public and private sector behaviour

Public and Private

Sector Behaviour

M.Brzoza-Brzezina:

Macroeconomics II - Public and

private sector behaviour

2

Outline

1. The role of expectations

2. Budget constraints

- Private sector

- Public sector

- Intertemporal budget constraint of the economy

- Ricardian equivalence

3. Private sector demand

- Consumption

- Investment

- Goods market equilibrium (IS curve)

This lecture follows chapters 5 and 6 of the textbook.

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1. The role of expectations

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Modern economic theory recognizes

that the central difference between

economics and natural sciences lies in

the forward-looking decisions made

by economic agents.

Evans, Honkapohja (2001)

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Why are expectations important?

People make decisions thinking about their present and future consequences

Example: why do you study instead of going to work?

- Because studying is funny?

- Because you expect to earn more in the future?

Hence, to understand macroeconomics we should also look at intertemporal decision problems

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How are expectations formed?

Alternative approaches

- Adaptive (e.g. Friedman 1956) – we look backwards:

Popular in the 1950’s-60’s. Now out of fashion –

allow for systematic mistakes

- Rational (Muth 1962, Lucas 1972) – we look forward:

Popular since 1970’s.

- Adaptive learning (Evans, Honkapohja 2001) – we

learn over time the true model

)|( 11 tt

e

t xEx

t

e

t xx 1

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Rational expectations

Dominant approach since the 1980s

Advantage:

- Consistent with rational behaviour assumption

Disadvantage:

- Inconsistent with (part of) the empirical evidence

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2. Budget constraints

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Private sector budget constraint

Private sector = households + private enterprises

Enterprises are owned by households. So, private sector budget constraint can be represented by the household budget constraint.

Because households can borrow and lend, their budget constraint is intertemporal

Assume household lives for two periods, has endowment (y1, y2).

If it can lend/ borrow it can trade current vs. future consumption at the interest rate r.

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Household budget constraint

Consumption tomorrow must equal income tomorrow

plus today’s savings with interest:

c2= y2+(1+r)(y1-c1)

or

c1+c2/(1+r)=y1+ y2 /(1+r)

Present value of consumption must equal present

value of income (wealth)

This is the intertemporal budget constraint which

determines the set of possible consumption baskets

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12 Consumption today

Consum

ption t

om

orr

ow

0

= - 1+ rslope ( )

Endowment, wealth...

Endowments M, A and P for interest rate

r imply the identical wealth OB, and

identical consumption possibilities.

Y1

Y2

D

B

M (student, low Y1 today, high Y2 tomorrow)

(Professional athlete, high Y1

P today, low Y2 tomorrow)

A

Figure 5.01

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Public sector budget constraint

The public sector is similar to the private

sector

- has income and expenditures,

- can save or borrow,

- has a budget constraint:

g1+g2/(1+r)= t1 + t2/(1+r)

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Is the public sector budget constraint

binding?

The real world has more than two periods

That’s why the budget constraint of the government is difficult to see

But it binds. Two proofs:

1. Higher public debt causes higher interest rates – investors demand a risk premium (e.g. Ford, Laxton 1995).

2. Sometimes countries default. Examples:

- Russia 1998

- Argentina 2002

- Greece 2011

© Oxford University

Press, 2012. All rights

reserved.

Primary Consolidated Budget Surpluses, 1970-2010

Figure 7.8 Primary Consolidated

Budget Surpluses, 1974-2009

Figure 7.8

Source: OECD, National Accounts

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Public debt in the EU

Source: European Commission

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Intertemporal budget constraint of

the economy

Adding up private and public sector budget constraints:

Private (with tax): c1+c2/(1+r)=(y1-t1) + (y2-t2) /(1+r)

Public: g1+g2/(1+r)= t1 + t2/(1+r)

Whole economy: c1+c2/(1+r)=(y1-g1) + (y2-g2) /(1+r)

Taxes disappear – the economy-wide constraint looks like the private sector constraint (with G expenditure instead of taxes)

Adding the government simply reduces private sector wealth by t1 + t2 /(1+r) = g1 + g2 /(1+r)

The present value of taxes or expenditure matters, not the distribution over time

If the government runs a deficit in period 1, people know that they will pay higher taxes in period 2. This reduces their wealth and thus consumption in both periods.

This is called Ricardian equivalence.



reserved.

Con

sum

ptio

n t

om

orr

ow

0

Before Government Spending and Taxes

B

D

= 1+ rslope ( )

The original endowment, i.e.

before government spending

and taxes, is A.

Consumption today

Figure 7.9 (a)

Y1

Y2 A

The national wealth is 0B, the

present discounted value of A.



reserved.

Con

sum

ptio

n t

om

orr

ow

0

With Government Spending and Taxes

B´

D´

B

D

= 1+ rslope ( )

A´

(Y1-G)

(Y2-G)

Deducting the present value of

government spending (equal to

the present value of taxes by

the government budget

constraint), we have private

wealth OB´ (= OB-B´B). For

simplicity we assume identical

G in both periods.

Consumption today

Figure 7.9 (b)

Y1

Y2 A



reserved.

Con

sum

ptio

n t

om

orr

ow

0

Ricardian Equivalence

B B´

D

D´

Y1

Y2 A

A´

(Y1-G)

(Y2-G)

= 1+ rslope ( )

The insight is that given the

present value of government

spending (i.e. the shift of private

wealth to D´B´), it doesn’t matter

for private wealth whether (i)

there are low taxes and a deficit

to be paid off later with higher

taxes or (ii) higher taxes now so

that taxes later are lower.

Consumption today

Figure 7.9 (c)

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Ricardian equivalence - consequences

Decline of public savings is fully compensated by increase of private saving,

Public deficit/ debt does not impact on interest rates,

Fiscal stimulus not possible,

No twin deficits.

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Does Ricardian equivalence hold?

Certainly not fully:

- public debt impacts on interest rates,

- fiscal stimulus usually works,

- in practice private savings compensate

probably not more than 50% of public

deficits.



reserved.

Figure 7.12

Sources: OECD, Economic Outlook

Ricardian Equivalence in the UK, 1970-2011

The Effect of Fiscal Consolidation on the Current Account

John Bluedorn and Daniel Leigh

M.Brzoza-Brzezina:

Macroeconomics II - Introduction

to Macroeconomics

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Effect of public stimulus

Source: Nickel & Tudyka 2013

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Why does Ricardian equivalence not

hold?

People die, governments seldom do,

People are not always forward-looking,

Interest rates at which public and

private sectors borrow differ,

Households may be restricted to

borrow.



reserved.

Table 7.1

Source: Macrobond



reserved.

Public and Private Borrowing Rates in Italy

Figure 7.10

2007 - 2011

Sources: ECB; Banca d‘Italia



reserved.

B

D

= 1+ rslope ( )

Consum

ption t

om

orr

ow

0

(a) Households Can Save, But Not Borrow

A

(Y1-G1)

(Y2-G2)

If households are constrained

from borrowing at all (but they

can still save), they can choose

only among the points along

segment AD.

Consumption today

Figure 7.11 (a)



reserved.

B

D

= 1+ rslope ( )

Consum

ption t

om

orr

ow

0

(b) The Government Can Borrow

A

(Y1-G1)

(Y2-G2)

A´ (Y2-T2)

(Y1-T1)

If the government is able to borrow at

the interest rate r the government

could reduce taxes today and raise

taxes in the future (to pay for the tax

saving this period plus interest).

This increases budget segment of

households to DA´.

Hence, timing of gov expenditure can

affect the private sector’s budget

constraint

Consumption today

Figure 7.11 (b)



reserved.

Consum

ption t

om

orr

ow

0

(c) Households Can Borrow

B

D

A

(Y1-G1)

(Y2-G2)

= 1+ rslope ( )

B´

= 1+ r´slope ( )

Consumption today

Figure 7.11 (c)

Households face a higher interest

rate (r‘) if they borrow than if they

save (r).



reserved.

B´´

= 1+ r´slope ( )

Consum

ption t

om

orr

ow

0

(d) Government Can Ease Borrowing Constraint

B´

D

A

(Y1-G1)

(Y2-G2)

= 1+ rslope ( )

A´ (Y2-T2)

(Y1-T1)

The government could reduce taxes

today and raise taxes in the future (to

pay for the tax saving this period plus

interest).

This increases budget segment of

households to DA´B´´ from DAB´.

Again, timing of gov expenditure can

affect the private sector’s budget

constraint

Consumption today

Figure 7.11 (d)

Reasearch on Ricardian

equivalence

„We investigate the impact of fiscal stimuli at different levels of the government debt-

to-GDP-ratio for a sample of 17 European countries from 1970 to 2010. […] We find

that responses to government spending shocks exhibit strong non-linear behaviour.

While the overall cumulative effect of a spending shock on real GDP is positive and

significant at moderate debt-to-GDP ratios, this effect turns negative as the ratio

increases. The total cumulative effect on the trade balance is negative at first but

switches sign at higher levels of debt. Consequently, depending on the degree of

public indebtedness, our results accommodate long-run fiscal multipliers which are

greater and smaller than one or even negative as well as twin deficit and twin

divergence behaviour within one sample and time period.”

Nickel & Tudyka 2013 „Fiscal Stimulus in Times of High Debt Reconsidering

Multipliers and Twin deficits”

(Good reading for those interested in the topic)

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3. Private sector demand

People choose

stable rather

than volatile

consumption

(R vs. M or A)

© Oxford University Press, 2012.

All rights reserved.

Optimal Consumption

Fig. 8.2

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Consumption smoothing – consequences (1)

consumption is more stable than output (income)

0

1

2

3

4

5

6

1996

q01

1997

q01

1998

q01

1999

q01

2000

q01

2001

q01

2002

q01

2003

q01

2004

q01

2005

q01

2006

q01

GDP EU-25 Consumption EU-25

Source: Eurostat

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We react differently to permanent and to

transitory shocks to income

we smooth income over the lifecycle

(Modigliani’s life cycle hypothesis)

Consumption smoothing –

consequences (2)



reserved.

Temporary vs. Permanent Income Change C

onsum

ption t

om

orr

ow

0

R´

A´´R´´

Y1

Y2

Y1´ B

D

A=R A´

B´ B´´

D´

Temporary: R to R´

Permanent: R to R´´

Fig. 8.3 (c)

Consumption today

Y2´



reserved.

Permanent vs. Temporary Shocks: Ireland and Germany

Fig. 8.4 (a)

Source: OECD Economic Outlook

2005 -

2011



reserved.

Permanent vs. Temporary Shocks: Ireland and Germany

Fig. 8.4 (b)

Source: OECD Economic Outlook

2005-

2011



reserved.

Borrowing

Saving

Time

Income,

Consumption

0

Life-Cycle Consumption

Income

Consumption Permanent

income

Fig. 8.5

Life-cycle in the data

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Source: Hammer 2015

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What determines consumption demand?

Let us solve the consumers problem (very simplified)

Hence, today’s consumption depends not (only) on current income, but rather on wealth.

211

2111

2121

21

1

1

2

1

:_

0)1()1(

11

:___

)1/()1/(

..

lnln)(max

yr

yc

termsgrearrangin

yyrcr

r

c

yieldsatingdifferentiandngsubstituti

ryyrcc

ts

cccU

Consumption and Net Wealth

300

400

500

600

700

800

900

1000

1100

1200

1300

1000 3000 5000 7000 9000

Net wealth (Euro bn.)

Co

ns

um

pti

on

( E

uro

bn

.)

Consumption and Disposable Income

300

400

500

600

700

800

900

1000

1100

1200

1300

400 600 800 1000 1200 1400

Disposable income (Euro bn.)

Co

ns

um

pti

on

(E

uro

bn

.)

Consumption, wealth and disposable income:

France, 1980-2002

Fig. 6.10

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Consumption, income and wealth

In reality consumption depends stronger

on current income:

- problems with wealth estimation

(forward looking problem)

- borrowing constraints



reserved.

Consum

ption t

om

orr

ow

0

Household With Credit Constraint

D

C

B

A

R

Fig. 8.8 (b)

Consumption today

With credit constraint, the

choice set is reduced.

As a result current

income (A) may

determine consumption

choice.

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Reaction function of consumption to

real interest rate hike in Poland

-1.5

-1.0

-0.5

0.0

0.5

5 10 15 20

Response of CONS to Cholesky

One S.D. RWIB1MEXP Innovation

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Investment demand

Determinants of investment demand

- real interest rates

- economic growth

Solve the firm’s problem

Π𝑡 = 𝑦𝑡 − 𝑟𝑡𝑘𝑡 −𝑤𝑡𝑙𝑡

𝑦𝑡 = 𝑘 𝑙𝑡1−𝛼

𝑡−1𝛼

Substitute and find optimum

𝛼𝑘 𝑙𝑡1−𝛼 − 𝑟𝑡 = 0𝑡−1

𝛼−1

𝛼𝑦𝑡𝑘𝑡−1

= 𝑟𝑡

© Oxford University Press, 2012.

All rights reserved.

The Optimal Capital Stock

Fig. 8.10

Determinants of investment

𝑘𝑡−1 = 𝛼𝑦𝑡

𝑟𝑡 and 𝑘𝑡 = 𝛼𝐸𝑡

𝑦𝑡+1

𝑟𝑡+1

Ignoring depreciation:

𝑖𝑡 = 𝑘𝑡 − 𝑘𝑡−1

So that:

𝑖𝑡 = 𝛼 𝐸𝑡𝑦𝑡+1𝑟𝑡+1

−𝑦𝑡𝑟𝑡

Investment rises with output and declines

with the interest rate

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Reaction function of investment to

real interest rate hike in Poland

-8

-6

-4

-2

0

2

4

5 10 15 20

Response of INWYOY to Cholesky

One S.D. RWIB1MEXP Innovation

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Enterprises tend to invest when they expect demand for their products to rise

Investment and economic growth (2)

80

90

100

110

120

130

100 101 102 103 104 105 106 107 108

PKB

na

kla

dy b

rutt

o n

a s

rod

ki tr

wa

le

80

90

100

110

120

130

96 97 98 99 00 01 02 03 04

PKB

Naklady brutto na srodki trwale

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Goods market equilibrium (IS curve)

Deriving the goods market equilibrium we ignore investment and capital formation

The general equilibrium model we will construct later is designed to explain short- to medium term behaviour. Capital formation is rather a long term phenomenon.

Take consumption demand and impose market clearing condition c=y:

Current output depends positively on (expected) future output and negatively on the current real interest rate. This is the IS curve.

21

211

1

1

1

1

2

1

yr

y

yr

yc

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IS curve

Originally comes from Hicks (1937) and

describes part of the Keynesian IS-LM model

r

Y

IS

Takeaways Expectations matter for economic decissions. Standard

assumption: rational, but evidence mixed

Household consumption:

– Is the results of intertemporal optimization

– Depends on current and expected future income

– Depends on real interest rates

– HHs smooth consumption over the business cycle and over the life cycless

Ricardian equivalence:

– HHs internalize the public sectors budget constraint

– As a consequence only gov. expenditure matters, not the timing of taxation

– HHs increase savings in reaction to higher government deficyt

– But Ricardian equivalence holds only partially (~50%): • People are myopic

• People die or emigrate

• People are credit constrained

Business investment:

– Is the result of profit maximization

– Depends on expected economic growth and on real interest rates

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Exercises

Derive IS curve

- under alternative utility function

assumptions

- with discount factor

public and private sector behaviour

Documents