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Keynesian Economics and Fiscal Policy Franklin Roosevelt’s Mandate: DO SOMETHING! But what? Classical Economics wasn’t working Two ways to get out of a depression Cut taxes More laissez-faire policies John Maynard Keynes 1883 – 1946 Radical idea for government to spend money they don’t have may have saved capitalism. John Maynard Keynes “The difficulty lies, not in the new ideas, but in escaping the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.” John Maynard Keynes “The avoidance of taxes is the only intellectual pursuit that still carries any reward.” “When the facts change, I change my mind. What do you do, sir?” Keynesian Economics Fiscal Policy where it is more important to get the people of the country working. Government goes into debt to employ people or give them benefits until they can find a job. Keynesian Economics IMPORTANT POINT!!! Okay to go into debt when times are bad. People are employed, they begin to consume and invest again. Then government can collect taxes. WHEN TIMES ARE “GOOD” UP THE TAXES TO GET READY FOR THE NEXT “BAD” TIME. US Government has not remembered that final rule of Keynesian Economics. When times were good in the 1990s – taxes were cut. Okay, now for the book stuff on Keynes! Important Point about Keynes! Keynsian economics is SHORT-RUN only. “In the long run we’re all dead.” John Maynard Keynes Keynes Idea! The level of GDP is determined primarily by prices. – Demand – driven economy. – Create demand to improve an economy. The New Deal work projects! Keynesian Cross 45-degree diagonal represents the relationship between demand and output. ASSUME that it is a closed economy and Classical government. C + I is all that creates demand. Keynesian Cross ALSO assume: Consumer / firms demand for goods is fixed. In the short run output = demand. Equilibrium Output on the Keynesian Cross Shows where output equals demand. If overproducing, stock piles up, prices drop and cutbacks in production. If producing at a lower level of outpur, demand is greater than their current production. Shortages happen. The Consumption Function In reality, we know that consumer spending depends on the level of income in the economy. More income = More spending Consumption Function – C= Ca + by Consumption has two parts Ca = constant and independent of income. Autonomous Consumption Spending Things that HAVE to be purchased, despite income. Food The second part of consumption: by The consumption that is dependent on income. Marginal Propensity to Consume (MPC) = b Y = income MPC tells how much consumption spending increases for every dollar that income increases. by B = .6 Then for every dollar income goes up, consumption increases 60 cents. Y = Both output and income See figure 10.4 on page 204 Consumption function intersects at Ca , the level of autonomous consumption must be greater than zero. Slope is b, the marginal propensity to consume. Output equals income on the x-axis. Income rises dollar for dollar with output. MPC MPC slope is always less than one. Consumers who receive a dollar income will spend part and save the rest. What fraction is saved is determined by MARGINAL PROPENSITY TO SAVE (MPS) MPS The sum of MPS and MPC MUST equal 1. MPC = .8 MPS= .2 So for every additional dollar, consumers spend 80 cents and saves 20 cents. Changes in the Consumption Function Levels of MPC and autonomous consumption can change over time. Why would there be an increase in autonomous consumption? Increases in consumer wealth. Franco Modigliani proved that increases in stock prices, raise consumer wealth and increase autonomous consumption. Changes in consumer confidence Consumer confidence based on household surveys. Current Consumer Confidence Statistics The idea behind consumer confidence is that when the economy warrants more jobs, increased wages, and lower interest rates, it increases our confidence and spending power Current Consumer Confidence Surveys 5,000 households per month and the want ads. Currently: DOWN: 67.1 compared to 89.7 in April. – Figure released May 5 Lowest since October 2005. Changes in the MPC Autonomous Consumption is assumed to be fixed. Increases in MPC causes function line to get steeper. Reasons for Changes in the Consumption Function Slope Consumers believe increases in income are permanent, and consume at a higher proportion. Permanent salary v. one time bonus Changes in the TAX RATE. What we get back in taxes we SPEND. Determining GDP Plot the Consumption Function C as a function of income If we assume that investment is constant at all levels – we can get the C + I line. Determining GDP Equilibrium output is Y It occurs where the 45degree diagonal line crosses C + I. Represents total spending for the economy Total Spending = Output Equilibrium in the economy. EQUATIONS! y* = (Ca + I) / (1 – b) OR Equilibrium output = (autonomous consumption + investment divided by 1 – MPC) Savings and Investment The Savings Function: The relationship between the level of income and the level of savings. S=y–C The Multiplier FACT: Investment spending fluctuates. Recession / Boom Economy Interest rates Etc The Multiplier Increase in output always exceeds the increase in investment. The Multiplier The ratio of changes in output to changes in spending. It measures the DEGREE to which changes in spending are “multiplied” into changes in output The Multiplier Computer firm invests $10-million in building a new plant. Total spending (y) for economy increases by $10-million. Construction workers and firm are paid. The Multiplier Suppose the owners of the construction firm and their employees buy new cars for $8-million. Producers of the cars will expand their production because of the increase indicated by the demand The Multiplier In turn, workers and owners in the car industry will earn an additional $8-million in wages and profits. They will spend part of the income - $6.4 million on digital t.v.s and other goods and services. The Multiplier The rounds continue with diminishing amounts. Add up all the spending in all the rounds we find the initial $10-million in spending leads to $50million increase in GDP and income. Multiplier = 5 The Multiplier Equation 1 / (1-MPC) Suppose MPC = .8 1/(1 -.8) = 1/.2 = 5 The Multiplier It can also work in reverse! Consumers cut back on autnomous consumption by $10-million. GDP falls by $10-million, output and income fall. Ending in $50-million loss. The Multiplier The multiplier increases as the MPC increases Multiplier occurs because initial increase in investment spending increases income which leads to higher consumer spending. Higher MPC increase in consumer spending increases. Keynesian Fiscal Policy The use of taxes and government spending to affect the level of GDP in the short-run. Influences on demand for goods and services Government makes purchases in the economy too! C + I + G = total spending including government. Increases in G purchases shift the C + I + G line upward. Multiplier effect the same for government spending 1 / (1 – MPC) What role do TAXES play? Disposable Personal Income – The income that flows back to households, taking into account transfers and taxes. AFTER subtraction from income of any taxes paid and the addition of any transfer payments. – Social Security, welfare, unemployment, etc. Consumption Function for taxes C = Ca + b (y – T) Income minus Taxes Consumption Function for taxes If taxes increase by $1, after tax income will decrease by $1. Since MPC is b – it means that consumption will fall by b x $1. b = .6 and a $1 increase in taxes means consumers have a dollar less in income and will decrease consumption spending by 60cents. The Tax Multiplier is NEGATIVE Increases in taxes decreases disposable personal income and lead to a reduction of consumption spending. If MPC is .6 Tax multiplier will be -.6 / (1 - .6) = - 1.5 What do you think happens when we increase govt. spending and taxes at the same time??? EQUAL increases in taxes and government spending will INCREASE GDP FIVE situations of recent Keynesian Policy Look at page 212 Example: Post 9-11 Government increased spending for disaster relief to NYC and provided loans and subsidies. Tax relief too. Two Terms for Fiscal Policy Expansionary Policies Government policy actions that lead to increases in output Contractionary Policies Actions that government does that leads to a decrease in output Two Types of Government Spending Discretionary spending, which accounts for roughly one-third of all Federal spending, includes money for things like the Army, FBI, the Coast Guard, and highway projects. Congress explicitly determines how much to spend (or not spend) on these programs on an annual basis. Two Types of Government Spending Mandatory spending accounts for two-thirds of all government spending. This kind of spending is authorized by permanent laws. It includes "entitlements" like Social Security, Medicare, and Food Stamps — programs through which individuals receive benefits based on their age, income, or other criteria. Mandatory Spending Spending levels in these areas are dictated by the number of people who sign up for these benefits, rather than by Congress Types of Government Payments Government Purchases Transfer Payments Government Interest Payments Comparison between the UK and US Budget Pies Comparison between UK and US Fiscal Budgets US Discretionary Budget Pie Government Purchases Sums of money spent for goods and services for government. Xerox machines, paperclips, office furniture, commissary items, guns, tanks, bombers, etc. Transfer Payments Also called Entitlements: Outright grants to people, rather than something given in exchange for goods or services. Interest Payments Sums of money paid for the interest on the national debt. Accumulated from the debt and deficits. When a government increases spending and cuts taxes DEFICIT! More outlays than receipts of money More going out than coming in. DEBT v. DEFICIT Deficit = yearly budget problem Debt = YEARS of deficit Current Debt???? http://www.brillig.com/debt_clock/ OR Google: “debt clock” How do we pay for the debt? US Savings Bonds IOUs for the government. Problems with Keynes He did not think that government deficit would be a “big” thing. IMPORTANT!!!! Read pages 213 – 216 for examples of Keynesian Policies in US History! Automatic Stabilizers Taxes and transfer payments that stabilize GDP without requiring policymakers to take explicit actions. Automatic Stabilizers When income is high, government collects more taxes and pays out less in transfer payments. Does lower GDP and MPC Automatic Stabilizers But in recessions the government collects less taxes and pays out more in transfer payments. Increases consumer spending. Money is in the hands of the consumers. Formula for Automatic Stabilizers T = ty T = Total taxes taken by government. t = tax rate y = income Consumer’s after-tax income will be (y – ty) = y (1 – t) See other formulas on p. 217 Increases in the Tax Rate Decreases the slope of C + I + G. Lowers output and reduces the multiplier. Smaller multiplier means smaller “shocks” to investment and have less impact on the economy. Most stabilizers are “running silent” Depending on the rise or fall of GDP, tax collections go up or down. No government intervention is needed. FINALLY!!!! Exports and Imports in a Keynesian Model Exports and imports influence how the world beyond the US demands goods and services produced in the US. Marginal Propensity to Import Imports = M – my M = imports m = MPI y = income MPI = Marginal Propensity to Import The fraction of additional income that is spent on imports. b – m. b = .8 m = .2 (.8 - .2) = .6 is now the MPC adjusted for imports. MPI Slope of the C + I + G + X is determined by (b – y) Just Suppose … The Japanese decide to by another $5-billion worth of goods from the US. What happens to US domestic output? Demand line shifts vertically upward with the increase in exports. Income increases. Therefore … .6 is the multiplier 1 / (1 - .6) = 2.5 Therefore a $5-billion increase in exports will lead to a $12.5 billion increase in GDP But! US citizens are more attracted to foreign goods, and as a result, our marginal propensity to import increases. The MPC(b-m) will fall as the marginal propensity to import increases. Reduces the slope of the demand line and output will fall back. The Netherlands’ Multiplier The multiplier differs from country to country. US has a bigger multiplier for government spending than the Netherlands. Reason? Smaller country that imports more than the US does.
