demand-side equilibrium: unemployment or inflation?
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Demand-Side Equilibrium: Unemployment or
Inflation?
● Meaning of Equilibrium GDP● Mechanics of Income Determination● Aggregate Demand Curve● Demand-Side Equilibrium and Full Employment● Coordination of Saving and Investment● Changes on the Demand Side: Multiplier
Analysis
Contents
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Real World Puzzle: Why does the Market Permit Unemployment?
● Market economies coordinate the decisions of millions of buyers and sellers to ensure the correct amount of C goods are produced with most efficient prod means.
● Yet market economies stumble with periodic episodes of mass UE and recessions.
● Widespread UE is a failure to coordinate economic activity.♦ If UE were hired, they could buy the goods firms can’t sell;
and revenues from these sales would allow firms to hire the UE.
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● Recall: total production (GDP) = total income● But total production need not = total spending● If total expenditures > value of output produced
♦ (1) ↓inventory stocks → signals retailers ↑orders → signals manufacturers ↑ production
♦ (2) if high levels of spending continue to deplete inventories → firms ↑prices
● If total expenditures < value of output produced ♦ (1) ↑inventory stocks → signals retailers ↓orders → signals
manufacturers ↓ production♦ (2) if low levels of spending continue → firms ↓prices
The Meaning of Equilibrium GDP
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● Equilibrium on the Demand-side of the Economy♦ GDP↑ when total expenditures > GDP♦ GDP↓ when total expenditures < GDP
● Equilibrium can only occur when there is just enough spending to absorb current level of prod. Then producers conclude their Q and P decisions were correct.
● Equilibrium: total spending = total production♦ Firms inventories remain at desired levels → no reason to ∆Q
or ∆P
The Meaning of Equilibrium GDP
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The Mechanics of Income Determination
● Expenditure Schedule = table showing the relationship between GDP and total spending
● Table 1: ♦ C is the Consumption f(x)♦ I, G, and X-IM are all fixed regardless of the level of GDP♦ C + I + G + X-IM = total expenditure
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TABLE 1. The Total Expenditure Schedule
GDP (Y) C I G X - IM Total Exp
4,800 3,000 900 1,300 -100 5,100
5,200 3,300 900 1,300 -100 5,400
5,600 3,600 900 1,300 -100 5,700
6,000 3,900 900 1,300 -100 6,000
6,400 4,200 900 1,300 -100 6,300
6,800 4,500 900 1,300 -100 6,600
7,200 4,800 900 1,300 -100 6,900
FIGURE 1. Construction of the Expenditure Schedule
G = $1,300
I = $900
C + I + G
C + I + G + (X – IM)
C + I
C
7,200 6,800 6,400 6,000 5,600
6,000 6,100
4,800
Rea
l Exp
endi
ture
Real GDP 5,200
3,900
X –IM = –$100
C is the C f(x). It is shifted up by the amount of I ($900) and G ($1,300) and shifted down by the amount of X-IM (-$100).
Slope of the expenditure schedule = MPC because I, G, and X-IM are assumed to be constant and do not vary with GDP.
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● Use Table 2 to understand why $6,000B must be equilibrium level of output.
● Any output below $6,000B → total expenditures > GDP → ↓inventories → ↑production
● Any output above $6,000B → total expenditures < GDP → ↑inventories → ↓production
● Equilibrium only occurs when Y = C + I + G + X-IM or GDP = total expenditure, which happens at $6,000B.
The Mechanics of Income Determination
TABLE 2. The Determination of Equilibrium Output
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● Use Figure 2 to show why $6,000B must be the equilibrium level of output.
● 45 degree line shows all points where output and spending are equal. ♦ These are all points where the economy can possibly be in
equilibrium.♦ Economy is not always on the 45 degree line but it is always on
the expenditure schedule. ♦ Equilibrium is shown where 45 degree line intersects the total
expenditure schedule.
The Mechanics of Income Determination
FIGURE 2. Income-Expenditure Diagram
Spending exceeds output
Output exceeds spending
Equilibrium
6,000
Rea
l Exp
endi
ture
45°
5,200 5,600 6,000 6,400 6,800 7,200 0
4,800
5,600
6,400
6,800
7,200
Real GDP 4,800
5,200
C + I + G + (X – IM)
E
Left of point E: total expenditure schedule is above the 45 degree line → spending > GDP → ↓inventories and firms ↑prod.
Right of point E: total expenditure schedule is below the 45 degree line → spending < GDP → ↑inventories and firms ↓prod.
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● The expenditure schedule is drawn for a fixed P level.● Derive AD curve using the expenditure schedule.● Recall P level shifts C f(x) downward
P level (at fixed levels of DI) purchasing power of wealth by lowering the value of money-fixed assets
P level shifts the expenditure schedule downward♦ ↓ P level shifts the expenditure schedule upward
The Aggregate Demand Curve
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● How do changes in the P level impact real GDP on the demand-side of the economy?♦ ↑P level → ↓expenditures → ↓Equil level of GDP♦ ↓P level → ↑expenditures → ↑Equil level of GDP
● We can now draw an AD curve (in Fig 3) where Y0, Y1, and Y2 correspond to the GDP levels depicted in the 45 degree line diagram.
The Aggregate Demand Curve
FIGURE 3. The Effect of the Price Level on Equilibrium AD
Y2
Pric
e Le
vel
Real GDP
C0 + I + G + (X–IM)
Y0 Y1
45
45
C2 + I + G + (X–IM)
E0
C1 + I + G + (X–IM) E1
Change in P level Movement along AD curve
Real GDP
Rea
l Exp
endi
ture
E0
AD
E1
E2
Y1 Y2 Y0
P0
P2
P1
E2
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The Aggregate Demand Curve
● AD has a (-) slope♦ ↑P level → ↓C via ↓wealth♦ ↑P level → ↓X-IM
■ Note: this also shifts the expenditure schedule down and lowers GDP.
● Each expenditure schedule describes only one P level. At different P levels, the expenditure schedule is different so equilibrium GDP is different.
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● Will economy achieve full employment without inflation?
● If the economy always gravitates toward full employment, then gov should leave the economy alone.
● We’ve shown that equil GDP is where 45 degree line intersects the exp schedule, but we haven’t determined if that equil level of GDP is at full employment.
Demand-Side Equilibrium and Full Employment
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● If equil GDP > full employment level of GDP → economy has inflation.
● If equil GDP < full employment level of GDP → economy has unemployment.
Demand-Side Equilibrium and Full Employment
FIGURE 4. A Recessionary Gap
Recessionary gap
C + I + G + (X – IM)
45°
45°
Potential GDP
7,000
Rea
l Exp
endi
ture
Real GDP 6,000
E
F
B
Full emp = $7,000B and equil GDP = $6,000B.
Here exp is too low to have full emp. Happens if C, I, G, or X are weak or P level is “too high.”
UE occurs because there isn’t enough output demanded to keep entire L force working.
Full emp can be reached if exp schedule shifts up to pt F. This could happen without gov intervention if ↓P level.
FIGURE 5. An Inflationary Gap
Inflationary gap
45°
45°
Potential GDP
8,000
Rea
l Exp
endi
ture
Real GDP 7,000
C + I + G + (X – IM)
F
B E
Full emp = $7,000B and equil GDP = $8,000B.
Happens if C, I, G, or X are very high or P level is “too low.”
Full emp can be reached if exp schedule shifts down to pt F. This could happen without gov intervention if ↑P level.
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The Coordination of Saving and Investment
● Must full employ level of GDP be an equilibrium? No!● Ignore G and X-IM then we can restate equil GDP:
♦ Y = C + I♦ Y – C = I♦ S = I
● Reach full employment equil only if S = I.♦ If S > I → spending is inadequate to support prod at full emp
→ GDP falls below potential and there is a recessionary gap.♦ If I > S → spending exceeds potential GDP → production is
above full emp level and there is an inflationary gap.
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The Coordination of Saving and Investment
● S is decided by households and I is decided by corporate executives and home buyers.
● Their decisions are not well coordinated.● Not clear the gov can solve the coordination problem of
UE.
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Changes on the Demand Side: Multiplier Analysis
● Multiplier = (∆ in equil GDP) (∆ in spending that caused the ∆ in GDP)
● In Table 3, I rises by $200B (from $900B in Table 1), yet equil GDP rises by $800B (not just $200B). Why?♦ Multiplier > 1 because one person’s spending is another
person’s income. Note: multiplier = 4 here. spending income♦ A portion of the ↑ in income is spent on C, creating more
income, which in turn creates more C, etc.
TABLE 3. Total Expenditure after a $200 Billion Increase in Investment
FIGURE 6. Illustration of the Multiplier
Rea
l Exp
endi
ture
45
$200 billion
6,800 0 6,000 Real GDP (or Y)
C + I1 + G + (X – IM)
C + I0 + G + (X – IM) E1
E0
Multiplier = ∆Y/∆I = $800/$200 = 4
Or multiplier = 1/(1-MPC) = 1/(1-0.75) = 4
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Changes on the Demand Side: Multiplier Analysis
● Multiplier = 1 (1 - MPC)♦ MPC in U.S. has been estimated to be about 0.95, implying
that the multiplier is 20. ♦ In fact, the multiplier in U.S. is < 2.
● Factors that reduce the size of the multiplier♦ International trade♦ Inflation♦ Income taxation♦ Financial system
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● ∆I has same multiplier effect as a ∆C, ∆G, or ∆(X - IM).● Consequently, trade links the GDPs of major economies.
GDP in a foreign country its IM, a portion of which are X from U.S.
♦ Growth in U.S. X has a multiplier effect, ↑GDP in U.S.♦ Booms and recessions tend to be transmitted across national
borders.
The Multiplier Is a General Concept
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The Multiplier and the Aggregate Demand Curve
spending shifts AD by an amount given by the oversimplified multiplier formula (1/(1-MPC)).
● In Fig 7, I has risen by $200B which shifts AD out by $800B (i.e., 4 (the multiplier) x $200B).
FIGURE 7. Two Views of the Multiplier
45
C + I1 + G + (X – IM )
$200 billion
C + I0 + G + (X – IM )
0 6,000
100 Pric
e Le
vel
Rea
l Exp
endi
ture
6,800
6,800 6,000
Real GDP
(I = $1,100) D1
D1
(I = $900) D0
D0
E0
E0
E1
E1
Supply-Side Equilibrium: Unemployment and
Inflation?
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● Aggregate Supply Curve● Equilibrium of AD and AS● Inflation and the Multiplier● Recessionary and Inflationary Gaps Revisited● Adjusting to a Recessionary Gap or an
Inflationary Gap● Stagflation from an Adverse Supply Shock
Contents
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The Aggregate Supply Curve
● Like AD, AS is a curve and not a fixed number.● Qs by firms depends on prices, wages, other input costs,
and technology.● AS represents the relationship between P level and GDP
supplied, holding all other determinants of Qs fixed.● AS has a (+) slope → ↑P → ↑Qs● Firms are motivated by profit.
♦ Profit per unit = P – AC
FIGURE 1. An Aggregate Supply Curve
Pric
e Le
vel
Real GDP
S
S
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Why does the Aggregate Supply Curve have a Positive Slope?
● Many input prices are fixed for certain periods of time.♦ Long-term contracts for L or raw materials
● Firms choose Qs by comparing selling prices with production costs which depend on input prices.♦ If ↑selling prices while input costs are fixed → ↑Qs♦ If ↓selling prices while input costs are fixed → ↓Qs
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Shifts of the Aggregate Supply Curve
● Costs of production are constant along the AS curve. costs of production shifts AS curve1. Money wage rate
● wages account for more than 70% of all prod costs. ♦ ↑wages → ↓profit at any given P of output → ↓Qs♦ ↑wages → shifts AS inward and ↓wages → shifts AS outward
2. Prices of other inputs♦ ↑P of any input → shifts AS inward and ↓P of any input →
shifts AS outward
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Shifts of the Aggregate Supply Curve
3. Technology and productivity● Technological breakthrough that ↑L productivity → ↑output
per hour of L → ↑profit per unit → ↑Qs● Technological improvements shift AS outward
4. Available supplies of labor and capital● AS curve shifts out if L force↑; ↑L quality; or ↑K stock
because more output can be produced at any given P level.
FIGURE 2. A Shift of the Aggregate Supply Curve
S1
S1 (higher wages)
S0
S0 (lower wages)
100
6,000
Pric
e Le
vel
5,500 Real GDP
A B
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Equilibrium of Aggregate Demand and Supply
● Intersection of AD and AS determine the equilibrium level of real GDP and the P level.
● Equilibrium (in Fig 3) occurs at a P level = 100 and GDP = $6,000B. ♦ At higher P levels, like 120, Qs > Qd by $800B → ↑inventories
→ ↓prices and ↓output.♦ At lower P levels, like 80, Qd > Qs by $800B → ↓inventories
→ ↑prices and ↑output.
FIGURE 3. Equilibrium Real GDP and the Price Level
Pric
e Le
vel
90
130
110
80
120
D
D S
S
100
6,400 6,800 5,200 5,600 6,000 Real GDP
E
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● Recall: multiplier effect suggests A’s spending becomes B’s income, and B’s spending becomes C’s income, etc.
● Earlier discussion focused on spending and assumed the P level was fixed.♦ Focused on the D-side equilibrium and ignored the reactions of
firms (i.e., the S-side).● Will firms supply the additional demand without ↑P?
♦ Not if AS slopes upward!● Inflation size of the multiplier
Inflation and the Multiplier
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● In Fig 4, ↑I by $200B which shifts AD out by $800B ($200B x oversimplified multiplier of 4). ♦ Shown by the movement from E0 to A.
● Firms react to higher levels of spending (shift of AD at P level = 100) by ↑output and ↑prices.♦ Shown by the movement from E0 to E1 –along AS curve.
● ↑P level → ↓purchasing power of money-fixed assets → ↓C and ↓X-IM♦ Shown by the movement from A to E1 –along new AD curve.
● Multiplier is only 2 now = ∆Y/∆I = $400B/ $200B.
Inflation and the Multiplier
FIGURE 4. Inflation and the Multiplier
Real GDP (Y)
6,8006,400
100
120
6,000
$800billion
80
110
130
90
NOTE: Amounts are in billions of dollars per year.
Price
Lev
el (Y
)
D1
D1
D0
D0
S
S
E0
E1
Assume I rises by $200B. This raises total expenditure (or Q of AD) by $800 (= $200B x multiplier of 4).
If AS were horizontal → multiplier = 4 and equil GDP would rise to $6,800B.
If AS were vertical → multiplier = 0 and equil GDP would remain at $6,000B.
Here AS is upward sloping and ↑P level with the shift in AD. The multiplier is 2 (= $400B/$200B).
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● Short run: equilibrium of AS and AD may or may not equal full employment GDP♦ Recessionary gap: equilibrium GDP < full employment or
potential GDP♦ Inflationary gap: equilibrium GDP > full employment or
potential GDP● Long run: wages adjust to labor market conditions to
make equilibrium GDP = full employment or potential GDP♦ But this may take a long time!
Recessionary and Inflationary Gaps Revisited
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Adjusting to a Recessionary Gap
● In Fig. 5, equil GDP falls below the full employment level.
● This might be caused by weak C or low I.● Loose L market
♦ There is UE and jobs are hard to find.♦ Employees may be anxious to keep their jobs.♦ Workers won’t win ↑wage and wages might fall.
● If ↓wages → AS shifts outward →↓P level and ↓UE● Deflation erodes the recessionary gap –but this process
happens very slowly!
FIGURE 5. The Elimination of a Recessionary Gap
100
6,000
Recessionary gap
S0
S0
D
D
Potential GDP
Pric
e Le
vel
7,000 Real GDP
E
S1
S1
F
B
Recessionary gap = $1,000B.
Weak spending and UE at pt E.
Weak labor markets put pressure on wages to fall.
Falling wages shift AS outward which lowers prices.
Falling prices stimulate C and net X.
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● In the real economy, however, wage reductions are slow and uncertain, particularly in the post-WWII period.
● E.g., even with the severe recession of 1981-82 where UE reached 10%, prices and wages were not forced down –though their rates of increase were.
Adjusting to a Recessionary Gap
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● Why haven’t wages fallen much since WWII?● Institutional factors: like min wages, union contracts, and
gov regulations that place legal floors on wages and prices. These were all developed since WWII.
● Psychological resistance: firms are reluctant to cut wages for fear their employees will resent it and reduce effort.♦ But why wasn’t this true prior to WWII?
Adjusting to a Recessionary Gap
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● Business cycles were less severe: after WWII so firms and workers wait out the bad times rather than accept wage or price cuts.
● Firms lose their best workers: if a firm cuts wages, it may lose its best employees. Individual productivity is hard to measure. The best workers have the greatest opportunities elsewhere.♦ Should have been true before WWII.
● With sticky wages and prices, cyclical unemployment may last a long time.
Adjusting to a Recessionary Gap
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Adjusting to a Recessionary Gap
● Does the Economy Have a Self-Correcting Mechanism?♦ The economy will self-adjust eventually.
wages demand for labor prices demand for goods and services
♦ But many people believe that gov intervention should help to speed up the process.
● Eg., Recovery from 1990-91 recession took almost 4 years.♦ UE fell from 7.7% to 5.4%♦ Inflation fell from 6.1% to 2.7%
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Adjusting to a Recessionary Gap
● An Example from Recent History: Disinflation in Japan in the 1990s.♦ Recovery from the 1990-91 recession was weak and
long delayed, but it did eventually come.♦ Practical question: How long can we afford to wait?
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Adjusting to an Inflationary Gap
● When spending is strong, equil GDP > full employment GDP.
● Labor markets are tight.♦ Jobs are plentiful and L is in demand.♦ Firms will have trouble filling vacant positions and may offer
higher wages to lure workers away from their current jobs.● ↑wages → shifts AS inward →↓output and ↑prices● Inflation occurs because buyers are demanding more
than the economy is capable of producing at normal operating rates.
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Adjusting to an Inflationary Gap
● In Fig. 6, AS shifts inward → ↑P level → ↓purchasing power of consumer wealth →↓C and ↓X-IM.♦ Shown by the movement from E to F along AD curve.
● Stagflation occurs in the movement from E to F as ↓GDP and ↑P level.
● This process takes time because wages and prices adjust slowly!
FIGURE 6. The Elimination of an Inflationary Gap
S1
S1
S0
S0
D
D
Real GDP
Pric
e Le
vel
E
Inflationary gap
Potential GDP
F
B
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Adjusting to an Inflationary Gap
● Demand Inflation and Stagflation● Inflationary gap is caused by high levels of spending.
♦ High demand for goods pushes prices and wages higher.♦ Often hear business managers and journalists claim that
↑wages are causing inflation. ♦ Yet, ↑wages are a symptom not the cause of inflation.
● Stagflation that follows a period of excessive AD is comparatively benign; output is falling, but it is still above potential GDP.
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Adjusting to an Inflationary Gap
● U.S. economy experienced an episode of stagflation between 1988 and 1990.♦ Economy reached UE rate of 5% (15 year low).♦ Inflation rose from 4.4% to 6.1% to cure the inflationary gap.♦ GDP growth rate fell from 3.5% in 1988 to -0.2% in 1990.
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Stagflation from an Adverse Supply Shock
● In 1973, OPEC x 4 the P of oil.♦ ↑costs of production for U.S. firms
● In 1979-80, OPEC struck again but P of oil x 2.● Same thing happened during 1990 Gulf War –but to a
smaller extent.● ↑P oil → inward shift of AS → ↓GDP and ↑P level.
FIGURE 7. Stagflation from an Adverse Shift in AS
42.2 35.4
3,870
Pric
e Le
vel
3,900
Real GDP
D
D
S1
S1
S0
S0
A
E
In 1973, ↑P of oil x 4 → ↓real GDP by 1% and ↑P level by 19%.
Data from 1973
Managing Aggregate Demand:
Fiscal Policy
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● Great Fiscal Stimulus Debate● Income Taxes & the Consumption Schedule● The Multiplier Revisited● Planning Fiscal Policy● Choice Between Spending Policy & Tax Policy● Some Harsh Realities● Supply-Side Tax Cuts
Contents
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Great Fiscal Stimulus Debate of 2009-10
● Has the $787B stimulus worked?● Republicans: No
♦ Too much spending♦ Not enough tax cuts♦ ↑budget deficit
● Democrats: Yes♦ ↑AD and moderated the recession♦ ↑G impacts the economy sooner and with more certainty than
↓T
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Income Taxes & Consumption Schedule
● Fiscal policy♦ Government’s plan for spending & taxation♦ Shift AD in desired direction
● Disposable income (DI = Y-T)♦ Where Y = Real GDP and T = Taxes
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Income Taxes & Consumption Schedule
● Tax increase♦ C f(x) and expenditure schedule shift downward♦ Equilibrium GDP (on the demand side) is decreased
● Tax decrease♦ C f(x) and expenditure schedule shift upward♦ Equilibrium GDP (on the demand side) is increased
FIGURE 1. How tax policy shifts the consumption schedule
Real GDP
Rea
l Con
sum
er S
pend
ing
C
Tax Increase
Tax Cut
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The Multiplier Revisited
● ∆ in G♦ Impacts spending directly
■ through G component of C + I + G + X – IM
● ∆ in T♦ Impacts spending indirectly– through C component♦ Unlike G, not every dollar is spent, some is saved♦ So the multiplier is smaller for T than for G
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The Multiplier Revisited
● Multiplier♦ Reduced by income tax♦ Income tax reduces the fraction of each dollar of GDP
that consumers actually receive and spend● Oversimplified multiplier of 1/(1-MPC)
♦ Overstates the economy’s actual multiplier1. Ignores variable imports 2. Ignores price-level changes 3. Ignores income tax
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The Multiplier Revisited
● Two ways taxes modify the multiplier analysis:1. Tax changes have a smaller multiplier effect than
spending changes by gov or others.2. An income tax reduces the multipliers for both tax
changes and changes in spending.
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The Multiplier Revisited
● Automatic stabilizer: feature of the economy that reduces its sensitivity to shocks
● Changes in spending components (C, I, G, or X-IM) occur all the time and they drive GDP up or down by a multiplied amount. ♦ If the multiplier is smaller → GDP is less sensitive to shocks
and the economy is less volatile● Ex.: personal income tax
♦ Taxes make DI and thereby C less volatile■ E.g., If ↑Y, ↑DI less sharply because part of the rise is absorbed by the
gov which helps limits any ↑C
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The Multiplier Revisited
● UI is also an automatic stabilizer♦ If ↓GDP and ↑UE → UI prevents DI from fallings as
dramatically as earnings♦ UE can maintain their spending better, so C fluctuates less than
employment does● Automatic stabilizers act as shock absorbers and
therefore lower the multiplier♦ Stabilizers (like taxes or UI) work automatically without the
need for gov action
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The Multiplier Revisited
● Gov transfer payments♦ Payments to individuals and not compensation for
production ♦ Intervene between GDP and DI in exactly the opposite
way from income taxes■ Add to earned income (rather than subtract from it)■ Function as negative taxes
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Planning Fiscal Policy
● Expansionary fiscal policy♦ ↑G, ↓taxes or ↑transfer payments♦ To close recessionary gap between actual and
potential GDP● Contractionary fiscal policy
♦ ↓G, ↑taxes or ↓transfer payments♦ To close inflationary gap between actual and potential
GDP
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Choice: Spending Policy & Tax Policy
● Any combination of higher spending and lower taxes that produces the same AD curve leads to the same increases in real GDP and prices
● So should policy makers use ↑G or ↓T to ↑AD?♦ How large a public sector do they want?♦ Conservatives argue for smaller government
■ Reduces taxes during recessions and cut spending during booms
♦ Liberals argue for larger government■ Increase spending during recessions and raise taxes during booms
72
Real GDP
Pric
e Le
vel
D0
D0
S
S
D1
D1
A
E
Rise in real GDP
Rise in Price level
FIGURE 2. Expansionary fiscal policy
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Some Harsh Realities
● Why can’t fiscal policy drive GDP to its full-employment level?
● C, I, and X-IM schedules shift abruptly with changes in expectations, technology, and events abroad, etc.
● Multipliers are unknown● What is the full-employment level of GDP?● Time lag between fiscal policies and their impact on
spending● Congress members (not economists) enact “political”
fiscal policies
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Some Harsh Realities
● Should policy makers work to push UE lower?♦ ↑G or ↓T will ↑deficits; What are the LR costs of
running large budget deficits?♦ How large will the inflationary cost be?
● If costs are large, then gov may be hesitant to use fiscal policy to fight recessions.
● “Supply-side” economics♦ Battle UE without sparking inflation
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Idea Behind Supply-Side Tax Cuts
● Certain types of tax cuts♦ Shift AS out which can ↓inflation and ↑real GDP ♦ Raise the returns to working, saving and investing
■ If people respond → ↑SL and ↑SK
● Supply-siders typically advocate tax cuts on:♦ Personal income♦ Income from savings♦ Capital gains♦ Corporate income
76
Real GDP
Pric
e Le
vel
D
DS0
S0
A
S1
S1
B
FIGURE 3. The goal of supply-side tax cuts
77
Real GDP
Pric
e Le
vel
D0
D0
S0
S0
E
S1
S1
D1
D1
A
C
FIGURE 4. A successful supply-side tax reduction
A successful supply-side tax cut will shift both AD and AS.
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Idea Behind Supply-Side Tax Cuts
● Some complications and undesirable side effects♦ Small magnitude of supply-side effects
■ People may not save more in response to tax incentives.■ Charles Schultz: “There’s nothing wrong with supply-side
economics that division by 10 couldn’t cure.”♦ Demand-side effects
■ People may work more but they will certainly spend more.● Figure 5 (rather than Figure 4) may better represent the
impact of supply-side policies on AD and AS.
79
Real GDP
Pric
e Le
vel
D0
D0
S0
S0
E
S1
S1
D1
D1
C
FIGURE 5. A more pessimistic view of supply-side tax cuts
A supply-side tax cut may shift AD much more than AS.
Inflation now rises as it did under “demand-side” fiscal stimulus in Figure 2.
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Idea Behind Supply-Side Tax Cuts
● Further complications♦ Problems with timing
■ I incentives are the most promising supply-side tax cuts but it may take years before we see the impact on GDP.
♦ Effects on income distribution■ Reductions in personal income-tax rates and capital gains
taxes increase income inequality.♦ Losses of tax revenue
■ Tax cuts raise the budget deficit.● 15 years to overcome the deficits created by Reagan’s tax cuts
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Idea Behind Supply-Side Tax Cuts
● Effectiveness of supply-side tax cuts?♦ Tax cuts to raise business I – have the greatest impact♦ Increase AS more slowly than AD
■ Leads to faster economic growth in LR but is not a substitute for SR stabilization policy
♦ Demand-side effects overwhelm supply-side effects in SR
♦ Likely to widen income inequalities♦ Lead to larger budget deficits
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Great Fiscal Stimulus Debate of 2009-10
● Both political parties wanted to stimulate the economy in 2009 but Republicans wanted less G and more T cuts.
● Democrats argued that the supply-side effects of Republican-proposed tax cuts are small and uncertain and that the economy has too little AD (not too little AS).
● Republicans countered that business tax incentives are the best way to spur LR job creation and that the fiscal multiplier is small or even zero.
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