EC Midterm 2 – July 21, Thursday 13:00 – 15:00 Exactly at class time, venue: Hisar Campus HKD 201 : ACAR – ISIK HKD 101 : INAM – YILDIZ Ch 9, Ch 10, Ch 11 (Sections 1,2,3,4 (except 4.4), 5) + if time permits Ch 12 (Section 1)

Outline Macroeconomic Theory and Policy Chapter 9 – Aggregate Demand and Economic Fluctuations Section 3 – Keynesian Model – Multiplier Chapter 10 – Fiscal Policy Section 1 – Role of Government Spending and Taxes Section 2 – Budgets, Deficits and Policy Issues

Output (Y* ) Income (Y* ) Insufficient Spending AD < Y* Production generates income Income goes to households If leakages are larger than injections… Lower Income Lower Spending AD = lower Y Lower Output Keynesian Model of AD

Keynesian Model - The Multiplier at Work Change in Intended Investment Change in Aggregate Demand (as C or II change) and in Output and Income (as firms respond to changes in AD) Change in Consumption ΔC = mpc Δ Y =.8  Column (2) 1. Investors lose confidence. Δ II =  Reduced investment spending leads directly to Δ AD =  80. Producers respond to reduced demand for their goods by cutting back on production. Δ Y =  Less production means less income. With income reduced by 80, households cut consumption by mpc Δ Y =.8   80 ΔC =  Lowered consumption spending means lowered AD Δ AD =  64 Producers respond. Δ Y =  Households cut consumption by mpc Δ Y =.8   64 ΔC =  Δ Y =  mpc Δ Y =.8   51.2 ΔC =  Δ Y =  ΔC =  Δ Y =  ΔC =  etc. Sum of changes in Y =  80 +  64 +    =  400

Fiscal Policy Fiscal policy - government spending and taxation policies Adding up the government sector to the Keynesian model AD = C + II + G G: government spending E.g. construction of new roads by the government – government money spent on goods and payments to workers: creating new AD, multiplier effect adding to the original stimulus by G

Fiscal Policy An increase in government spending has a similar effect to an increase in intended investment. The end result is increases in the equilibrium levels of income and output.

Aggregate demand and output AD 1 (G=80) AD 0 (G=0) 45° E1E1 E0E0 400 Y* Income (Y) 800 Unemployment equilibrium Full employment equilibrium Full employment Fiscal Policy

Government spending is one way of increasing GDP. Other options: cutting taxes and/or increasing transfer payments Transfer payments: government grants, subsidies, social security/social assistance/unemployment compensation payments to individuals, interest payments to holders of government bonds Mostly used fiscal tool: tax reductions – politically popular

Fiscal Policy Q: How do the changes in taxes and transfer payments affect equilibrium level of output and income? not similar to the changes in G! G – directly affects AD and GDP T – indirectly affect AD and GDP (through C or II) Depends on the type of tax and transfer payment introduced or altered. Focus on effects of changes in income taxes and transfers to individuals.

Fiscal Policy E.g. assume tax cut of 50 – not fully reflected in increasing spending by 50 but rather works through “marginal propensity to consume”! mpc * amount of tax cut = change in consumption E.g. assume transfer payment of 50 – same mechanism! mpc * amount of transfer = change in consumption Disposable income – income available to consumers after paying taxes and receiving transfers Y d = Y – T + TR

Fiscal Policy Lump-sum taxes : fixed at a level irrespective of the income level Tax multiplier -> impact of a change in a lump sum tax on equilibrium level of income/output. Works in two stages: (i) consumption is reduced by mpc * change in lump sum tax (ii) The reduction in consumption has multiplier effect on equilibrium income multiplier * (mpc * change in lump sum tax)

Fiscal Policy Tax increase – reduces Yd; contractionary effect Tax cut – increases Yd; expansionary effect Transfer payments – some sort of negative tax; works in the same logic as tax cuts. In reality – income taxes are generally proportional or progressive (i.e. increase with income levels) Effect on AD – flattening AD curve because higher impact on high levels of income Balanced budget – governments may intend to offset the effect of increase in G by increase in T

Fiscal Policy Expansionary Fiscal Policy – use of government spending, transfer payments or tax cuts to stimulate higher levels of economic activity increase G, increase TR, decrease T How to finance?? borrowing or increased taxation. Second option is likely to offset the impact Too much spending may have inflationary effect – increase in G may overshoot the FE level of output, excess demand -> “overheating”

Fiscal Policy Contractionary Fiscal Policy – reductions in government spending, transfer payments or tax cuts leading to lower levels of economic activity lower G, lower TR, increase T Could be regarded as a cure for inflation to overcome the excessive aggregate demand. Unwise to use at times of unemployment – may lead to further stagnation by overshooting in the downward direction!

Budgets, Deficits and Policy Issues Fiscal policy - government spending and taxation Government expenditures = government outlays G + TR Budget => revenues and expenditures Revenue side = taxes (T) When revenues are not sufficient to cover expenditures => borrowing Internal borrowing: sale of government bonds or treasury bills to the public, interest-bearing securities with a promise to pay in future

Budgets, Deficits and Policy Issues Revenues, 2009 Expenditures, 2009 Balance = deficit (revenues fall short of expenditures)

Budgets, Deficits and Policy Issues Budget Balance = Surplus (+) /Deficit (-) = T – (G+TR) Generally shown as a % of GDP - larger the economy, easier to handle a given deficit as the fiscal impacts of the deficit would be relatively small

Budgets, Deficits and Policy Issues Deficit vs. Debt? Deficit is a flow variable for the current period but debt is a stock variable hich shows accumulated deficits over the years! Debt increases when there is deficit ! Commonly held view: “Debt as a burden on future generations” ??

Budgets, Deficits and Policy Issues Most of the goverment debt is domestically owed – domestic citizens are holding government bonds, treasury bills etc. which are indeed “assets”. Debt does not necessarily have to be paid off immediately – “rolling over”: replacing it by another debt => possible as long as government is credible Easier to roll over when denominated in domestic currency

Budgets, Deficits and Policy Issues BUT still problematic to have debt -interest must be paid on the debt: intergenerational inequalities as a burden on future taxpayers -increasing proportion of debt has to be paid in FX Need for management of debt if cannot avoid having it: e.g.productive investments versus unwise defense expenditures – need for a careful cost-benefit analysis for debt and pursue spending and tax policies accordingly.

Budgets, Deficits and Policy Issues Keynesian idea: Government spending is an important part of the economic policies to prevent recession. Recently – controversies over use of fiscal policies especially in relation to the impacts on inflation and deficits Evidence shows that government budget moderates fluctuations in AD without any other intervention Automatic stabilizers – tax and spending institutions tend to increase government revenues and lower expenditures during expansions and vice versa during recessionary periods.

Budgets, Deficits and Policy Issues Automatic stabilization but HOW? Suppose there is recession => AD falls, government deficit increases as tax revenues are decreasing due to declining incomes and expenditures increase as there is more receipt of welfare payments (unemployment benefit etc.), decline in C is prevented, therefore recession is moderated. Suppose there is expansion => tax revenues increase as incomes increase, expenditures fall as fewer people receive welfare benefits, disposable income does not rise as fast as national income, C slows down, limiting inflationary overheating