Download GNP - MIT

Introduction to Macro Policy
and Models
Fiscal Policy:
Government Taxation,
Spending and Deficit
Impacts on the Macroeconomy
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902mit03.ppt
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902mit03.ppt
Focus Today
Setting up the questions regarding fiscal
policy
 Understanding preliminary answers and
their basis
 Applying this knowledge to a
contemporary issue, the emergence of a
budget surplus following huge deficits

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902mit03.ppt
The Central Model

The Key Behavioral Actors:
– Domestic Households, buying
consumer goods and housing
– Domestic Businesses, buying machines
or building factories & offices or
stocking goods in inventory
– Foreign buyers and suppliers
– Some Government Agencies Whose
Behavior is “Regular”
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902mit03.ppt
The Central Model

The Key Exogenous Influences
– Domestic Government tax, transfer and
purchasing decisions (that change on
an irregular basis)
– Domestic Central Bank “control” of the
money supply and interest rates
– The International Counterparts to these
– International Commodity Markets and
Cartel Behavior
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902mit03.ppt
A First Model
7
Endogenous/ Behavioral Variables
(Including ID’s) and 7 Equations
– Consumer Spending : C=f ( YD, i )
– Business Spending : I = f ( d GNP, i)
– Imports : M = f ( C, I , i )
– Exports : X = f ( GNPW, i )
– Total Output=Spending :

GNP = C+I+X-M+G
– After-tax Income : YD = GNP - T
– Inflation : R P = f ( GNP )
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A First Model
4 Exogenous/Policy Variables
– Government Purchases : G
– Taxes (Net of Transfers) : T
– Interest Rate : i
– Rest-of-World Demand : GNPW
 Omitted Variables
– Wealth
– Supply Capacity

The Reduced Forms of the 7
Behavioral Equations
C=C ( G, T, i, GNPW )
 I = I ( G, T, i, GNPW )
 M = M ( G, T, i, GNPW )
 X = X ( G, T, i, GNPW )
 GNP = C+I+X-M +G

=
GNP ( G, T, i, GNPW )
YD = GNP - T
 RP = RP ( GNP) = RP( G, T, i, GNPW )

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The GNP Reduced Form
Equation is a Useful Summary
GNP
i=
INTEREST
RATE
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902mit03.ppt
= C+I+X-M +G= GNP ( G, T, i, GNPW )
GNP2=
GNP(G2,T1)
GNP1=
GNP(G1,T1)
GNP=NATIONAL SPENDING/OUTPUT
The GNP Reduced Form
Equation is a Useful Summary
GNP
Why
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902mit03.ppt
= C+I+X-M +G= GNP ( G, T, i, GNPW )
does GNP=GNP(i) slope down?
Both
Consumers (C) and Businesses (I) spend
less if credit costs are higher.
Higher interest rates tend to boost the exchange
rate, which cuts Exports (X) and boosts Imports (M)
How
do changes in G, T shift GNP(i)?
For
any given C or I , less G subtracts from GNP,
and sets up multiplier, feedback effects
Extra T reduces YD which reduces C and thus
cuts GNP.
If interest rates are fixed at i1,
reducing G cuts GNP by a “multiple” of G
GNP
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902mit03.ppt
= C+I+X-M +G= GNP ( G, T, i, GNPW )
i=
INTEREST
RATE
i1
GNP1=
GNP(G1,T1)
GNP2=
GNP(G2,T1)
GNP2
GNP
1
GNP=NATIONAL SPENDING/OUTPUT
What if lower GNP implies lower i
due to Fed or market reactions?
i=
INTEREST
RATE
i=i(GNP)
GNP2=
GNP(G2,T1)
GNP=NATIONAL SPENDING/OUTPUT
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902mit03.ppt
What if lower GNP implies lower i
due to Fed or market reactions?
i1
i2
GNP2 GNP1
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What if the Fed has a strict inflation
target and thus a fixed GNP target?
i1
i2
GNP2 GNP1
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Deficit Reduction
Will Change the Economy
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But it might not boost unemployment.
 What sectors will offset lower G?
 What does the Fed need to do?
 What might change the equilibrium level
of GNP?
 Who gains and loses, considering
incomes, wealth, skill-building?
 Is a constitutional amendment necessary?

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902mit03.ppt
Build a Model
Build a basic model of an economy from the following description:
1. Businesses
GDP
For each $100 dollars of revenue (GDP) they receive, they have costs and profits of:
W
$75 wages
Profit=Dividend
$25 profit, and this is paid as dividends to consumer households
I
They buy new plant and equipment equal to profits each year, plus
$10 extra(less) for each 1 percentage point the interest rate is below(above) 5%.r (interest rate)
Hint: r, the interest rate, enters the equations as a whole number like 4,5, or 6 and not .04, .05, .06.
2. Consumers
W, Profit, T
Pay a flat 1/3 of their gross wages and profits in taxes.
Buy consumer goods equal to 75% of their after-tax wage and dividend income, EXCEPT....C
r (interest rate)
...they reduce purchases by $20 for each 1 percentage point interest rates exceed 5%
( and symmetrically raise purchases when rates fall below 5%)
Hint: r, the interest rate, enters the equations as a whole number like 4,5, or 6 and not .04, .05, .06.
3. Government
G
The Government buys $250 in goods.
T
No taxes other than income taxes are collected.
4. Foreign Buyers and Sellers are excluded from this first economy.
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Build a Model
T=(1/3)*(W+D)
C=(3/4)*(W+D-T)-20*(r-5)=((3/4)*(2/3))*(W+D)-20*(r-5)
W=.7*GDP
D=.3*GDP
I=.25*GDP-10*(r-5)
Reduced form equation: the endogenous variable is a function of only exogenous variables
GDP=C+I+G
substitute for W, D to derive the C reduced form equation
C
=
((3/4)*(2/3))*(W+D)-20*(r-5)
=
((3/4)*(2/3))*(.7*GDP+.3*GDP)-20*(r-5)
=
.5*GDP - 20r + 100
simply the I function to derive the I reduced form equation
I
=
.30*GDP-10*(r-5)
=
.30 * GDP - 10*r + 50
Add together to obtain the GDP reduced form equation----the "IS" curve
GDP
=
.5*GDP - 20r + 100 + .30 * GDP - 10*r + 50 + G
=
.80* GDP - 30 r + 150 + G
=
750 + 5 G -150 r
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902mit03.ppt
Build a Model
GDP
=
=
=
.5*GDP - 20r + 100 + .30 * GDP - 10*r + 50 + G
.80* GDP - 30 r + 150 + G
750 + 5 G -150 r
Change G in Year 4 and note the results
Year
C
I
G
GDP
W
D
T
W+D-T
r
1
2
3
4
5
6
7
8
9
10
625
375
250
1,250
875
375
417
833
625
375
250
1,250
875
375
417
833
625
375
250
1,250
875
375
417
833
500
300
200
1,000
700
300
333
667
500
300
200
1,000
700
300
333
667
500
300
200
1,000
700
300
333
667
500
300
200
1,000
700
300
333
667
500
300
200
1,000
700
300
333
667
500
300
200
1,000
700
300
333
667
500
300
200
1,000
700
300
333
667
5
change in GDP from year 1
change in G from year 1
multiplier
5
5
-
5
5
5
5
5
5
5
(250)
(50)
5.0
(250)
(50)
5.0
(250)
(50)
5.0
(250)
(50)
5.0
(250)
(50)
5.0
(250)
(50)
5.0
(250)
(50)
5.0
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902mit03.ppt
Build a Model
Now, assume no lag in consumer response to income and rates
Assume a 1 year lag in business response to profit and rates
Year
C
I
G
GDP
W
D
T
W+D-T
r
1
2
3
4
5
6
7
625
375
250
1,250
875
375
417
833
625
375
250
1,250
875
375
417
833
575
375
200
1,150
805
345
383
767
545
345
200
1,090
763
327
363
727
527
327
200
1,054
738
316
351
703
516
316
200
1,032
723
310
344
688
510
310
200
1,019
714
306
340
680
5
5
5
5
5
5
5
(160)
(50)
3.2
(196)
(50)
3.9
(218)
(50)
4.4
(231)
(50)
4.6
Note the multiplier starts at 2 and rises toward 5.
change in GDP from year 1
change in G from year 1
multiplier
(100)
(50)
2.0
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Build a Model
Now, let interest rates respond to GDP, dropping from 5% to 4%:
Year
C
I
G
GDP
W
D
T
W+D-T
r
change in
GDP from
year 1
change in G
from year 1
multiplier
9
503
303
200
1,007
705
302
336
671
10
542
302
200
1,044
731
313
348
696
11
563
323
200
1,087
761
326
362
724
12
576
336
200
1,112
778
334
371
741
13
584
344
200
1,127
789
338
376
751
14
588
348
200
1,136
795
341
379
758
15
591
351
200
1,142
799
343
381
761
16
593
353
200
1,145
802
344
382
763
17
594
354
200
1,147
803
344
382
765
5
4
4
4
4
4
4
4
4
(243)
(206)
(163)
(138)
(123)
(114)
(108)
(105)
(103)
(50)
4.9
(50)
4.1
(50)
3.3
(50)
2.8
(50)
2.5
(50)
2.3
(50)
2.2
(50)
2.1
(50)
2.1