Unit 6: Fiscal Policy

KEYNES Criticisms of Classical Theory: The Great Depression KEYNES Criticisms of Classical Theory: C and I move together KCM = 1/MPS Liquidity Trap

KEYNES KEY QUESTIONS: WHERE ARE WE? WHERE WERE WE? WHERE SHOULD WE BE?

NATIONAL INCOME ACCOUNTING Total production and wealth of a nation in a given period in monetary terms. Recorded NOT black market, under table Productive NOT transfers This country NOT imports This year NOT used items or subtractions from inventory Final value NOT value-added

Adding It Up: GDP = C + Ig + G + Xn Measuring GDP The four categories of expenditures that provide a measure of the market value of total output in a particular year include: Personal consumption expenditure (C) Gross Private Domestic Investment (Ig) Government Purchases (G) Net Exports (Xn) Adding It Up: GDP = C + Ig + G + Xn

Measuring GDP The four categories of income that provide a measure of the market value of total output in a particular year include: Wages (W) Rent (R) Interest (r) Profit (Pf) Adding It Up: NY = W + R + r + Pf

NY (W + R + r + Pf) + KCA + IBT = C + Ig + G + XN Measuring GDP Adding It Up NY (W + R + r + Pf) + KCA + IBT = C + Ig + G + XN income = expenditures Y = C

Measurement of Unemployment The total U.S. population is divided into three groups. People “not counted”: under 16 years of age, over 65, institutionalized, house spouses Adults in the labor force; those who SHOULD BE working Employed, working over 32 hours a week unemployed and seeking work

Measurement of Unemployment The unemployment rate is the percentage of the labor force unemployed. Unemployment rate = x100 unemployed labor force

Types of Unemployment Structural Unemployment Frictional Unemployment ACCEPTABLE UNEMPLOYMENT: those searching for jobs or waiting to take jobs in the near future. Cyclical Unemployment is unemployment associated with the business cycle; Actual Unemployment – Frictional Unemployment = Cyclical Unemployment. Structural Unemployment is unemployment that is associated with technological change; obsolete workers. Not Counted for Employment purposes.

– Frictional Unemployment Cyclical Unemployment Types of Unemployment Actual Unemployment – Frictional Unemployment Cyclical Unemployment

Definition of Full Employment Full employment occurs when the economy experiences only frictional; there is no cyclical unemployment. The level of real GDP that would occur if there was full employment is called potential output.

Economic Cost of Unemployment If actual GDP is above or below potential GDP, the result is a GDP gap. When actual GDP is less than potential GDP, there is a negative GDP gap accompanied with a higher unemployment rate and foregone income. When actual GDP is greater than potential GDP, there is a positive GDP gap accompanied with a high inflation rate and overfull employment. GDP gap = actual GDP – potential GDP

OKUN’S LAW GDP gap = actual GDP – potential GDP GDP gap = Cyclical Unemployment x 2.5

Inflation It is difficult to compare values over time without correcting them for inflation or deflation. Nominal GDP, or unadjusted GDP, is gross domestic product in terms of the price level at the time of measurement. Real GDP, or adjusted GDP, is gross domestic product measured in terms of the price level in a base period (or reference year). It is a GDP that has been deflated or inflated to reflect changes in the price level.

Inflation Inflation is a rise in the general level of prices in an economy. When there is inflation, each dollar of income buys fewer goods and services; the purchasing power of money declines.

Measurement of Inflation Inflation is a rise in the general level of prices in an economy. When there is inflation, each dollar of income buys fewer goods and services; the purchasing power of money declines. The main measure of inflation in the U.S. is the Consumer Price Index, or CPI. The CPI is an index that compares the price of a market basket of goods and services in one period with the price of the same (or highly similar) market basket in a base period, currently 1982-1984. The CPI includes some 300 products that are presumably purchased by the typical consumer.

Types of Inflation Demand-pull inflation is increases in the price level caused by excessive spending beyond the economy’s capacity to produce. Excess demand from expanding output bids up the prices of the limited output. Cost-push inflation is increases in the price level caused by sharp rises in the cost of key resources. Supply shocks are the main source of cost-push inflation.

Measurement of Inflation CPI for any particular year equals: price of the market basket of the particular year price of the same market basket in the base year

The Multiplier

The Multiplier The Multiplier: -- The view that a change in autonomous expenditures (e.g. investment) leads to an even larger change in aggregate income. An increase in spending by one party increases the income of others. Thus, an increase in spending can expand output by a much larger amount. The multiplier is the number by which the initial change in spending is multiplied to obtain the total amplified increase in income. The size of the multiplier increases with the marginal propensity to consume (MPC).

The Multiplier Principle Expenditure Stage Additional Income (Dollars) Marginal Propensity To Consume Additional Consumption (Dollars) For simplicity (here) it is assumed that all additions to income are either spent domestically or saved. Round 1 Round 2 Round 3 Round 4 Round 5 Round 6 Round 7 Round 8 Round 9 Round 10 3/4 1,000,000 750,000 750,000 562,500 562,500 421,875 421,875 316,406 316,406 237,305 237,305 177,979 177,979 133,484 133,484 100,113 100,113 75,085 75,085 56,314 All Others 225,253 168,939 Total 4,000,000 3,000,000 3/4 The multiplier concept is fundamentally based upon the proportion of additional income that households choose to spend on consumption: the marginal propensity to consume (here assumed to be 75%  3/4). Here, a $1,000,000 injection is spent, received as payment, saved and spent, received as payment, saved and spent … etc. … until . . . effectively, $4 million is spent in the economy.

A Higher MPC Means a Larger Multiplier SIZE OF MULTIPLIER 9/10 10.0 4/5 5.0 3/4 4.0 2/3 3.0 1/2 2.0 1/3 1.5 As the MPC increases more and more money of every injection is spent (and so received as payment and then spent again, received as payment and spent again, etc.). The effect is that for higher MPCs, higher multipliers result, specifically the relationship follows this equation: M = 1 1 - MPC

The Keynesian View of Fiscal Policy

The Keynesian View of Fiscal Policy When an economy is operating below its potential output, the Keynesian model suggests that the government should institute expansionary fiscal policy -- it should either: increase the government’s purchases of goods & services, and/or, cut taxes.

Expansionary Fiscal Policy to Promote Full-Employment Goods & Services (real GDP) Price level LRAS AD1 Y F P 1 SRAS1 e1 AD2 SRAS3 P 2 E2 Expansionary fiscal policy stimulates demand and directs the economy to full-employment P 3 E3 Keynesians believe that allowing for the market to self-adjust may be a lengthy and painful process. Y F Y F We begin in the short run at Y1, below the economy’s potential capacity (YF). There are 2 routes to long-run full-employment equilibrium. Classic theory would wait for both lower wages and resource prices to reduce costs, increase supply to SRAS3 and restore equilibrium at YF. Keynesians would use expansionary fiscal policy to stimulate aggregate demand (shift AD1 to AD2) and guide the economy back to E2, at YF.

The Keynesian View of Fiscal Policy When inflation is a potential problem, the Keynesian analysis suggests a shift toward a more restrictive fiscal policy: reduce government spending, and/or, raise taxes. Keynesians challenged the view that the government’s should always be balance its budget. Rather than balancing the budget annually, Keynesians argued that counter-cyclical policy should be used to offset fluctuations in aggregate demand.

Restrictive Fiscal Policy to Combat Inflation Goods & Services (real GDP) Price level LRAS Y F P 1 SRAS1 AD1 e1 SRAS3 AD2 P 3 E3 Restrictive fiscal policy restrains demand and helps control inflation. P 2 E2 Y F Y F Strong demand such as AD1 will temporarily lead to an output rate beyond the economy’s long-run potential (YF). Classic theory says the high level of demand will lead to the long-run equilibrium E3 at a higher price level (as SRAS shifts back to SRAS3). Keynesian restrictive fiscal policy would restrain demand from expanding to AD2 in the first place and guide the economy to a non-inflationary equilibrium (E2).

Fiscal Policy: Examples of Automatic Stabilizers: Automatic Stabilizers: -- without any new legislative action, they tend to increase the budget deficit (or reduce the surplus) during a recession and increase the surplus (or reduce the deficit) during an economic boom. Examples of Automatic Stabilizers: Transfer Payments Unemployment Compensation Welfare A Progressive Income Tax

Budget Deficits and Surpluses Budget deficit: -- Present when total government spending exceeds total revenue from all sources. When the money supply is constant, deficits must be covered with borrowing. The U.S. Treasury borrows funds by issuing bonds. Budget surplus: -- Present when total government spending exceeds total revenue from all sources. Surpluses reduce the size of the government’s outstanding debt.

Budget Deficits and Surpluses Changes in the size of the federal deficit or surplus are often used to gauge whether fiscal policy is adding additional demand stimulus or imposing additional demand restraint. Changes in the size of the budget deficit or surplus may arise from either: A change in the state of the economy, or, A change in discretionary fiscal policy -- that is, through either government spending and/or changes in taxation.

11/17/2018 End Unit 5