Copyright © 2010 by Nelson Education Limited 1 PowerPoint Slides to accompany Prepared by Apostolos Serletis University of Calgary

Copyright © 2010 by Nelson Education Limited 2 C h a p t e r 1 2 Government Expenditure

Copyright © 2010 by Nelson Education Limited 3 Data on Government Expenditure Government expenditure is the dollar amount spent at all levels of government for purchases of goods and services, transfer payments (amounts given to households and businesses), and interest payments.

Copyright © 2010 by Nelson Education Limited 4 Data on Government Expenditure

Copyright © 2010 by Nelson Education Limited 5 Data on Government Expenditure

Copyright © 2010 by Nelson Education Limited 6 Data on Government Expenditure

Copyright © 2010 by Nelson Education Limited 7 Data on Government Expenditure

Copyright © 2010 by Nelson Education Limited 8 Just How Much Bigger is Government in Canada?

Copyright © 2010 by Nelson Education Limited 9 The Government’s Budget Constraint G t represents government purchases in real terms for year t. C t + I t + G t, is the aggregate real spending on goods and services in year t. V t represent the government’s real expenditure on transfers. The real revenue from money creation for year t is (M t −M t−1 )/P t T t is the total real taxes collected by the government in year t. We assume that there is no public debt in the model, B t = 0.

Copyright © 2010 by Nelson Education Limited 10 The Government’s Budget Constraint Government budget constraint: total uses of funds = total sources of funds G t + V t = T t + (M t − M t−1 )/P t (real purchases + real transfers = real taxes + real revenue from money creation)

Copyright © 2010 by Nelson Education Limited 11 The Government’s Budget Constraint Government budget constraint G t + V t = T t (real purchases + real transfers = real taxes)

Copyright © 2010 by Nelson Education Limited 12 Public Production We are assuming that the government subcontracts all of its production to the private sector. Public investment, publicly owned capital, and government employment are zero.

Copyright © 2010 by Nelson Education Limited 13 Public Services Begin with the hypothetical case in which public services have zero effect on utility and production.

Copyright © 2010 by Nelson Education Limited 14 The Household’s Budget Constraint Household budget constraint (with π = 0) C + (1/P)·∆B+∆K = (w/P)·L s + i·( B/P+K) C t + (1/P)·∆B t +∆K t = (w/P) t ·L s t + r t−1 ·(B t−1 /P + K t−1 ) With Government (with π = 0) C t + (1/P)·∆B t +∆K t = (w/P) t ·L s t + r t−1 ·( B t−1 /P + K t−1 ) +V t − T t

Copyright © 2010 by Nelson Education Limited 15 The Household’s Budget Constraint Multiyear household budget constraint with transfers and taxes: C 1 + C 2 /(1+r 1 ) + · · · = (1+r 0 )·( B 0 /P+K 0 ) +(w/P) 1 ·L s 1 +(w/P) 2 · L s 2 /(1+r 1 ) + ·· · +( V 1 − T 1 ) + ( V 2 − T 2 )/( 1 + r 1 ) +( V 3 − T 3 )/[(1+ r 1 ) · ( 1 + r 2 ) ] + ·· ·

Copyright © 2010 by Nelson Education Limited 16 Permanent Changes in Government Purchases Theory G + V = T or V − T = −G –If G rises by one unit each year, V − T falls by one unit each year. –Household’s disposable real income falls by one unit each year.

Copyright © 2010 by Nelson Education Limited 17 Permanent Changes in Government Purchases Theory –Since the typical household has one less unit of real disposable income each year, we predict that the decrease in C each year will be roughly by one unit.

Copyright © 2010 by Nelson Education Limited 18 Permanent Changes in Government Purchases Theory –How the increase in government purchases affects the demand and supply of capital services and real GDP. An increase in government purchases, G, does not shift the curves for the demand or supply of capital services. –The market-clearing real rental price, (R/P) ∗, and quantity of capital services, (κK) ∗, do not change.

Copyright © 2010 by Nelson Education Limited 19 Permanent Changes in Government Purchases

Copyright © 2010 by Nelson Education Limited 20 Permanent Changes in Government Purchases

Copyright © 2010 by Nelson Education Limited 21 Permanent Changes in Government Purchases Theory –We found that the quantity of capital services, κK, is unchanged, and we assumed that the technology level, A, and the quantity of labour input, L, are fixed. –Therefore, Y is unchanged. –The important conclusion is that a permanent increase in government purchases does not affect real GDP.

Copyright © 2010 by Nelson Education Limited 22 Permanent Changes in Government Purchases Theory r = ( R/ P) · κ − δ(κ) A permanent increase in government purchases does not affect the real interest rate.

Copyright © 2010 by Nelson Education Limited 23 Permanent Changes in Government Purchases Theory G, does not shift labour supply, L s, which is fixed at L, and does not shift the labour demand curve, L d. The market-clearing real wage rate, (w/P) ∗, does not change. We conclude that a permanent increase in government purchases does not affect the real wage rate.

Copyright © 2010 by Nelson Education Limited 24 Permanent Changes in Government Purchases Theory –We know from our analysis of income effects that a permanent rise in government purchases, G, by one unit reduces C in each year by roughly one unit.

Copyright © 2010 by Nelson Education Limited 25 Permanent Changes in Government Purchases Theory –The intertemporal-substitution effect depends on the real interest rate, r. Since r does not change, the intertemporal-substitution effect does not operate. Another substitution effect involves consumption and leisure, but we have assumed that the quantity of labour and, hence, the quantity of leisure, is fixed. In any event, this substitution effect depends on the real wage rate, w/P, which does not change.

Copyright © 2010 by Nelson Education Limited 26 Permanent Changes in Government Purchases Theory –Our prediction is that a permanent increase in government purchases by one unit causes consumption to decrease by about one unit.

Copyright © 2010 by Nelson Education Limited 27 Permanent Changes in Government Purchases Theory Y = C+ I + G The changes in C and G fully offset each other and, thereby, allow investment, I, to remain unchanged.

Copyright © 2010 by Nelson Education Limited 28 Permanent Changes in Government Purchases Theory –We predict that a permanent increase in government purchases, G, Reduces consumption, C, roughly one to one. The variables that do not change include real GDP, Y; gross investment, I; the quantity of capital services, κK; the real rental price, R/P; the real interest rate, r; and the real wage rate, w/P.

Copyright © 2010 by Nelson Education Limited 29 Permanent Changes in Government Purchases

Copyright © 2010 by Nelson Education Limited 30 Temporary Changes in Government Purchases Theory –Assume now that year 1’s real government purchases, G 1, rise by one unit, while those for other years, G t, do not change. That is, everyone expects that G t in future years will return to the original level.

Copyright © 2010 by Nelson Education Limited 31 Temporary Changes in Government Purchases Theory V t − T t = −G t V t − T t falls by one unit, and households have one unit less of real disposable income. In subsequent years, V t − T t and, hence, real disposable income return to their original levels.

Copyright © 2010 by Nelson Education Limited 32 Temporary Changes in Government Purchases Theory –Households would spread their reduced disposable income in year 1 over reduced consumption, C t, in all years t. Therefore, the effect on year 1’s consumption, C 1, will be relatively small. The propensity to consume out of a temporary change in income is greater than zero, but much less than one.

Copyright © 2010 by Nelson Education Limited 33 Temporary Changes in Government Purchases Theory Y = C+ I + G Y, is unchanged; real government purchases, G, are higher in year 1 by one unit; and consumption, C, is lower, but by much less than one unit. Consequently, equation (12.9) implies that gross investment, I, must fall.

Copyright © 2010 by Nelson Education Limited 34 Temporary Changes in Government Purchases Theory –Since the decrease in C is relatively small, the decline in I is large. That is, year 1’s extra G comes mainly at the expense of I, rather than C. –When the change in G was permanent, we predicted that most or all of the extra G came at the expense of C.

Copyright © 2010 by Nelson Education Limited 35 Government Purchases and Real GDP During Wartime: Empirical We test the model by studying the response of the economy to the temporary changes in government purchases that have accompanied U.S. wars.

Copyright © 2010 by Nelson Education Limited 36 Government Purchases and Real GDP During Wartime: Empirical

Copyright © 2010 by Nelson Education Limited 37 Government Purchases and Real GDP During Wartime: Empirical

Copyright © 2010 by Nelson Education Limited 38 Government Purchases and Real GDP During Wartime: Empirical The data also show that the rises in real GDP are by less than the increases in government purchases. That is, aside from military purchases, the totals of the other components of real GDP are down during wartime. The model accords with this pattern. However, the components of real GDP other than military purchases do not fall nearly as much as predicted by the model.

Copyright © 2010 by Nelson Education Limited 39 Wartime Effects on the Economy Employment during wartime –The basic pattern is that the military took in a significant number of persons total employment expanded a little more.

Copyright © 2010 by Nelson Education Limited 40 Wartime Effects on the Economy Effects of war on labour supply –At this point, there is no settled view among economists about the best way to understand labour supply during wartime. A large expansion of real government purchases, G, means that households have less real disposable income. Casey Mulligan (1998) argues that labour supply, L s, increases during wartime because of patriotism. The military draft would affect the labour supply of single women.

Copyright © 2010 by Nelson Education Limited 41 Wartime Effects on the Economy

Copyright © 2010 by Nelson Education Limited 42 Wartime Effects on the Economy Employment Effects on Labour Markets –Prediction that a war reduces the real wage rate, w/P.

Copyright © 2010 by Nelson Education Limited 43 Wartime Effects on the Economy Effects of war on the rental market –A wartime increase in labour supply, L s, led to an increase in labour input, L. This change affects the rental market, because the rise in L tends to increase the MPK (for a given quantity of capital services, κK). The demand curve shifts right because the higher quantity of labour, L, raises the MPK for a given quantity of capital

Copyright © 2010 by Nelson Education Limited 44 Wartime Effects on the Economy

Copyright © 2010 by Nelson Education Limited 45 Wartime Effects on the Economy Effects of war on the rental market –For a given capital stock, K, the rise in κK corresponds to an increase in the capital utilization rate, κ. r = ( R/ P) · κ − δ(κ) Increases in R/P and κ imply that r increases.

Copyright © 2010 by Nelson Education Limited 46 Wartime Effects on the Economy Effects of war on the rental market –The predictions for higher real interest rates during wartime conflict with the U.S. data.