective thrift may be bad for the economy) If AD = Y, but the economy operates at a full employment, the desire to save will increase actual saving and encourage investment, so AD and Y need not decline What is true of the parts must not be true of the whole 17

The government and aggregate demand 1 The government’s spending and tax decisions constitute fiscal policy A budget – a description of the spending and financing plans of an individual, business or government Budget deficit – excess of government expenditure over its receipts Deficit paid by borrowing from the public through selling bonds The national debt – amount of government debt in the hands of the public 18

19 The government and aggregate demand 2 Government’s spending financed by: indirect taxes minus transfers payed to business, direct taxes minus transfers payed to households (NT), income from state property D Government purchases G - a part of the demand for goods and services AD=C+I+G If we assume that net indirect taxes = 0 and D = 0, the budget income equals net income from direct taxes NT = t x Y, Yd=Y-NT, Yd=Y-tY, Yd=Y(1-t) C =MPC x Yd, C=MPC x Y(1-t) MPC’ = MPC(1-t), Multiplier = 1/ 1-MPC’ = 1/1-MPC(1-t) Taxes drive a gap between GNP and personal disposable income

The impact of changes in G and NT Change in G (NT=0) changes the equilibrium output level. The increase of G – the same effect as an increase in investment demand ( the role of multiplier) The aggregate demand curve shifts upward by the amount=G The change of NT – change of C because of the change in MPC’ The slope of C curve is changing The increase in G and decrease in NT – the increase of the equilibrium output level. 20

21 The budget deficit The government budget describes: a) what goods and services the government will buy, b) what transfers it will make and c) how it will finance its spending with tax revenues D=0, indirect taxes =0, so net direct taxes NT taken into consideration only S+NT= leakages from circular flow: net taxes and saving – incomes not spent on consumption I+G=injections: income of firms and government not financed by huseholds Budget deficit = G - NT S+NT =G+I, it means that S ≠ I if there is budget deficit or surplus S-I=G-NT, If G > NT (budget deficit), some saving used to finance the deficit (S>I) 2 cases: 1) The increase in G. It makes the budget deficit higher: the equilibrium output level goes up, personal disposable income goes up, that increases saving and S-I, because I does not depend on income. At the same time tax revenues go up because income is going up. But tax revenue do not increase by so much as to end up reducing the deficit. The increased G is only partially, not fully self-financing 2a) G constant, tax rate increases, a direct increase in tax revenue, but also a decline of tax collection because income falls. Direct effect always dominates: higher taxes improve the budget situation, the deficit is going down. 2b) G constant. A tax cut, a direct decrease in tax revenue, but also an increase in tax collection because income goes up. Direct effect dominates – a reduction of budget deficit not possible

G=250, MPC=0.75, t=0.2, M=2.5=1/1-0.75(1-0.2 ) (1) Change in G MPC(2) Tax rate (3) Multiplier (4)=(3)x(1) Change in Y (5)=(2)x(4) Change in taxes (6)=(1)-(5) Change in deficit

23 Poland’s budget 2011 and 2012 Budget deficit 2011 ca 25 billion PLN, 2.0% of GDP Budget deficit billion PLN, 2,1% 9f GDP Revenues structure: (2008): tax revenues 80.95%, no-tax revenues 6,53%, EU funds 12,52% High percentage of expenditure regulated by law in GDP (2011)- 74 %, the share of social expenditure 41%, OECD countries 30% only The national debt (2011) 53%GDP

US budget situation 2013 National debt 2012= 100% of GDP Reduction of expenditure together with moderate increase of tax rate needed But political gridlock: republicans against tax increase March the law on automatic reduction of budget spending in force. Accepted by the Congress 1.5 year ago Effects of the law: drastic reduction of expenditure in 2 sectors: deffence and education Higher unemployment in those sectors, danger of recession Opinion of the Council of Economic Advisers to the President: the rate of growth will decrease by0.5%, unemployment will increase by 1 mln. 24

25 Fiscal policy Changes in budget revenues and expenditure change aggregate demand level. Increase in G and decrease in NT may stimulate growth of AD Active use of fiscal policy can get the economy close to its potential level, Tools of fiscal policy: a) public investment, b)programs supporting employment (subsidies to firms creating new jobs, c)increase in social transfers, tax cut Limited effects because of: recognition lag, legislation lag (gridlock), implementation lag. Automatic stabilizers: mechanism that reduces the response of GNP to shifts in aggregate demand caused by oil shock for example or the war Main automatic stabilizers: unemployment benefits, the income tax

the multiplier with proportional taxes MPCtMPC’= MPC(1-t) multiplier 1/1-MPC’ 0.9O

27 Foreign trade and income determination Y=C+I+G+Ex-Im The marginal propensity to import: the increase in imports per 1$ increase in national income Multiplier in the open economy 1/1-(MPC’-MPI) = 1/1-MPC’+MPI Does imports steal jobs at home? Yes but it is dangerous view. It can lead to world wide restriction of trade. Recession – a need for world-wide expansionary policies not for policies in which each country attempts to steal employment from abroad