Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
Macro1 Manual Purpose of the Module Two of the major problems faced by national economies are inflation and unemployment. Both of these have significant social costs, and it is generally considered the job of the national government to keep those costs down. As a result, governments are constantly trying to avoid recession (with rising unemployment), or get out of recession, or avoid inflation, or reduce inflation. In their efforts to use the major tools at their command they face the problem of deciding how much to do, since doing too little will leave them short of their goals, and doing too much may cause new problems to arise. In this module you face the problems that national governments face, but in a simpler form. By acting as the whole government (President, Congress, Federal Reserve Board) you can begin to see how each of the tools they have affect the inflation and unemployment rates. Nature of the Problem In the real world, governments face more difficulties than are included in this module, but the module does allow you to experience important aspects of their problems. One is the difficulty in deciding which of the policy tools discussed under “Tools” below should be used. For example, when a government wants to reduce unemployment each tool has “side effects.” In other words, in addition to effects the government wants, there are other things, such as a rise in the inflation rate, that it does not want, and some things it may, or may not, consider desirable. The latter could involve changes in the relative amounts of government, consumer, and investment goods produced, changes in the “burden of taxation” and more. Since different tools have different side effects, consideration of those effects should influence the choice of tools. Governments also need to consider how much of a given tool to use. If the government wants to cut unemployment, and wants to do so by increasing government spending, it needs to determine how much of an increase in government spending will be needed in order to get the desired change in unemployment. This aspect of the government’s problem is made more difficult by the fact that whatever it does will cause gradual changes in all aspects of the economy, and will take quite a while to have its full, final effect. Consequently, it can’t just do a little, see what happens, and then maybe do a little more. If it does try that, the problem will probably become the concern of a new set of leaders -- people will not wait for many years to have a serious problem addressed. Part of the problem faced by governments is that their policies can cause inflation. Inflation is the rate at which prices are rising (e.g., the percentage change in the GDP deflator). On the other hand, their policies can cause extra unemployment. Unemployment is measured as the percentage of the nation’s labor force that wants to work but currently is not working. Both inflation and unemployment cause costs for society, but policies that reduce inflation may cause more unemployment, and vice versa. The Model This module is built around the basic Keynesian model. In this model everything depends on decisions that affect aggregate spending plans to buy goods and services. Every economic variable discussed in the module is given in “real” terms so that, for example, GDP is real GDP. Decisions to buy are made for different reasons by four different groups: households (Consumption Expenditure or C), business (Investment Expenditure or I), foreigners (Net Exports or NX), and the government (Government Expenditure or G). For simplicity, in this module Net Exports are assumed to always be zero, that is, the nation sells exactly as much to foreigners as it buys from them. Thus, there are three sources of spending contained in the Aggregate Expenditure (AE) for the nation. Aggregate Expenditure can be expressed as: AE = C + I + G + NX But since NX is assumed to be zero: AE = C + I + G In this model, spending plans will determine what happens to production, or GDP, because producers will not produce more than what is going to be bought (not for long anyway), nor will they produce less than can be sold. (Assume there are enough resources to produce whatever amount is wanted, and that the profitability of producing – the prices of products compared to the prices of resources—is not an issue.) As a result, the aggregate expenditure decision will turn out to also be the same as GDP. When that occurs the macroeconomy is in equilibrium and GDP = C + I + G If you want to know what GDP will turn out to be, you need to know what determines the spending plans of each group. In this module government spending is either the default (built-in) value or whatever you want it to be. The parts that need explaining are the consumption and investment decisions. Consumption For purposes of this module assume household decisions on how much to spend depend on two things—after tax income, and interest rates. After tax income is all the income received from production (GDP) minus the amount the government takes for taxes. The more income people have left after paying taxes, the more they will spend on goods and services. In fact, the model assumes a fixed amount of extra spending will be done for every extra dollar in after-tax, or disposable, income. The proportion between extra spending and extra disposable income is the “marginal propensity to consume.” 2 The second influence on consumer spending is interest rates. Higher interest rates make it more expensive for households to buy consumer durable goods, like cars or refrigerators, that are often bought on credit. Higher rates also make it more desirable for households to save (they get paid higher interest on the extra saving they do). As a result, the higher interest rates go, the less consumer spending there should be. Investment In the real world business decisions on how much to spend on investment depends on many things. In this module, it depends on only one thing -- interest rates. The higher interest rates go, the higher the cost of buying machines, buildings, piling up inventory, and the lower the profit expected from doing such things. As a result, higher interest rates should mean lower investment spending. Combining these three relationships would allow you to solve the model (see the Math section) to determine, for any values of the tools, what GDP and all the other results will turn out to be. Besides the level of GDP, there are the inflation and unemployment rates to consider. The unemployment rate has a negative relationship with GDP, the lower GDP is, the higher the unemployment rate. While the exact relationship differs from that found in the US economy, the basic behavior is as described in “Okun’s law.” The inflation and unemployment rates are negatively, or inversely, related to each other, as in the standard short run Phillip’s Curve. However, due to bias in the measurement of inflation (described in more detail in the Math section) full employment in this module would be at an inflation rate of 1.5%. Finally, the delay between the time the government begins a new policy and the time when the policy has its full impact is built into this module. In the model used: 1) The new policy is implemented and the policy shifts Aggregate Expenditure. 2) Aggregate output (GDP) increases or decreases in response to the initial increase or decrease in AE, and the amount demanded changes in accordance with the change in GDP. As a result, demand for goods and service still fails to match actual production, so: 3) GDP continues to rise (or fall) with similar effects on AE as in (2). The process continues until final equilibrium is reached, and output equals planned spending. Running the Module When you start up the module you have to decide the initial state of the economy. One situation is an economy with inflation; the other is an economy with excessive 3 unemployment. Once you have decided which problem you want to investigate, click on “Continue” in the toolbar, and you will be given the necessary information about the macroeconomy, including the default values the three policy tools that determine GDP and its components, as well as unemployment and inflation. In the next step, you have to decide what policy tool you want to use. To make it easier for you to learn the power of each policy tool, you only get to change one tool at a time. You get to control government spending, the amount of taxes collected, or the prevailing rate of interest. All your policy controls are “real,” meaning that inflation (rising price level) and deflation (falling price level) do not affect their usefulness. Before starting to make changes you should know what they are, how they work, and how to evaluate the effects of changes you make. Once you make your decision – which policy tool you want to use -- you need to enter a value for that tool. Then you be given the long run equilibrium results of your policy decision in numerical terms. You can elect to see how the economy moved toward that new equilibrium over the following four years by clicking “annually.” (It won’t reach equilibrium in four years, but it will get closer.) (If you leave the default value in place you will just get the initial conditions information when you click on “Continue.”) In addition to the numerical results you can see the adjustment process and final results in graphical (Keynesian Cross) form. You can also see the final results in the Aggregate Supply-Aggregate Demand diagram. (These graphs are explained later in this manual.) The Tools There are three major ways governments try to manage inflation and unemployment problems. Government spending and taxes are referred to “fiscal policy” tools, and in the US the President and Congress control them. The third macroeconomic stabilization tool is monetary policy -- controlling either the money supply or interest rates. In the US the Federal Reserve controls monetary policy. Government Spending When you change government spending, with tax collections and interest rates constant, you should first look for how the change has affected the value of real GDP. Consider the proportion of the change in real GDP divided by the change in government spending. This proportion tells you the value of the government spending multiplier, and measures the power of government spending as a macroeconomic stabilization tool. That is, if it takes a big change in government spending to cause a small change in real GDP then government spending is a weak tool -- maybe not even worth using. The “spending multiplier” measures the effect of government spending on real GDP when interest rates and taxes are kept constant: the spending multiplier is the ratio of the change in real GDP divided by the change in government spending that caused that real GDP change, or: 4 Spending Multiplier = real GDP / Government Spending The same multiplier is relevant if there is a shift in investment or consumer spending, but neither can happen in this module. The user can only change government spending and observe the spending multiplier results of such spending. In the real world, an increase in government spending, holding tax collections constant, would cause interest rates to go up unless measures were taken by the Federal Reserve to prevent that from happening. Such measures would involve increasing the supply of money in the country. The results in this module therefore differ from the real world results of only changing government spending. (Also, if real GDP started to go up (in reality) because of a rise in government spending, tax collections would also start to go up – unless tax rates were reduced. Higher real GDP means higher incomes, so more income taxes are be collected, more sales, more sales taxes are collected, etc. This also exaggerates the effects of changes in government spending compared to the real world.) Taxes In the module, when you cut taxes people have more disposable income to spend, so consumption spending rises. You should compare the effects of a given size tax cut (or increase) on real GDP with the effects of an equal sized change in government spending. There will be a difference and you should figure out why. You should also compare the effects of the two tools on the composition of real GDP. That means comparing what proportions of real GDP are consumer goods, investment goods, and government goods. There will be differences in the effects of these two tools on these proportions. (In the real world investment depends on the level of GDP as well as on interest rates and business taxes. In this program investment depends only on interest rates. That makes the comparison easier, but oversimplifies real world problems. Remember that the term “investment” in this module means business firms buying equipment, buildings, and inventory. It does not mean buying stocks, bonds or any other pieces of financial paper.) Definition: The “tax multiplier” is the change in real GDP divided by the change in taxes that caused that real GDP change (holding interest rates and government spending constant): Tax Multiplier = Real GDP / Taxes In the real world governments cannot just change tax collections, they change tax rates and that changes the amount of tax collections. Changing tax rates alters how much someone owes in income taxes, sales taxes, corporate profits taxes, etc. Governments have the difficult job of figuring out how much of a change in tax collections there will be if they change tax rates in a certain way. Your job has been simplified by giving you 5 power the real government lacks -- direct control over the amount of tax revenue collected. Also, as with government spending, a change in taxes will cause a change in interest rates unless steps are taken to prevent this from happening. This means the results you get exaggerate the power of tax changes to control real GDP. Interest Rates (Monetary Policy) In this module the monetary policy tool is the level of interest rates. Interest rates affect business investment decisions and consumer decisions as to how much to save versus how much to spend on consumer goods, so changing interest rates affects private demand for goods and services, aggregate demand, and GDP. You should see how much of a change in interest rates are needed to cause changes in GDP similar to those you got changing the previous tools. You should also see what changing interest rates do to the proportion of GDP going to investment, consumption, and government. Compare these results with those obtained by changing the other tools. In the real world, real interest rates influence investment and savings. The interest rates the Federal Reserve controls are “nominal” interest rates. (Almost all interest rates you’ve seen quoted are nominal rates.) The real interest rate is approximately the nominal rate minus the inflation rate people expect. The approximation is OK as long as expected inflation isn’t too large. (When analyzing countries with inflation rates even close to 100% per year this approximation should not be used.) Real Rate = Nominal Rate – Expected Inflation Rate If people (for any reason) start expecting more inflation, having the same nominal interest rate would mean real interest rates went down, and investment and consumer decisions would change. In this module you control real interest rates directly, so you do not have the problem the actual government has—that changes in expectations make it hard to know what the actual current value of your “tool” is. This makes using interest rates to control the economy easier in this module than in reality. In effect, this module can be considered to hold the expected inflation rate constant -- so any change in the nominal interest rate is equal to the change in the real interest rate. Your Results When you enter a value for whatever tool you have chosen, you get results -- the GDP, consumption, investment, inflation, and unemployment values -- that your policy choice will eventually produce. When you try to determine things like the value of the spending multiplier, or the tax multiplier, these are the numbers you should be using. However, you should notice that there is also a menu item labeled “Annual.” The reason it is there is that policy changes do not work all at once, they take time to affect the economy. In other words there are lags, delays from the time a policy is changed to when it has its full impact on the economy. 6 Lags in Policy Effect When government spending is changed, for example, government demand for goods and services increases. However, it takes some time for that increase in demand to affect GDP. It takes time because after the basic decision is made the government has to decide just what to buy and from whom. Until contracts are negotiated and signed, and firms and individuals start doing things, real GDP doesn’t change. Once the government starts getting products and services, GDP has risen, and so have the incomes of those supplying the goods and services. When their incomes increase people start spending more, but it takes them some time to decide what to buy with their new income. When they start to spend more, firms notice the increase in demand and start to increase production. At this point GDP has increased again. With the increase in GDP people’s incomes have gone up again, and they plan on further spending, leading to more increases in GDP. Keynesian Cross Graph One way of illustrating the process is shown in the Keynesian Cross graph below, and displayed in the module. Figure 1 Keynesian Cross 45º line AE AE´ c b AE a 0 Real GDP Old GDPE New GDPE In Figure 1, the 45 line from the origin shows all the points where planned spending equals planned output, or real GDP, the points where all income is spent. If planned spending does not equal planned output (income), either people want to buy more than is produced -- excess planned spending, or they want to buy less than is produced -- excess planned output. Either way, when the two are not equal, real GDP will change. Only if the two are equal, which happens on the 45 line, is there an equilibrium for real GDP. 7 In Figure 1, the old planned spending line, or AE, shows the amount consumers, businesses, and government planned to spend at various levels of GDP with the default values of government spending, taxes, and interest rates. Since consumer spending rises when income rises, the line is upward sloping, the point where it crosses the 45 line is the old macro equilibrium, or Old GDPE . A change in plans will shift this line and eventually bring the economy to a new equilibrium, New GDPE. For example, if government spending increases, the line shifts up to the new planned spending line, AE´. The initial rise in planned government spending is the vertical shift in the line, and is shown by the arrow labeled a. The first actual increase in real GDP, shown by arrow b, is the same amount as the initial rise in planned spending (as the business produces the goods and services the government wants). Then there is the next increase in planned spending -- since it is due to the rise in income it is not a shift in the line, but a movement along the line -- it is indicated by arrow c. The arrows can be connected to a numerical sequence. Suppose the initial increase in government spending was 100, and out of every $1 of extra income people spent $.50 (not true in this module). If only households increase spending when income rises, the marginal propensity to consume (MPC) is 50%, or 0.50. The increases in GDP correspond to the prior increases in planned spending, and the sequence can be seen in the table below. The top row of the table marks out time periods -- which could be months, quarters, or years. Only the first four are shown. In principle, there are an infinite number of these terms, but most of the effects are seen in the first few terms (or years in the module). Time Period Change in Planned Spending Change in Real GDP 1 $100 $ 0 2 $ 50 $100 3 $25 $50 4 $12.5 $25 By the end of Period 4, the total effect of the government spending change on GDP is: 0 + $100 + $50 + $25 = $175. Since effects continue in later periods it is convenient to be able to determine the eventual total impact. There is a formula used for calculating the full effect. If MP is the “marginal propensity to spend”, or the extra spending from a one-dollar change in real GDP, the size of the spending multiplier is: Spending Multiplier = Real GDP / Government Spending = 1/(1 – MP) If only consumer spending is affected by income changes, MP is the marginal propensity to consume (MPC), and the spending multiplier is 1/(1-MPC). If the MPC is 0.5, as it is in the example in the table, the spending multiplier is 1/(1-.5) = 2. In Figure 1, if the AE line was shifted by an increase in government spending, the spending multiplier can be seen as the ratio between the horizontal move from Old GDP to New GDP (length of arrow b) and the vertical rise in AE (the length of the arrow a). The total impact on GDP in the long run would be a change in GDP of $200. 8 The analysis of the effect of a tax change is similar. However, if taxes are cut by $100 and the MPC is 0.5, initially planned spending would rise by only $50 (the other $50 would go into saving). Since the initial effect on spending is smaller, the final effects on GDP are also smaller. The formula for calculating the tax multiplier (when only consumers react to income changes) is: Tax Multiplier = Real GDP / Taxes = (1/(1 – MPC)) – 1 = MPC/(1 – MPC) If the MPC is 0.5, then the tax multiplier is 1. Aggregate Supply and Demand Another way of presenting the results of changes in the policy tools is the AS-AD model. In it, AD has an inverse relationship between changes in real GDP and changes in the aggregate price level (P), or GDP deflator. The reason for the downward slope is that, with a given nominal money supply, the higher the price level the lower the purchasing power will be for the fixed number of dollars in the economy. The reduction in the real value of the money supply at higher prices causes (among other things) higher interest rates, which cause business and consumer spending to fall—so less quantity is demanded. The model has an upward sloping AS curve because higher prices for final goods and services (with no change in resource prices) imply production is more profitable. The AD-AS model does not exactly fit the way this module works. In the module when you change government spending the real interest rate stays constant, but the nominal money supply does not. In fact, if government spending rises, in order to keep real interest rates from rising, the nominal and real measures of the money supply must increase. As a result the apparent shift in AD with a change in government spending is the result of both the change in government spending and the change in the money supply. The same caution applies to the effects of tax changes; a tax cut (real interest rate constant) implies that the money supply increases. If you change the real interest rate tool you are changing the money supply, the AD-AS model is a better fit for this case. In addition, this module does not address the long run adjustment mechanism of the ADAS model, in which rising final good prices cause rising resource prices, shifting the AS curve. Many presentations of the AD-AS model also assume that policy tools are set in nominal terms, i.e., the government decides on a budget with a certain number of dollars to be spent, and if prices go up the government gets fewer goods than it expected. In this module you control real government spending, so changing the price level has no such effect. The same is true for the tax tool you control. The AD-AS Graph Figure 2 shows how a rise in government spending, a tax cut, or cut in real interest rates affect AD, the equilibrium price level, and GDP. P0 is the original price level, P1, the new price level (after the policy change), GDP0 is the original GDP value, and GDP1 is 9 the new value. The vertical line indicates the full employment level of GDP, GDP FE. The arrow shows the direction of shift in the AD curve. In Figure 2, both the old (AD) and new (AD´) curves do not intersect AS at the full employment level of GDP and thus do not reach full employment equilibrium. Figure 2 Aggregate Supply and Demand Price Level AS P1 P0 AD´ AD Real GDP 0 GDP0 GDP1 GDPFE Mathematical Model The results of this module come from the following set of equations: 1) GDP = C + I + G 2) C = a0 + a1 (GDP – T) + a2 (Interest rates) a0 is the amount of consumption that would be done if interest rates and disposable income were zero, The value of a0 is 201.818. T is the amount the government takes in taxes, a1 is the marginal propensity to consume, set at 0.9, and a2 is the sensitivity of consumption to interest rates, set at –1725 (negative). 3) I = b0 + b1 (Interest Rates) b0 is the amount of investment spending done if interest rates fell to zero, set at 285, while b1 represents the effect of a unit change in interest rates on the level of investment spending, it is set at –1775 (negative). 10 So: 4) GDP = a0 + a1 (GDP – T) + a2 (Interest Rates) + b0 + b1 (Interest Rates) + G To see how GDP is determined, solve (4) for GDP: 5) GDP = [(a0+b0) / (1–a1)] + [(a2+b1)/(1–a1)](Interest Rates) + [(G–a2 T)/(1–a1)] If you know the values of all the a’s and b’s, of interest rates, government spending, and taxes, you can calculate the value of GDP. Once you know GDP you can calculate the value of consumption (knowing interest rates is also necessary, but you needed that to get this far). You could also calculate the amount of investment, knowing the values of b0, b1, and interest rates. To determine the unemployment rate you also need to know what this module uses for “Okun’s Law,” the relationship between changes in GDP and changes in the unemployment rate. In this module the unemployment rate and GDP are related through this equation: 6) Unemployment = 0.5 - (0.0001 * GDP) To get unemployment to drop by one percent (0.01) it would be necessary to get GDP to rise by 100. In models of this type the inflation rate is usually discussed in terms of a “Phillips curve,” a negative short run relationship between the inflation rate and the unemployment rate. In this module the inflation rate is actually determined directly by the level of GDP (that does give it a negative relationship with the unemployment rate). The module uses two functions to determine the inflation rate—one for high value of GDP, the other for low values, because in the real world inflation usually reacts less to changes in GDP at low levels than at high ones. Where $4500 billion is the full employment level of GDP: 7a) 7b) If GDP > 4500 Then inflation = 0.015 + 185 * (((GDP - 4500) / 4500) ^ 1.8) If GDP <= 4500 Then inflation = 0.015 -0.5 * (((4500 - GDP) / 4500) ^ 3.3) In both 7a and 7b the 0.015 (1.5%) incorporated in the relationship represents the built in bias in the price index that is used to measure the inflation rate. This bias (including quality changes, substitution bias, outlet bias) means the measured inflation rate overstates the true inflation rate. At full employment in this module the true inflation rate would be zero, but the measured inflation rate would be 1.5%. The lag effects of policy changes are calculated as follows: For period 1, there is no impact on actual spending (effect of any shift is zero): GDP1=GDP0 + ΔGDP=GDP0 (GDP0 is the original equilibrium) 11 For period 2: ΔGDP = S (where S is the size of the initial shift in AE): GDP2 = GDP1 + ΔGDP = GDP1 + S For period 3: ΔGDP = S*MPC GDP3 = GDP2+ ΔGDP = GDP2+S*MPC = GDP1+S+(S*MPC) For period 4: ΔGDP=S*S*MPC GDP4 = GDP3+ ΔGDP = GDP1+S+(S*MPC)+(S*S*MPC) Once GDP is calculated, substitute into the Consumption equation to get consumer spending, into the Okun’s Law equation for the unemployment rate, and into the Phillip’s curve equation for the unemployment rate. If one of the fiscal policy tools was used there will be no change in interest rates anywhere along the line, including in the final equilibrium. If interest rates were used, the full change in investment spending will show up in period 2, there will be no further change in investment after that. 12