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Economic Environment Lecture 2 Joint Honours 2003/4 Professor Stephen Hall The Business School Imperial College London Page 1 © Stephen Hall, Imperial College London Revision from last week Page 2 © Stephen Hall, Imperial College London The circular flow of income, expenditure and output I C S C+I Households Firms Y Page 3 © Stephen Hall, Imperial College London Government in the circular flow I C+I+G C S G Households C + I + G - Te Te Government Firms B - Td Y + B - Td Page 4 Y © Stephen Hall, Imperial College London National income accounting: a summary NYA G GNP (and GNI) at market prices Page 5 I X-Z C NYA Deprec'n Indirect taxes GDP NNP at market at basic National prices prices income Profits, rents Selfemployment Wages and salaries © Stephen Hall, Imperial College London This Lecture • We begin to develop the basic demand side model Page 6 © Stephen Hall, Imperial College London Demand-Side Models The “Keynesian” approach to modelling the economy is to focus solely on domestic demand. This is because John Maynard Keynes’s “General Theory ...” (1936) was developed during the Great Depression, when supply constraints were not a problem. (Indeed, the real problem was to get people back to work!) • Recall the equality C+S+T+M = C+I+G+X • This can be re-written as C+S+T = C+I+G+(X-M) Page 7 © Stephen Hall, Imperial College London Demand-Side Models • The term (X-M) is simply “net exports”. The right-hand side of this equation is domestic demand for goods and services. In equilibrium, this must equal the domestic supply of goods and services (which is the left-hand side). Denoting this supply by “Y”, we have Y = C+I+G+(X-M) Page 8 © Stephen Hall, Imperial College London National Income Determination • For an economy to be in equilibrium, it must be that the supply of goods equals the demand for goods. Stated another way, whatever is produced must be used by someone. From the previous section, this equality was written as Y = C+I+G+(X-M) • (In some books, aggregate demand, the right hand side of this equality, is denoted by the term “AD”) Page 9 © Stephen Hall, Imperial College London National Income Determination Before proceeding, it is useful to review the various components of aggregate demand C = is households’ personal consumption I = is business firms’ real investment G = is the government’s expenditure, and (X-M) = is net exports to the foreign sector (*For now, we will assume that net exports are zero, and will omit them from the analysis) Page 10 © Stephen Hall, Imperial College London The Keynesian assumption • If we assume as did Keynes that supply (or identically income) “Y” is unconstrained, then its equilibrium value will be determined solely by the right-hand side of the equation. That is, income will be wholly demand-determined. • The following models of national income determination will focus solely on demand. Page 11 © Stephen Hall, Imperial College London National Income Determination • In this model, then, AD = C+I+G+(X-M). • As it is assumed (for now) that (X-M) = O, • AD=C+I+G. Therefore, in equilibrium Y = C+I+G • Our objective is to find the equilibrium value of income, “Ye”, that will satisfy our the equilibrium condition; i.e., Ye solves Ye = C+I+G Page 12 © Stephen Hall, Imperial College London How to proceed • To solve this, we must make some assumptions about the functional forms of the right hand variables C, I, G. Indeed, the only differences between the simplest model and other, more complicated models are in • (i) the inclusion of a foreign sector, and • (ii) the assumptions we make about these functional forms. Page 13 © Stephen Hall, Imperial College London Simplest Model 1 In the simplest model we will use, we make the following assumptions regarding functional forms: • C is positive - and a positive function of income; • I is positive - but independent of income, because firm’s investment decisions depend upon other factors (like profit levels) • G is positive - but independent of income. Page 14 © Stephen Hall, Imperial College London Consumption demand • Households allocate their income between CONSUMPTION and SAVING • Personal Disposable Income – income that households have for spending or saving – income from their supply of factor services (plus transfers less taxes) Page 15 © Stephen Hall, Imperial College London Consumption and income in the UK at constant 1995 prices, 1989-1998 Household consumtpion expenditure (£bn.) 500 475 450 425 400 375 350 400 425 450 475 500 525 550 Real disposable income (£bn.) Income is a strong influence on consumption expenditure – but not the only one. Page 16 © Stephen Hall, Imperial College London The consumption function The consumption function shows desired aggregate consumption at each level of aggregate income With zero income, C = 8 + 0.7 Y desired consumption is 8 (“autonomous consumption”). 8 { 0 Page 17 The marginal propensity to consume (the slope of the function) is 0.7 – i.e. for each additional £1 of income, 70p is consumed. Income © Stephen Hall, Imperial College London The saving function The saving function shows desired saving at each income level. S = -8 + 0.3 Y 0 Page 18 Income Since all income is either saved or spent on consumption, the saving function can be derived from the consumption function or vice versa. © Stephen Hall, Imperial College London The aggregate demand schedule AD = C + I I C Aggregate demand is what households plan to spend on consumption and what firms plan to spend on investment. The AD function is the vertical addition of C and I. (For now I is assumed autonomous.) Income Page 19 © Stephen Hall, Imperial College London Equilibrium output 45o E o line shows the The 45 line points at which desired spending equals output AD or income. Given the AD schedule, equilibrium is thus at E. Output, Income Page 20 This the point at which planned spending equals actual output and income. © Stephen Hall, Imperial College London Simplest Model 1: Example 1 Suppose: C = 400 + 0.75Y I = 600 G = 1,000 Then by definition: AD = 2,000 + 0.75Y And, in equilibrium: Ye = 2,000 + 0.75Ye which solves as (1 - 0.75)Ye = 2,000 or Ye = [1/(1 - 0.75] x 2,000 or Ye = 4 x 2,000 = 8,000 Page 21 © Stephen Hall, Imperial College London Simplest Model 1: Example 1 cont. AD=C+I+G=2000+.75Y AD D C+I=1000+.75Y C=400+.75Y Y • It is common to illustrate such simple examples with diagrams, with (the components of) aggregate demand graphed as a function of Y: • As the equilibrium is where Y = AD, it must lie somewhere along a 45 degree line on the diagram. Page 22 © Stephen Hall, Imperial College London Simplest Model 1: Example 1 cont. • Graphically: AD=C+I+G=2000+.75Y ADD C+I=1000+.75Y C=400+.75Y Y Page 23 © Stephen Hall, Imperial College London The Expenditure Multiplier • In the previous example, the slope of the AD curve is 0.75, (the mpc). More generally, as the diagram demonstrates, the slope of AD has important consequences for the (relatively large) change in Ye resulting from any (relatively small) change in C, I or, most importantly, G. AD’ (if G increases) AD Increase in Y Page 24 © Stephen Hall, Imperial College London The Expenditure Multiplier • Suppose in the previous example that the government decides to increase its spending from G = 1,000 to G1 = 1,100 (an increase of 100). Mathematically, AD1 = 2,100 + 0.75Y. • • The new equilibrium condition is Y1e = 2,100 + 0.75Y1e which solves for Y1e = 8,400, an increase of 400. • Thus a 100 increase in G has lead to a 400 increase in Ye . This is what is known as the multiplier effect. • The expenditure multiplier is the amount by which equilibrium output will change relative to the amount by which autonomous spending changes. • In the previous example, the expenditure multiplier equals 4. Page 25 © Stephen Hall, Imperial College London • Recall that we solved for Ye = [1/(1 - 0.75)] x 2,000. More generally, this can be written • Ye = [1/(1 - mpc)] x expenditure. • The change in equilibrium income will equal [1/(1 mpc)] times the change in expenditure. Therefore, in the simplest model [1/1-mpc)] is the expenditure multiplier. In this example it equals 1/(1-.75)] or 4. • The expenditure multiplier can be written in different ways, and will become a more complicated term as the model becomes more complex. Page 26 © Stephen Hall, Imperial College London Comments • The increase in output that resulted from the increase in government expenditure would seem to suggest that the government can induce the economy to grow - or grow more than it otherwise would - simply by increasing its expenditure. However, this result is a function of the naive model we are now employing. As the model becomes more complicated, this result becomes more dubious. Page 27 © Stephen Hall, Imperial College London An alternative approach S An equivalent view of equilibrium is seen by equating planned investment (I) E I Output, Income to planned saving (S) again giving us equilibrium at E The two approaches are equivalent. Page 28 © Stephen Hall, Imperial College London Questions You Should Be Asking Yourself are: • According to the model, there are no constraints on supply. What happens when such constraints exist? • If supply constraints exist, there is an “opportunity cost” associated with government expenditure. In particular, the resources used by the government could instead be used by private businesses for capital investment. What are the associated implications? • What, exactly, is the nature of government expenditure? Does it matter if the government builds roads or missiles? (The term “G” doesn’t make such a distinction.) Page 29 © Stephen Hall, Imperial College London Questions You Should Be Asking Yourself are: • What are the side-effects of increased government expenditure? What happens, for example, to interest rates and inflation? • How does the government pay for the additional expenditure? (Indeed, how is it financing G?). What happens as a result? • Can the increased expenditure and output (and jobs!) last forever, or will the economy eventually suffer an economic hangover? Page 30 © Stephen Hall, Imperial College London Model 2: Income Taxes • Let us now suppose that the government is financing itself through income taxes. The tax scheme it has adopted is T = 100 + 0.20Y • In words, this means that the government is collecting 100 from everyone (a kind of “poll tax”) plus 20 percent of everything earned by households. • As this new tax applies only to households, we need to change the consumption function to solve for the new equilibrium. We must also, however, change our interpretation of the consumption function Consumption is now written as a function of disposable income “Yd”, where Yd is simply gross income less income taxes. Page 31 © Stephen Hall, Imperial College London Model 2: Income Taxes Now, C = 400 + 0.75Yd = 400 + 0.75 (Y - (100 + 0.20Y )) or C = 325 + 0.6Y I = 600 (as before) G = 1,000 (as before) (*In this example, the mpc out of disposable income is still 0.75. And a new term, the marginal propensity to tax “mpt” is 0.20.) Page 32 © Stephen Hall, Imperial College London Then by definition: AD = 1,925 + 0.60Y And, in equilibrium: Ye = 1,925 + 0.60Ye which solves as Ye = [1/(1 - 0.60)] x 1,925 or Ye = 2.50 x 1,925 = 4,812.5 (The expenditure multiplier is thus 2.50). Page 33 © Stephen Hall, Imperial College London Model 2 cont. • Comparing the equilibrium values in the two previous examples is not really useful, since the problems are entirely different. (In particular, the government’s budget deficit has shrunk) However, it is useful to look again at the expenditure multiplier. • From the equations above, the new expenditure multiplier is 2.50. If you work backwards through the algebra, you’ll find that in this slightly more complicated model, E=multiplier = [1/(1-mpc (1-mpt))] (to verify, [1/(1-0.75 (1.0-.20))] = [1/(1-0.60)] = 1/0.40 = 2.50) Page 34 © Stephen Hall, Imperial College London • If you were to work through a diagrammatic analysis once again, you would get the anticipated result: an upward-sloping AD curve with slope equal to 0.60. • Question: Why, intuitively, does an income tax reduce the expenditure multiplier and, in this model, the government’s ability to boost equilibrium output? Page 35 © Stephen Hall, Imperial College London Deflationary & Inflationary Gaps • It is possible that the equilibrium output level Ye is less than the full employment output level “Yf “ meaning there are unused resources (i.e. unemployment). In the simple model, this happens if aggregate demand is too low. Keynes called this a “deflationary gap”. The converse can also happen, and is called an “inflationary gap”. Page 36 © Stephen Hall, Imperial College London Deflationary & Inflationary Gaps Deflationary Gap Deflationary Gap Y Page 37 Yf Inflationary Gap Inflationary Gap Yf Y © Stephen Hall, Imperial College London Deflationary & Inflationary Gaps • As Keynes was writing during the Depression, he lived in a time of a “deflationary gap”. His proposed solution was for the government to take action to increase aggregate demand. Specifically, he urged government to spend more (i.e. increase “G”) to make up for insufficient private demand. • At a most general level, the “Keynesian” remedy to unemployment is for the government to spend more money on public works projects like bridge and road construction. Page 38 © Stephen Hall, Imperial College London