Econ 208 Marek Kapicka Lecture 7 The Effects of Gov’t Spending

Announcements Today’s lecture is based on Hall (2009) and Ramey (2009). Look at Hall’s paper. PS3 will be posted today, due next week.

Empirical Evidence Main question: How does output, consumption and wages respond to an increase in government spending?

Empirical Evidence Hall 2009

Empirical Evidence Vector Autoregressions (VAR’s)

Advantage: include additional factors (e.g. taxes, dynamics of govt spending) Earlier studies typically find positive multiplier on consumption

Empirical Evidence Ramey (2009) Ramey (2009): a positive consumption multiplier is mostly because of incorrect timing: Military spending typically becomes known in advance e.g. 9/11: higher military spending was expected in October However, Iraq invaded only in March 2003

Empirical Evidence Ramey (2009) Why does this matter? The negative wealth effect causes immediate drop in consumption and increase in labor supply Lower consumption means higher investment When G increases, consumption does not change much (consumption smoothing) Missing the anticipated effect can lead to a misleading conclusion!

Ramey (2009): The effects on GDP

Ramey (2009): The Effects on Consumption and Wages

2009 Stimulus (Hall 2009)

Summary The frictionless model seems to get it qualitatively However, quantitatively, it predicts a fiscal multiplier that is too small Taking into account frictions like sticky prices provides a better explanation

Roadmap Government Expenditures A) Data on Govt Expenditures B) Changes in Gov’t Spending in a frictionless world C) Changes in Gov’t Spending in a world with frictions D) Social Security

Reading DLS, chapter 12.3

Transfers

Social Security Two Types of SS PAYG Fully Funded 2 periods: young and old N old people, N’ young people

PAYG Young pay SS taxes t Old receive benefits b Balanced budged each period PAYG introduced in period T

PAYG for Consumers Who Are Old in Period T

PAYG for Consumers Born in Period T and Later

Change in wealth depends on r and n Better off if n>r Worse off if n<r

Fully Funded Social Security Essentially a mandated savings program where assets are acquired by the young, with these assets sold in retirement. Either ineffective or decreases welfare

Fully Funded Social Security When Mandated Retirement Saving Is Binding

What’s missing in the model? Costs of having no social security Procrastination Idiosyncratic risk Costs of fully funded social security Transition costs Risky investment Costs of PAYG system Distortions of labor supply Fertility declines

US Social Security