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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