1. BRINNER 1 902mit03.ppt Introduction to Macro Policy and Models Fiscal Policy: Government Taxation, Spending and Deficit Impacts on the Macroeconomy

2. BRINNER 2 902mit03.ppt Focus Today u Setting up the questions regarding fiscal policy u Understanding preliminary answers and their basis u Applying this knowledge to a contemporary issue, the emergence of a budget surplus following huge deficits

3. BRINNER 3 902mit03.ppt The Central Model u The Key Behavioral Actors: –Domestic Households, buying consumer goods and housing –Domestic Businesses, buying machines or building factories & offices or stocking goods in inventory –Foreign buyers and suppliers –Some Government Agencies Whose Behavior is “Regular”

4. BRINNER 4 902mit03.ppt The Central Model u The Key Exogenous Influences –Domestic Government tax, transfer and purchasing decisions (that change on an irregular basis) –Domestic Central Bank “control” of the money supply and interest rates –The International Counterparts to these –International Commodity Markets and Cartel Behavior

5. BRINNER 5 902mit03.ppt A First Model u 7 Endogenous/ Behavioral Variables (Including ID’s) and 7 Equations –Consumer Spending : C=f ( YD, i ) –Business Spending : I = f ( d GNP, i) –Imports : M = f ( C, I, i ) –Exports : X = f ( GNPW, i ) –Total Output=Spending : u GNP = C+I+X-M+G –After-tax Income : YD = GNP - T –Inflation : R P = f ( GNP )

6. BRINNER 6 902mit03.ppt A First Model u 4 Exogenous/Policy Variables –Government Purchases : G –Taxes (Net of Transfers) : T –Interest Rate : i –Rest-of-World Demand : GNPW u Omitted Variables –Wealth –Supply Capacity

7. BRINNER 7 902mit03.ppt The Reduced Forms of the 7 Behavioral Equations u C=C ( G, T, i, GNPW ) u I = I ( G, T, i, GNPW ) u M = M ( G, T, i, GNPW ) u X = X ( G, T, i, GNPW ) u GNP = C+I+X-M +G u = GNP ( G, T, i, GNPW ) u YD = GNP - T u RP = RP ( GNP) = RP( G, T, i, GNPW )

8. BRINNER 8 902mit03.ppt The GNP Reduced Form Equation is a Useful Summary l GNP = C+I+X-M +G = GNP ( G, T, i, GNPW ) i= INTEREST RATE GNP2= GNP(G2,T1) GNP1= GNP(G1,T1) GNP=NATIONAL SPENDING/OUTPUT

9. BRINNER 9 902mit03.ppt The GNP Reduced Form Equation is a Useful Summary l GNP = C+I+X-M +G = GNP ( G, T, i, GNPW ) l Why does GNP=GNP(i) slope down? l Both Consumers (C) and Businesses (I) spend less if credit costs are higher. l Higher interest rates tend to boost the exchange rate, which cuts Exports (X) and boosts Imports (M) l How do changes in G, T shift GNP(i)? l For any given C or I, less G subtracts from GNP, and sets up multiplier, feedback effects l Extra T reduces YD which reduces C and thus cuts GNP.

10. BRINNER 10 902mit03.ppt If interest rates are fixed at i1, reducing G cuts GNP by a “multiple” of G l GNP = C+I+X-M +G = GNP ( G, T, i, GNPW ) i= INTEREST RATE GNP2= GNP(G2,T1) GNP1= GNP(G1,T1) GNP=NATIONAL SPENDING/OUTPUT i1 GNP2 GNP 1

11. BRINNER 11 902mit03.ppt What if lower GNP implies lower i due to Fed or market reactions ? i= INTEREST RATE GNP2= GNP(G2,T1) GNP=NATIONAL SPENDING/OUTPUT i=i(GNP)

12. BRINNER 12 902mit03.ppt i1 i2 GNP2 GNP1 What if lower GNP implies lower i due to Fed or market reactions ?

13. BRINNER 13 902mit03.ppt What if the Fed has a strict inflation target and thus a fixed GNP target ? i1 i2 GNP2 GNP1

14. BRINNER 14 902mit03.ppt Deficit Reduction Will Change the Economy u But it might not boost unemployment. u What sectors will offset lower G? u What does the Fed need to do? u What might change the equilibrium level of GNP? u Who gains and loses, considering incomes, wealth, skill-building? u Is a constitutional amendment necessary?

15. BRINNER 15 902mit03.ppt Build a Model

16. BRINNER 16 902mit03.ppt Build a Model

17. BRINNER 17 902mit03.ppt Build a Model

18. BRINNER 18 902mit03.ppt Build a Model

19. BRINNER 19 902mit03.ppt Build a Model Now, let interest rates respond to GDP, dropping from 5% to 4%: