THE ECONOMY: THE CORE PROJECT

UNIT 14. UNEMPLOYMENT AND FISCAL POLICY

T14.1 Aggregate consumption function The diagram depicts a consumption function of an economy, where C is the aggregate consumption spending, Y is the current income of the economy, and c0 is the fixed (or autonomous) consumption such that c0 > 0. Assume that households that are not credit-constrained would completely smooth their consumption. Which of the following statements is correct? Select one answer If all households were not credit-constrained, and all income changes were perceived to be temporary, then the aggregate consumption line would be horizontal. During a credit crunch when the banks become less willing to lend, the aggregate consumption line would become flatter. If a higher proportion of households have "weakness of will", then the aggregate consumption line would be flatter. If the current income falls to zero, there will be zero consumption. Section 14.2

ANSWER: T14.1 Aggregate consumption function The diagram depicts a consumption function of an economy, where C is the aggregate consumption spending, Y is the current income of the economy, and c0 is the fixed (or autonomous) consumption such that c0 > 0. Assume that households that are not credit-constrained would completely smooth their consumption. Which of the following statements is correct? Feedback In this case, all households can completely smooth consumption and would not react to temporary changes in income, so the aggregate consumption line would be horizontal. In a credit crunch, more households would become credit-constrained. Therefore the line would become steeper. “Weakness of will” means that when there is an expected fall in the income, the households are less likely to adjust their consumption ahead of the fall, in order to build up some savings so that they can smooth consumption. In this case their marginal propensity to consume would be higher, implying a steeper aggregate consumption line. c0 > 0 means that even if the current income is zero, the households will consume a strictly positive amount. Select one answer If all households were not credit-constrained, and all income changes were perceived to be temporary, then the aggregate consumption line would be horizontal. During a credit crunch when the banks become less willing to lend, the aggregate consumption line would become flatter. If a higher proportion of households have "weakness of will", then the aggregate consumption line would be flatter. If the current income falls to zero, there will be zero consumption. Section 14.2

T14.2 Multiplier Assuming that there is no government spending or trade, an economy’s aggregate demand is given by its domestic consumption C and investment I, AD = C + I = c0 + c1Y + I. In the economy’s goods market equilibrium this equals its output: AD = Y. Solving for Y this yields: Y = [1/(1 -c1 )] (c0+ I) Given this equation, which of the following statements is correct? Select one answer The multiplier is given by 1 – c1. The boost in the economy’s output is the same, regardless of whether the aggregate demand shock comes from an increase in investment I or in autonomous consumption c0. The larger the marginal propensity to consume (c1), the smaller the multiplier. If c1 = 1/3, then a £1 million increase in investment would result in a £2 million increase in output. Section 14.2

ANSWER: T14.2 Multiplier Assuming that there is no government spending or trade, an economy’s aggregate demand is given by its domestic consumption C and investment I, AD = C + I = c0 + c1Y + I. In the economy’s goods market equilibrium this equals its output: AD = Y. Solving for Y this yields: Y = [1/(1 -c1 )] (c0+ I) Given this equation, which of the following statements is correct? Select one answer The multiplier is given by 1 – c1. The boost in the economy’s output is the same, regardless of whether the aggregate demand shock comes from an increase in investment I or in autonomous consumption c0. The larger the marginal propensity to consume (c1), the smaller the multiplier. If c1 = 1/3, then a £1 million increase in investment would result in a £2 million increase in output. Feedback The multiplier is given by 1 / (1 – c1). Any change in autonomous consumption or investment would increase output by 1 / (1 – c1) times the change. A larger c1 means a smaller 1 – c1, which in turn means a larger multiplier 1 / (1 – c1). When c1 = 1/3, then 1 / (1 – c1) = 1.5, and therefore a £1 million increase in I would result in a £1.5 million increase in Y. Section 14.2

T14.3 Household wealth and consumption spending 1 Assume that in France and Germany, it is not possible for a household to increase its borrowing based on an increase in the market value of their house. In addition, a large down-payment (as a percentage of the house price) is required to purchase a house. On the basis of this information, which of the following statements is correct when there is a rise in housing prices? Select one answer There is a positive financial accelerator effect for the existing homeowners who are credit-constrained. Would-be homeowners would increase saving and reduce consumption. A rise in housing prices leads to an increase in human capital. A rise in housing prices is likely to lead to an increase in consumption in France and Germany. Section 14.3

ANSWER: T14.3 Household wealth and consumption spending 1 Assume that in France and Germany, it is not possible for a household to increase its borrowing based on an increase in the market value of their house. In addition, a large down-payment (as a percentage of the house price) is required to purchase a house. On the basis of this information, which of the following statements is correct when there is a rise in housing prices? Feedback For credit-constrained homeowners, an increase in their house price can increase consumption spending because the higher collateral would enable higher borrowing. However, doing so is prohibited in France and Germany, as stated in the question. A rise in housing prices means that a higher down-payment is required to purchase a house. Households planning to buy a house now have to save more and reduce their consumption. c. Human capital is the expected future earnings from employment. This is not affected by housing prices. d. As there is no accelerator effect for the credit-constrained homeowners, and the would-be homeowners would also reduce consumption due to their increased savings, a rise in the house price is likely to dampen consumption in France and Germany. Select one answer There is a positive financial accelerator effect for the existing homeowners who are credit-constrained. Would-be homeowners would increase saving and reduce consumption. A rise in housing prices leads to an increase in human capital. A rise in housing prices is likely to lead to an increase in consumption in France and Germany. Section 14.3

T14.4 Household wealth and consumption spending 2 In the US and the UK, loans are widely available based on a rise in home equity. Additionally, unlike in France and Germany where large down-payments (as a percentage of the house price) are required, in the US and the UK only small down-payments are required for house purchases. On the basis of this information, which of the following statements is correct for the US and the UK when there is a rise in housing prices? Select one answer There is a positive financial accelerator effect for the existing homeowners who are credit-constrained. There would be no effect on the consumption of the existing homeowners who are not credit-constrained. Would-be homeowners would increase saving and reduce their consumption more than they would in France and Germany. A rise in housing prices is likely to dampen consumption in the US and the UK. Section 14.3

ANSWER: T14.4 Household wealth and consumption spending 2 In the US and the UK, loans are widely available based on a rise in home equity. Additionally, unlike in France and Germany where large down-payments (as a percentage of the house price) are required, in the US and the UK only small down-payments are required for house purchases. On the basis of this information, which of the following statements is correct for the US and the UK when there is a rise in housing prices? Feedback For credit-constrained homeowners, an increase in their house price can increase consumption spending because the higher collateral would enable higher borrowing. For those for are not credit-constrained, a rise in housing prices would improve their net worth and raise their wealth relative to target levels. This leads to reduced precautionary savings, increasing their consumption. As only small down-payments are required, the negative effect on the consumption would be smaller in the US and the UK than in France and Germany. As opposed to France and Germany, the positive financial accelerator effect and the positive collateral effect are likely to outweigh the effect of the increased saving by the would-be homeowners, resulting in higher consumption. Select one answer There is a positive financial accelerator effect for the existing homeowners who are credit-constrained. There would be no effect on the consumption of the existing homeowners who are not credit-constrained. Would-be homeowners would increase saving and reduce their consumption more than they would in France and Germany. A rise in housing prices is likely to dampen consumption in the US and the UK. Section 14.3

T14.5 Open economy multiplier Which of the following statements regarding the multiplier is correct? Select one answer If two countries were identical except for the share of credit-constrained households, then the country with the higher share would have a smaller multiplier. The multiplier is constant over the business cycle. An increase in exports leads to a higher multiplier. Taxation and imports are “leakages” from the circular flow of income, which reduce the size of the multiplier. Section 14.5

ANSWER: T14.5 Open economy multiplier Which of the following statements regarding the multiplier is correct? Feedback A higher share of credit-constrained households means a higher marginal propensity to consume. Therefore the multiplier will be larger. The proportion of credit-constrained households would vary over a business cycle. The multiplier would therefore vary accordingly. The multiplier in an open economy depends on the marginal propensity to consume, the marginal propensity to import, and the income tax rate. The level of exports does not affect the multiplier (it affects the level of the aggregate demand curve, but not the slope). Some household income goes back to the government via taxes, and some is spent on goods and services produced abroad. These both reduce the effect of government spending on the domestic economy. Select one answer If two countries were identical except for the share of credit-constrained households, then the country with the higher share would have a smaller multiplier. The multiplier is constant over the business cycle. An increase in exports leads to a higher multiplier. Taxation and imports are “leakages” from the circular flow of income, which reduce the size of the multiplier. Section 14.5

T14.6 Fiscal policy Which of the following statements regarding fiscal policy is correct? Select one answer Expansionary fiscal policy (e.g. increasing the government deficit or reducing the surplus) always has a stabilising effect on the economy. Unemployment benefits and taxes automatically increase government spending and cut taxation in a downturn, while they trim spending and raise taxes in a boom. These are therefore automatic stabilisers. In a recession, the aim of a government fiscal expansion is to over-ride the effects of automatic stabilisers. As a family worried about mounting debts should cut spending and save more, so should an economy adopt austerity measures when its debt level is high, to restore its public finances to balance. Section 14.6

ANSWER: T14.6 Fiscal policy Which of the following statements regarding fiscal policy is correct? Select one answer Expansionary fiscal policy (e.g. increasing the government deficit or reducing the surplus) always has a stabilising effect on the economy. Unemployment benefits and taxes automatically increase government spending and cut taxation in a downturn, while they trim spending and raise taxes in a boom. These are therefore automatic stabilisers. In a recession, the aim of a government fiscal expansion is to over-ride the effects of automatic stabilisers. As a family worried about mounting debts should cut spending and save more, so should an economy adopt austerity measures when its debt level is high, to restore its public finances to balance. Feedback During a boom, expansionary fiscal policy may be destabilising. Unemployment benefits and taxes offset the expansion and contraction of the economy, so are automatic stabilisers. In a recession, the government would use fiscal expansion to enhance the effects of automatic stabilisers. This is the paradox of thrift; if everyone stops consuming then that creates further unemployment, causing a vicious cycle. Section 14.6