quick review. price level real gdp ad sras lras qn q1
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QUICKQUICKREVIEWREVIEW
PRICE LEVEL
REAL GDP
AD
SRAS
LRAS
QnQ1
PRICE LEVEL
REAL GDP
AD
SRASLRAS
Qn
Price Level
NaturalReal GDP
SRAS
0
AD
QN
LRAS
Long-runequilibrium
Short-runequilibrium
Answer the following:Answer the following:
What is Say’s law? What three things must be flexible in the
Classical model? What is the Classical solution for too much
unemployment? How does the self-regulating economy get
out of a recessionary gap?
Self-Regulating Economy Self-Regulating Economy Self-Regulating Economy Self-Regulating Economy
KEYNESIAN ECONOMICSKEYNESIAN ECONOMICS
J. M. Keynes wrote during the Great Depression
Keynes focused on the demand side of the economy
Keynes did not believe that the economy was necessarily self-correcting
KEYNES ON WAGES AND PRICESKEYNES ON WAGES AND PRICES
Keynes believed that wages and prices were STICKY DOWNWARD
The lack of wage and price flexibility suggested that the economy might get STUCK in a recessionary gap.
Keynes tended to focus on the short run because
“IN THE LONG RUN WE ARE ALL DEAD”
KEYNES AND INCOMEKEYNES AND INCOME
Keynes focused his analysis on Total Expenditures in the economy
In particular, he focused on Consumption CONSUMPTION is a function of
DISPOSABLE INCOME SAVING is also determined by
DISPOSABLE INCOME
CONSUMPTION AND CONSUMPTION AND SAVING TERMSSAVING TERMS
Autonomous Consumption - the portion of consumption that is not related to income (it is the amount of Cons. when income is 0).
MPC - marginal propensity to consume (it is change in C / change in Y)
MPS - marginal propensity to save (it is the change in saving / change in Y)
CONSUMPTION AND CONSUMPTION AND SAVING TERMSSAVING TERMS
Break-even income - the level of disposable income where consumption spending is just equal to disposable income.
C = Yd
S must be zero
EQUATION FOR C AND SEQUATION FOR C AND S
C = a + b(Yd) Consumption = autonomous consumption +
the MPC * (disposable income)
S = -a + (1-b)(Yd) Saving = negative autonomous
consumption + MPS * ( disposable income)
EXAMPLEEXAMPLE
C = 100 + .75 (Yd) Find Aut. Cons., MPC, MPS, and C and S
when Yd=1000. Aut. Cons. = 100 MPC = .75 MPS = .25 C = 100 + .75 (1000) = 100 + 750 = 850
CONSUMPTION FUNCTIONCONSUMPTION FUNCTION
INCOME CONS. SAVING0 100 -100100 180 -80200 260 -60300 340 -40500 500 0600 580 20
Find MPC Find MPS Find Autonomous Consumption Give the equation for consumption Give the equation for saving Find breakeven income Find C and S when income is 700
CONSUMPTION FUNCTIONCONSUMPTION FUNCTION
A change in Disposable Income causes a MOVEMENT ALONG the Consumption Function
A change in Autonomous Consumption causes a SHIFT of the Consumption Function
SAVINGSAVING
SAVING is the unspent portion of a consumer’s income.
SAVING = Income - Consumption Exp.
INVESTMENTINVESTMENT2 components2 components
Capital goods (producer durables) - goods used by businesses to produce other goods and services. They have an expected service life of more than one year.
Inventory investment - changes in the stocks of finished goods, goods in process, and in raw materials a firm keeps on hand.
TOTAL EXPENDITURESTOTAL EXPENDITURES
Total Expenditures = C + I + G + (X-M) C depends on Disp. Y S depends on Disp. Y Disp. Y = C + S I depends on the interest rate ( not Y ) G is assumed to be autonomous
EQUILIBRIUMEQUILIBRIUM
TOTAL EXPENDITURES are equal to TOTAL PRODUCTION is equal to INCOME
DISEQUILIBRIUMDISEQUILIBRIUMTOTAL OUTPUT < TOTAL EXPENDITURESTOTAL OUTPUT < TOTAL EXPENDITURES
unplanned inventories production employment Real GDP income
DISEQUILIBRIUMDISEQUILIBRIUMTOTAL OUTPUT > TOTAL EXPENDITURESTOTAL OUTPUT > TOTAL EXPENDITURES
unplanned inventories production employment Real GDP income
C = 200 + .80(Yd)C = 200 + .80(Yd)I = 300I = 300
Find Autonomous Cons., MPC, and MPS Find breakeven income Find equilibrium income In Qn=3000, identify the following: type of
gap, size.
THE MULTIPLIERTHE MULTIPLIER
A dollar injected into the economy (i.e. investment) has an impact beyond the initial expenditures. The dollar continues to be spent multiplying its impact on the economy. The number of times it circulates through the economy is known as THE MULTIPLIER.
THE MULTIPLIER cont.THE MULTIPLIER cont.
The rate of circulation is related to the MPC and MPS. The larger the MPC, the more consumption rises as a result of an increase in income. This will result in a larger MULTIPLIER.
Autonomous Government Autonomous Government Spending & the Multiplier Spending & the Multiplier
Exhibit 12Exhibit 12
Autonomous Government Autonomous Government Spending & the Multiplier Spending & the Multiplier
Exhibit 12Exhibit 12(1)EXPENDITUREROUND
(2)CHANGE INAUTONOMOUSGOVERNMENTSPENDING
(3)CHANGE IN REALNATIONAL INCOMEOR REAL GDP($ millions)
(4)MPC
(5)CHANGE INCONSUMPTION($ millions)
Round 1
Round 2
Round 3
Round 4
$60.00 $ 60.00
48.00
38.40
30.72
.80
.80
.80
.80
$ 48.00
38.40
30.72
24.57........
.
.
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.
..
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..
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.
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..
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All other 122.88 .80 98.88
TOTAL $300.00 $240.00(Approx.
THE FORMULATHE FORMULA
MULTIPLIER = 1 or 1
1 - MPC MPS
EXPANSIONARY FISCAL EXPANSIONARY FISCAL POLICYPOLICY
TO ADDRESS A RECESSIONARY GAPTO ADDRESS A RECESSIONARY GAP
policy aimed at increasing economic activity through increasing G &/or
decreasing T to increase AD or increase SRAS
CONTRACTIONARY FISCAL CONTRACTIONARY FISCAL POLICYPOLICY
TO ADDRESS AN INFLATIONARY GAPTO ADDRESS AN INFLATIONARY GAP
policy aimed at decreasing economic activity through decreasing G &/or
increasing T to decrease AD or decrease SRAS
Fiscal Policy in Keynesian Theory: Ridding the Fiscal Policy in Keynesian Theory: Ridding the Economy of Recessionary Gaps Economy of Recessionary Gaps
Fiscal Policy in Keynesian Theory: Ridding the Fiscal Policy in Keynesian Theory: Ridding the Economy of Inflationary Gaps Economy of Inflationary Gaps
Exhibit 2 (2 of 2)Exhibit 2 (2 of 2)
THE MULTIPLIER EFFECTTHE MULTIPLIER EFFECT
both G and T are subject to the multiplier effect SO a change in
either will lead to an even greater change in equilibrium real output
(which is equilibrium Y)
THE EXPENDITURE THE EXPENDITURE MULTIPLIERMULTIPLIER
1 / 1- MPC or 1 / MPS Change in Real GDP =
multiplier x (change in G)
COMMON MULTIPLIERSCOMMON MULTIPLIERS
MPC .9 .8 .75 .66 .5
EXPMULT
10 5 4 3 2
EXAMPLEEXAMPLE
Qe = 800 while Qn = 1000 MPC = .75 find the G necessary to bring the economy
to natural real GDP
THE TAX MULTIPLIERTHE TAX MULTIPLIER
- MPC / MPS or ( 1 - exp. mult.) Change in Real GDP
= tax multiplier x (change in T)
EXAMPLEEXAMPLE
Qe = 1200 while Qn = 800 MPC = .66 find the T necessary to bring the economy
to full employment GDP
BALANCED BUDGET BALANCED BUDGET MULTIPLIERMULTIPLIER
if both G & T increase (or decrease) by the same amount, then equilibrium real GDP will increase by the amount
of the increase (or decrease) in G
C = 200 + .80(Yd)C = 200 + .80(Yd)I = 300I = 300
Find equilibrium income
In Qn=3000, identify the following: type of gap, size, fiscal policy options to close it.
Should Fiscal Policy be Used?Should Fiscal Policy be Used?
NOT NECESSARILY
Crowding Out Lags
CROWDING OUTCROWDING OUT
increases in G may lead to decreases in private sector spending ( C or I )
CROWDING OUT CROWDING OUT may occur due to:may occur due to:
direct substitution more on public libraries fewer books at bookstores
interest rate effects more on social programs and defense budget
deficit increases government’s demand for credit rises interest rate rises investment drops
Lags and Discretionary Fiscal Lags and Discretionary Fiscal PolicyPolicy
The data lag: not aware of changes in the economy as soon as they happened
The wait-and-see lag: adopt a more cautious attitude
The legislative lag The transmission lag: take time to be put into
effect The effectiveness lag: take time to affect the
economy
KEYNESIAN PERSPECTIVEKEYNESIAN PERSPECTIVE
fiscal policy is effective crowding out is relatively small lags are short
CLASSICAL PERSPECTIVECLASSICAL PERSPECTIVE
fiscal policy is ineffective crowding out is significant lags are long
FISCAL POLICYFISCAL POLICY
Discretionary Fiscal Policy
DISCRETIONARY FISCAL DISCRETIONARY FISCAL POLICYPOLICY
deliberate changes in G and/or T to achieve particular objectives
requires new action by Congress
FISCAL POLICYFISCAL POLICY
Discretionary Fiscal Policy Automatic Stabilizers
AUTOMATIC STABILIZERSAUTOMATIC STABILIZERS
changes in G and/or T that occur automatically as economic conditions change
these changes do not require new action by Congress
Four Types of Fiscal Policy Four Types of Fiscal Policy
Automatic
Discretionary
Expansionary Contractionary
Policy Makers Gor Tor both
Policy Makers Gor or both
UnemploymentCompensation
Welfare Payments
UnemploymentCompensation
Welfare Payments
(1) (2)
(3) (4)
The New Classical View Of The New Classical View Of Fiscal PolicyFiscal Policy
crowding out does occur as people save more in anticipation of higher taxes
these adjustments cause expansionary fiscal policy to be ineffective.
SUPPLY SIDE POLICYSUPPLY SIDE POLICY
dislike demand side policies because increases in AD means growth comes with higher prices
prefer to focus on tax issues which alter incentives to work, save, and invest
What Are the Major Federal What Are the Major Federal Taxes?Taxes?
What Are the Major Federal What Are the Major Federal Taxes?Taxes?
Personal income tax Corporate income tax Social security tax
Exhibit 1Major Federal Taxes
SOURCE: Council of Economic Advisers, Economic Report of the President, 1999.
MARGINAL TAX RATEMARGINAL TAX RATE
tax rate applied to additional income change in tax payment divided by the
change in taxable income
Three Three Income Income
Tax Tax Structures Structures
Three Three Income Income
Tax Tax Structures Structures
MARGINAL TAX RATES AND MARGINAL TAX RATES AND FISCAL POLICYFISCAL POLICY
decreasing marginal tax rates leads to an increase in SRAS
b/c increases the incentive to work if the tax change is permanent, then the
change in AS is too the LRAS will shift to the right
Laffer Curve Laffer Curve
TX
Tax Rate (percent)
Tax Revenues
0
A
Laffer Curve
C
X
B
TZ TY
Y
Z
100
B to C: Tax rateand tax revenuesinversely related.
A to B: Tax rateand tax revenuesdirectly related.
What are the Major Federal What are the Major Federal Government Spending Government Spending
Programs?Programs?
What are the Major Federal What are the Major Federal Government Spending Government Spending
Programs?Programs?
National defense Income security Health Medicare Social security Net interest on the National Debt
Exhibit 3Major Federal Spending Programs
SOURCE: Council of Economic Advisers, Economic Report of the President, 1999.
DEBT AND DEFICITSDEBT AND DEFICITSDEBT AND DEFICITSDEBT AND DEFICITS
BUDGET DEFICITS occur when government expenditures exceed tax receipts
A BUDGET SURPLUS occurs when tax receipts exceed government expenditures
CYCLICAL DEFICITSCYCLICAL DEFICITSCYCLICAL DEFICITSCYCLICAL DEFICITS The portion of the deficit that is a result of
an economic downturn many economists (Keynes) believe that
deficits are natural and necessary during recessions because tax revenues fall and benefit payments rise
Our problem is that we have continued to run deficits in expansionary periods
STRUCTURAL STRUCTURAL DEFICITSDEFICITS
The structural deficit is the portion of a budget deficit which exists when the economy is operating at full employment
Total Budget Deficit = structural deficit + cyclical deficit
National DebtNational Debt NATIONAL DEBT is the total sum of what
the federal government owes its creditors (the sum of past deficits)
Exhibit 5 Public Debt for 1987–1999
The 1999 amount is for November 1999.
SOURCE: Bureau of the Public Debt.
NATIONAL DEBTNATIONAL DEBTNATIONAL DEBTNATIONAL DEBT
As the debt grows, interest on the debt grows in its share of the budget.
The portion of the budget that can be cut in order to balance the budget is SHRINKING
PORTION OF THE BUDGET PORTION OF THE BUDGET THAT IS CONSIDERED THAT IS CONSIDERED
UNTOUCHABLEUNTOUCHABLE
PORTION OF THE BUDGET PORTION OF THE BUDGET THAT IS CONSIDERED THAT IS CONSIDERED
UNTOUCHABLEUNTOUCHABLE
Interest on the Debt 14% Social Security 22% untouchable total 36% National Defense 20% Total 56%
WHO BEARS THE BURDEN WHO BEARS THE BURDEN OF THE DEBT?OF THE DEBT?
WHO BEARS THE BURDEN WHO BEARS THE BURDEN OF THE DEBT?OF THE DEBT?
CURRENT GENERATION - if crowding out occurs then households are giving up consumption to pay for increases government spending
FUTURE GENERATIONS - will have to pay higher taxes to pay off the bonds when they come due. They bear the cost while the bondholders receive the payoffs.
COUNTERPOINTCOUNTERPOINTCOUNTERPOINTCOUNTERPOINT
WE-OWE-IT-TO -OURSELVES - if American taxpayers make payments to American bondholders, money is simply shifted from one pocket to another.
Only works if debt is held domestically (currently 14-18% is held by foreigners)