1. Unit 9: Keynesian Theory & Fiscal Policy “The difficulty lies not so much in developing new ideas as in escaping from old ones.” "In the long-run we are all dead." --- John Maynard Keynes Created: 2013 by Jim Luke. This work is licensed under the Creative Commons Attribution-NonCommercial License

2. Why A New Theory? New Data. Classical Theory Can’t Explain Great Depression

3. Why? Classical Theory Can’t Explain Great Depression

4. Crash and Great Depression U.S. Depression Data192919311933193719381940 Real GNP101.484.368.3103.9103.7113.0 Consumer Price Index 122.5108.792.4102.799.4100.2 Unemployment (% )3.116.125.213.816.513.9  Unprecedented Deflation + Unemployment  Larger  Longer  Persistent, not temporary  Worldwide

5. Slide 5 Context: Keynesian Theory Global Economy Stumbles  Versailles Treaty & Inflations  Failed Gold Standard  Tariff Wars  Declining Trade  Financial bubbles Great Depression Rise of Fascism & Communism  Fears capitalism won’t survive

6. Slide 6 Keynesian Questions Is market capitalism inherently unstable? Can depressions continue forever? Any alternative to state socialism? Can “democratic” governments restore full- employment in a modern industrial economies?

7. Created: Jan 2008 by Jim Luke. This work is licensed under the Creative Commons Attribution-NonCommercial License Assumptions Compared Classical Competitive markets Flexible prices Current income/prices drive C & I S = I Conclusion: SRAS/LRAS matter Keynes Monopolistic markets Sticky prices Expectations drive C & I I =/= S. Conclusion: AD matters

8. Slide 8 Keynesian Insights Wages & Prices are 'sticky'  “Efficiency” wages  Monopolistic firms reduce output not prices Expectations  Plans  Spending  but can be wrong  Say’s Law won’t hold Expectations are irrational  Assume current trends continue  Excessively optimistic or pessimistic AD Shifts  creates recession or inflation

9. Slide 9 Keynesian Insight: Wages & Prices are “sticky”  “Efficiency” wages  Monopolistic firms reduce output not prices

10. Slide 10 Keynesian Insight: Expectations  Plans  Spending  AD shifts  Firms produce to expected demand  Say’s Law won’t hold

11. Slide 11 Keynesian Insight: Expectations are irrational  Assume current trends continue  Excessively optimistic or pessimistic  “Animal Spirits”

12. Slide 12 Keynesian Insight: AD Shifts  creates recession or inflation Equilibrium (stability) is possible at less than full employment.

13. Let’s take another look at spending and Aggregate Demand: C, I, and G

14. C: Consumer Spending C based on expectations for future:  Job security  Price levels  Interest rates  Life expectancy  Wealth, not just income

15. I: Investment “Forward looking” decisions Two major determinants  Market interest rate  Business expectations NOTE: Not the current level of income!

16. Business Expectations Factors:  Wars  Future resource costs  Technological change  Changes in tax structure  Other destabilizing events  Recent growth rates  “Animal spirits”

17. G: Government Purchases Budget controlled of public officials  G “autonomous”  No reason gov’t cannot borrow short-run  G could be independent of T

18. The Keynesian Theory Using AD-AS Model The Classical Theory says the economy corrects itself in the long-run. But after seven years of continuing depression, in 1936 John Maynard Keynes counters with the observation that “in the long-run we are all dead”.

19. Circular Flow: Keynesian View Govt may run deficits or surpluses. G not equal to T Expectations & plans, not Interest rates drive S. (“save for a rainy day”). Closed economy: Ignore ROW. Spending on I depends on expectations, not interest rate Financial markets may not reach equilibrium. S > I

20. Recessionary Gap: High unemployment P Price Level (price index) Real GDP @start Price Index @start start LRAS SR-AS AD Real GDP if we had full employm ent Gap represents amount of unemploymen t Prices & wages are “sticky” – SRAS stays where it is. Firms lay-off workers instead of cutting wages.

21. Recessionary Gap shifts AD P Price Level (price index) Real GDP @start Price Index @start start LRAS SR-AS AD at start Real GDP if we had full employment Real GDP declines further instead of recovering. The economy moves AWAY from full employment. Workers & firms cut spending plans RESULT: AD shifts to the left, making the recessionary gap worse. AD after layoffs & loss of confidence after Real GDP declines even further Price Index after

22. Conclusions from Keynesian Model - Recession Modern industrial economy:  Can get “stuck” in long recession with very high unemployment  May NOT automatically correct itself. Conclusion:  Optimism, expectations, plans are critical THE Rx: Counter-cyclical Fiscal policy “manage” AD

23. Slide 23 Keynesian Rx: Fiscal Policy to Manage AD Improve Confidence & Expectations  Disaster safety nets  Unemployment insurance  Social Security  Banking deposit insurance  Securities regulation Manage business cycle  Counter-cyclical fiscal policy  Change G to offset changes in C and I  Borrow in recession, surplus in boom

24. Recessionary Gap: Keynesian Rx Fiscal Policy: Increase G and/or Decrease T to offset Declines in C and I. P Price Level (price index) Real GDP @start Price Index unchanged start LRAS SR-AS AD at start Real GDP if we had full employment Government Increases G or decreases T, with result AD shifts right. AD after govt fiscal stimulus after

25. Inflationary Gap: Keynesian Rx Fiscal Policy: Cut G and/or raise T  reduce AD P Price Level (price index) Real GDP @start start LRAS SR-AS AD at start Real GDP if we had full employment Government decreases G or increases T, with result AD shifts left AD after govt fiscal policy after

26. Created: Jan 2008 by Jim Luke. This work is licensed under the Creative Commons Attribution-NonCommercial License Fiscal Policy Government purchases, transfer payments, taxes, and borrowing as they affect macroeconomic variables

27. Created: Jan 2008 by Jim Luke. This work is licensed under the Creative Commons Attribution-NonCommercial License Automatic Stabilizers Spending and taxes automatically change in response to economic change: Unemployment compensation Welfare assistance Income tax collections

28. Created: Jan 2008 by Jim Luke. This work is licensed under the Creative Commons Attribution-NonCommercial License Discretionary Fiscal Policy Congress & President must decide to spend more/tax less and pass a new law or budget to do it. often called “stimulus” program

29. Slide 29 Fiscal Policy - How Federal Budget, Expenditures & Tax Revenues G+G transfer > T  budget deficit G+G transfer < T  budget surplus G+G transfer = T  balanced budget Stimulus effect: Raise G, lower T Increase deficit (or reduce the surplus) Contractionary effect: lower G, raise T Increase surplus (or reduce deficit)

30. Which Is Better: T or G? Spending Multiplier:  MPC: marginal propensity to consume  = 1/(1–MPC)  If MPC is 0.8  1 / 0.2  5  initial increase G of $100 billion will eventually boost real GDP by 5 times, or $500 billion In theory, multiplier of G is greater than multiplier of T  Increased G is directly spent –all affects GDP  Part of a Tax cut is saved and doesn’t affect GDP  BUT, timing is important too

31. Slide 31 Keynesian Theory: Summary Industrial Economy inherently unstable  Equilibrium possible with unemployment  Extended depressions possible AD matters ‘Equilibrium’ : when actual = planned Confidence & Expectations important  Self-fulfilling Fiscal Policy can work