Download Macroeconomics - Econproph on Macro

Unit 9:
Keynesian Theory & Fiscal Policy
“The difficulty lies not so much in developing new ideas as in
escaping from old ones.”
"In the long-run we are all dead."
--- John Maynard Keynes
Created:
2013
by Jim Luke.
This work is licensed under
the Creative Commons
Attribution-NonCommercial
License
Why A New Theory? New Data. Classical
Theory Can’t Explain Great Depression
Why?
Classical Theory Can’t Explain Great Depression
Crash and
Great Depression
 Unprecedented Deflation
+ Unemployment




Larger
Longer
Persistent, not temporary
Worldwide
U.S. Depression Data
1929
1931
1933
1937
1938
1940
Real GNP
101.4
84.3
68.3
103.9
103.7
113.0
Consumer Price Index
122.5
108.7
92.4
102.7
99.4
100.2
Unemployment (% )
3.1
16.1
25.2
13.8
16.5
13.9
Context: Keynesian Theory
Global Economy Stumbles





Versailles Treaty & Inflations
Failed Gold Standard
Tariff Wars
Declining Trade
Financial bubbles
Great Depression
Rise of Fascism & Communism

Fears capitalism won’t survive
Slide 5
Keynesian Questions
•
Is market capitalism inherently unstable?
•
Can depressions continue forever?
•
Any alternative to state socialism?
•
Can “democratic” governments restore fullemployment in a modern industrial economies?
Slide 6
Assumptions Compared
Created:
Jan 2008
by Jim Luke.
This work is licensed under
the Creative Commons
Attribution-NonCommercial
License
Classical
Keynes
• Competitive markets
• Flexible prices
• Current income/prices
drive C & I
• S= I
• Monopolistic markets
• Sticky prices
• Expectations
drive C & I
• I =/= S.
Conclusion:
Conclusion:
• SRAS/LRAS matter
• AD matters
Keynesian Insights
Wages & Prices are 'sticky'
 “Efficiency” wages
 Monopolistic firms reduce output not prices
Expectations  Plans  Spending
 but can be wrong
 Say’s Law won’t hold
Expectations are irrational
 Assume current trends continue
 Excessively optimistic or pessimistic
AD Shifts  creates recession or inflation
Slide 8
Keynesian Insight:
Wages & Prices are “sticky”
 “Efficiency” wages
 Monopolistic firms reduce output not
prices
Slide 9
Keynesian Insight:
Expectations  Plans  Spending
 AD shifts
 Firms produce to expected demand
 Say’s Law won’t hold
Slide 10
Keynesian Insight:
Expectations are irrational
 Assume current trends continue
 Excessively optimistic or pessimistic
 “Animal Spirits”
Slide 11
Keynesian Insight:
AD Shifts  creates recession or
inflation
Equilibrium (stability) is possible at
less than full employment.
Slide 12
Let’s take another look at spending
and Aggregate Demand: C, I, and G
C: Consumer Spending
C based on expectations for future:





Job security
Price levels
Interest rates
Life expectancy
Wealth, not just income
I: Investment
“Forward looking” decisions
Two major determinants


Market interest rate
Business expectations
• NOTE: Not the current level of income!
Business Expectations
Factors:
 Wars
 Future resource costs
 Technological change
 Changes in tax structure
 Other destabilizing events
 Recent growth rates
 “Animal spirits”
G: Government Purchases
Budget controlled of public officials
 G “autonomous”
 No reason gov’t cannot borrow short-run
 G could be independent of T
The Keynesian Theory
Using AD-AS Model
The Classical Theory says the economy corrects itself in the long-run.
But after seven years of continuing depression, in 1936 John Maynard
Keynes counters with the observation that “in the long-run we are all
dead”.
Circular Flow: Keynesian View
Expectations & plans,
not Interest rates drive S.
(“save for a rainy day”).
Govt may run
deficits or
surpluses.
G not equal to T
Closed
economy:
Ignore
ROW.
Spending on I
depends on
expectations,
not interest
rate
Financial
markets may
not reach
equilibrium.
S>I
Recessionary Gap: High
unemployment
LRAS
P
Price Level
(price index)
SR-AS
Price
Index
Gap
represents
amount of
unemploymen
t
start
@start
Prices & wages are “sticky” –
SRAS stays where it is.
Firms lay-off workers
instead of cutting wages.
AD
Real
GDP
Real
GDP
@start
if we had
full
employm
ent
Recessionary Gap shifts AD
LRAS
P
Price Level
(price index)
SR-AS
Price Index
start
@start
Price Index
after
ADat start
after
ADafter layoffs & loss of confidence
Real
GDP
Workers & firms cut
spending plans
RESULT: AD shifts to
the left, making the
recessionary gap
worse.
Real
GDP
declines @start
even
further
Real
GDP
if we had full
employment
Real GDP declines
further instead of
recovering. The
economy moves AWAY
from full employment.
Conclusions from Keynesian
Model - Recession
Modern industrial economy:
 Can get “stuck” in long recession with very high
unemployment
 May NOT automatically correct itself.
Conclusion:
 Optimism, expectations, plans are critical
THE Rx: Counter-cyclical Fiscal policy “manage” AD
Keynesian Rx:
Fiscal Policy to Manage AD
Improve Confidence & Expectations




Disaster safety nets
Unemployment insurance
Social Security
Banking deposit insurance
 Securities regulation
Manage business cycle
 Counter-cyclical fiscal policy
 Change G to offset changes in C and I
 Borrow in recession, surplus in boom
Slide 23
Recessionary Gap: Keynesian Rx
LRAS
P
Price Level
(price index)
SR-AS
after
Price Index
unchanged
ADafter govt fiscal stimulus
start
ADat start
Real
GDP
@start
Fiscal Policy:
Increase G and/or
Decrease T to offset
Declines in C and I.
Real
GDP
if we had full
employment
Government Increases
G or decreases T, with
result AD shifts right.
Inflationary Gap: Keynesian Rx
P
Price Level
(price index)
Government
decreases G
or increases T,
with result AD
shifts left
LRAS
SR-AS
start
after
ADat start
ADafter govt fiscal policy
Real
GDP
Fiscal Policy:
Cut G and/or raise T  reduce AD
if we had full
employment
Real
GDP
@start
Fiscal Policy
Government purchases, transfer payments, taxes,
and borrowing as they affect macroeconomic
variables
Created:
Jan 2008
by Jim Luke.
This work is licensed under
the Creative Commons
Attribution-NonCommercial
License
Automatic Stabilizers
Spending and taxes automatically
change in response to economic
change:
Unemployment compensation
Welfare assistance
Income tax collections
Created:
Jan 2008
by Jim Luke.
This work is licensed under
the Creative Commons
Attribution-NonCommercial
License
Discretionary Fiscal Policy
Congress & President must decide to spend
more/tax less and pass a new law or budget to
do it.
often called “stimulus” program
Created:
Jan 2008
by Jim Luke.
This work is licensed under
the Creative Commons
Attribution-NonCommercial
License
Fiscal Policy - How
Federal Budget, Expenditures & Tax Revenues
• G+Gtransfer > T  budget deficit
• G+Gtransfer < T  budget surplus
• G+Gtransfer = T  balanced budget
Stimulus effect:
• Raise G, lower T
• Increase deficit (or reduce the surplus)
Contractionary effect:
• lower G, raise T
• Increase surplus (or reduce deficit)
Slide 29
Which Is Better: T or G?
Spending Multiplier:




MPC: marginal propensity to consume
= 1/(1–MPC)
If MPC is 0.8  1 / 0.2  5
initial increase G of $100 billion
will eventually boost real GDP
by 5 times, or $500 billion
In theory, multiplier of G is greater than multiplier of T



Increased G is directly spent –all affects GDP
Part of a Tax cut is saved and doesn’t affect GDP
BUT, timing is important too
Keynesian Theory: Summary
Industrial Economy inherently unstable
 Equilibrium possible with unemployment
 Extended depressions possible
AD matters
‘Equilibrium’: when actual = planned
Confidence & Expectations important
 Self-fulfilling
Fiscal Policy can work
Slide 31