Download Working With Our Basic Aggregate Demand / Supply Model

Unit 6:
Fiscal Policy
The Great
Depression
KEYNES
Criticisms of
Classical Theory:
• C and I move together
• KCM = 1/MPS
• Liquidity Trap
KEYNES
KEY
QUESTIONS:
• WHERE ARE WE?
• WHERE WERE WE?
• WHERE SHOULD WE BE?
NATIONAL INCOME ACCOUNTING
Total production and wealth of a nation in a
given period in monetary terms.
• Recorded
– NOT black market, under table
• Productive
– NOT transfers
• This country
– NOT imports
• This year
– NOT used items or subtractions from inventory
• Final value
– NOT value-added
Measuring GDP
• The four categories of expenditures that
provide a measure of the market value of total
output in a particular year include:
– Personal consumption expenditure (C)
– Gross Private Domestic Investment (Ig)
– Government Purchases (G)
– Net Exports (Xn)
Adding It Up: GDP = C + Ig + G + Xn
Measuring GDP
• The four categories of income that provide a
measure of the market value of total output in
a particular year include:
– Wages (W)
– Rent (R)
– Interest (r)
– Profit (Pf)
Adding It Up: NY = W + R + r + Pf
Measuring GDP
Adding It Up
NY (W + R + r + Pf) + KCA + IBT = C + Ig + G + XN
income = expenditures
Y=C
Measurement of
Unemployment
The total U.S. population is divided into three
groups.
1) People “not counted”: under 16 years of age,
over 65, institutionalized, house spouses
2) Adults in the labor force; those who SHOULD BE
working
A. Employed, working over 32 hours a week
B. unemployed and seeking work
Measurement of
Unemployment
The unemployment rate is the percentage of
the labor force unemployed.
Unemployment rate =
unemployed x100
labor force
Types of Unemployment
• Frictional Unemployment
– ACCEPTABLE UNEMPLOYMENT: those searching for jobs or
waiting to take jobs in the near future.
• Cyclical Unemployment
– is unemployment associated with the business cycle; Actual
Unemployment – Frictional Unemployment = Cyclical
Unemployment.
• Structural Unemployment
– is unemployment that is associated with technological
change; obsolete workers. Not Counted for Employment
purposes.
Types of Unemployment
Actual Unemployment
– Frictional Unemployment
Cyclical Unemployment
Definition of Full Employment
• Full employment occurs when the economy
experiences only frictional; there is no cyclical
unemployment.
• The level of real GDP that would occur if there
was full employment is called potential
output.
Economic Cost
of Unemployment
• If actual GDP is above or below potential GDP,
the result is a GDP gap.
GDP gap = actual GDP – potential GDP
– When actual GDP is less than potential GDP, there
is a negative GDP gap accompanied with a higher
unemployment rate and foregone income.
– When actual GDP is greater than potential GDP,
there is a positive GDP gap accompanied with a
high inflation rate and overfull employment.
OKUN’S LAW
GDP gap = actual GDP – potential GDP
GDP gap = Cyclical Unemployment x 2.5
Inflation
• It is difficult to compare values over time without
correcting them for inflation or deflation.
• Nominal GDP, or unadjusted GDP, is gross domestic
product in terms of the price level at the time of
measurement.
• Real GDP, or adjusted GDP, is gross domestic
product measured in terms of the price level in a
base period (or reference year).
– It is a GDP that has been deflated or inflated to reflect
changes in the price level.
Inflation
• Inflation is a rise in the general level of prices
in an economy.
– When there is inflation, each dollar of income
buys fewer goods and services; the purchasing
power of money declines.
Measurement of Inflation
• Inflation is a rise in the general level of prices in an
economy.
– When there is inflation, each dollar of income buys fewer
goods and services; the purchasing power of money
declines.
• The main measure of inflation in the U.S. is the
Consumer Price Index, or CPI.
– The CPI is an index that compares the price of a market
basket of goods and services in one period with the price
of the same (or highly similar) market basket in a base
period, currently 1982-1984.
– The CPI includes some 300 products that are presumably
purchased by the typical consumer.
Types of Inflation
• Demand-pull inflation is increases in the price
level caused by excessive spending beyond the
economy’s capacity to produce.
– Excess demand from expanding output bids up the
prices of the limited output.
• Cost-push inflation is increases in the price level
caused by sharp rises in the cost of key
resources.
– Supply shocks are the main source of cost-push
inflation.
Measurement of Inflation
• CPI for any particular year equals:
price of the market basket of the particular year
price of the same market basket in the base year
The Multiplier
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The Multiplier

The Multiplier:
-- The view that a change in autonomous
expenditures (e.g. investment) leads to an
even larger change in aggregate income.


An increase in spending by one party
increases the income of others. Thus, an
increase in spending can expand output by
a much larger amount.
The multiplier is the number by which the
initial change in spending is multiplied to
obtain the total amplified increase in income.

The size of the multiplier increases with the
marginal propensity to consume (MPC).
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The Multiplier Principle
Additional
Income
Additional
Consumption
(Dollars)
(Dollars)
Marginal
Propensity
To Consume
Round 1
Round 2
Round 3
Round 4
Round 5
Round 6
Round 7
Round 8
Round 9
Round 10
All Others
1,000,000
750,000
562,500
421,875
316,406
237,305
177,979
133,484
100,113
75,085
225,253
750,000
562,500
421,875
316,406
237,305
177,979
133,484
100,113
75,085
56,314
168,939
3/4
3/4
3/4
3/4
3/4
3/4
3/4
3/4
3/4
3/4
3/4
Total
4,000,000
3,000,000
3/4
Expenditure
Stage
For simplicity (here) it is assumed that all additions to income are either spent domestically or saved.


The multiplier concept is fundamentally based upon the proportion of
additional income that households choose to spend on consumption:
the marginal propensity to consume (here assumed to be 75%  3/4).
Here, a $1,000,000 injection is spent, received as payment, saved and
spent, received as payment, saved and spent … etc. … until . . .
effectively, $4 million is spent in the economy.
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A Higher MPC
Means a Larger Multiplier
SIZE OF
MPC
9/10
4/5
3/4
2/3
1/2
1/3


MULTIPLIER
10.0
5.0
4.0
3.0
2.0
1.5
As the MPC increases more and more money of every injection is spent
(and so received as payment and then spent again, received as payment
and spent again, etc.).
The effect is that for higher MPCs, higher multipliers result, specifically
the relationship follows this equation:
1
M = 1 - MPC
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The Keynesian View
of Fiscal Policy
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The Keynesian View
of Fiscal Policy

When an economy is operating below its
potential output, the Keynesian model
suggests that the government should institute
expansionary fiscal policy -- it should either:
 increase the government’s purchases
of goods & services, and/or,
 cut taxes.
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Expansionary Fiscal Policy
to Promote Full-Employment
Price
level
LRAS
P2
P1
P3
SRAS1
SRAS3
E2
Expansionary fiscal policy
stimulates demand and
directs the economy to
full-employment
e1
E3
Keynesians believe that allowing
for the market to self-adjust may
be a lengthy and painful process.
AD1
Y1 YF

AD2
Goods & Services
(real GDP)
We begin in the short run at Y1, below the economy’s potential capacity (YF).
There are 2 routes to long-run full-employment equilibrium.

Classic theory would wait for both lower wages and resource prices to
reduce costs, increase supply to SRAS3 and restore equilibrium at YF.

Keynesians would use expansionary fiscal policy to stimulate aggregate
demand (shift AD1 to AD2) and guide the economy back to E2, at YF.
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The Keynesian View
of Fiscal Policy


When inflation is a potential problem, the
Keynesian analysis suggests a shift toward
a more restrictive fiscal policy:
 reduce government spending, and/or,
 raise taxes.
Keynesians challenged the view that the
government’s should always be balance its
budget.

Rather than balancing the budget annually,
Keynesians argued that counter-cyclical
policy should be used to offset fluctuations
in aggregate demand.
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Restrictive Fiscal Policy
to Combat Inflation
Price
level
SRAS3
LRAS
P3
E3
P1
P2
SRAS1
Restrictive fiscal policy
restrains demand and
helps control inflation.
e1
E2
AD2
YF Y1

AD1
Goods & Services
(real GDP)
Strong demand such as AD1 will temporarily lead to an output rate beyond
the economy’s long-run potential (YF).

Classic theory says the high level of demand will lead to the long-run
equilibrium E3 at a higher price level (as SRAS shifts back to SRAS3).

Keynesian restrictive fiscal policy would restrain demand from expanding
to AD2 in the first place and guide the economy to a non-inflationary
equilibrium (E2).
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Fiscal Policy:
• Automatic Stabilizers:
-- without any new legislative action, they
tend to increase the budget deficit (or
reduce the surplus) during a recession and
increase the surplus (or reduce the deficit)
during an economic boom.

Examples of Automatic Stabilizers:


Transfer Payments
 Unemployment Compensation
 Welfare
A Progressive Income Tax
Budget Deficits and Surpluses

Budget deficit:
-- Present when total government spending exceeds
total revenue from all sources.
 When the money supply is constant, deficits must
be covered with borrowing.
 The U.S. Treasury borrows funds by issuing bonds.

Budget surplus:
-- Present when total government spending exceeds
total revenue from all sources.
 Surpluses reduce the size of the government’s
outstanding debt.
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Budget Deficits and Surpluses


Changes in the size of the federal deficit or
surplus are often used to gauge whether fiscal
policy is adding additional demand stimulus or
imposing additional demand restraint.
Changes in the size of the budget deficit or
surplus may arise from either:


A change in the state of the economy, or,
A change in discretionary fiscal policy
-- that is, through either government spending
and/or changes in taxation.
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End
Unit 5