Lecture Principles of economics (Asia Global Edition) - Chapter 22

Chapter 22 - Spending, output, and fiscal policy. After completing this unit, you should be able to: Identify the key assumptions of the basic Keynesian model and explain how this affects firms'' production decisions; discuss the determination of planned investment and aggregate consumption spending and how these concepts are used to develop a model of planned aggregate expenditure; analyze how an economy reaches short-run equilibrium in the basic Keynesian model, using both numbers and graphs,…

Spending, Output, and Fiscal Policy Chapter 22 McGraw­Hill/Irwin Copyright © 2015 by McGraw­Hill Education (Asia). All rights reserved 22­1 Learning Objectives Identify the key assumptions of the basic Keynesian model and explain how this affects the production decisions made by firms Discuss the determinations of planned investment and aggregate consumption spending and how these concepts are used to develop a model of planned aggregate expenditure Analyze, using graphs, how an economy reaches short-run equilibrium in the basic Keynesian model Show how a change in planned aggregate expenditure can cause a change in short-run equilibrium output and how this is related to the income-expenditure multiplier Explain why the basic Keynesian model suggests that fiscal policy is useful as a stabilization policy, and discuss the qualifications that arise in applying fiscal policy in real-world situations 22­2 Recessionary Gap • Great Depression – – • A decrease in spending leads to lower production – – • Available resources are unemployed Public’s willingness or ability to spend declines Laid-off workers reduce their spending Insufficient spending to support the normal level of production Conventional economic policy of the 1920s and 1930s would not solve this problem – John Maynard Keynes revolutionized economic thought and public policy 22­3 John Maynard Keynes (1883 – 1946) • After World War I, Keynes recognized that the terms of the peace would lead to another war – • German war reparations would prevent growth and recovery The General Theory of Employment, Interest, and Money (1936) is his best-known work – Problem was explaining why economies kept a recessionary gap for long periods • • Aggregate spending is too low for full employment Stabilization policies use government spending or taxes to substitute for spending in other sectors 22­4 Keynesian Model • • Building block for current theories of short-run economic fluctuations and stabilization policies In the short run, firms meet demand at preset prices – Firms typically set a price and meet the demand at that price in the short run • Menu costs are the costs of changing prices – – – • Determining the new price Incorporating prices into the business Informing consumers of new prices Firms change prices when the marginal benefits exceed the marginal costs 22­5 Technology of Changing Prices • Technology has reduced menu costs – – • • Highly segmented airline pricing Internet mechanisms for setting price – • Bar codes and scanners reduce costs of changing prices in the store Online surveys eBay ■ Priceline Other costs remain – – Competitive analysis prices Informing consumers ■ Deciding the new 22­6 Planned Aggregate Expenditure • • Planned aggregate expenditure (PAE) is total planned spending on final goods and services Four components of planned aggregate expenditure – – – – Consumption (C) by households Investment (I) is planned spending by domestic firms on new capital goods Government purchases (G) are made by federal, state, and local governments Net exports (NX) equals exports minus imports 22­7 Planned Investment Example • Fly-by-Night Kite produces $5 million of kites per year – – • If actual sales are only $4.6 million – – • Expected sales are $4.8 million and planned inventory increase is $0.2 million Capital expenditure of $1 million is planned • Total planned investment is $1.2 million Unplanned inventory investment of $0.2 million Actual investment is $1.4 million If actual sales are $5.0 million – – Unplanned inventory decrease of $0.2 million Actual investment is $1.0 million 22­8 Planned Aggregate Expenditure (PAE) • Actual spending equals planned spending for – – – • • Consumption Government purchases of final goods and services Net exports Adjustments between actual and planned spending are accomplished with changes in inventories The general equation for planned aggregate expenditures is PAE = C + IP + G + NX 22­9 Consumption Expenditures • Consumption (C) accounts for two-thirds of total spending – – Powerful determinant of planned aggregate expenditure Includes purchases of goods, services, and consumer durables, but not new houses • • Rent is considered a service C depends on disposable income, (Y – T) 22­10 What Caused the U.S Recession 2007 - 2009 • Decline in spending by businesses and households – – • Decline in planned aggregate expenditure – • Difficult to borrow Uncertainty about the state of the economy Downward shift of the PAE line Recessionary gap 22­32 Income-Expenditure Multiplier • The income – expenditure multiplier shows the effect of a one-unit increase in autonomous expenditure on short-run equilibrium output – – Initial planned expenditure = 960 + 0.8 Y New planned expenditure = 950 + 0.8 Y • • • • – The 10-unit drop in C implied a 10 unit drop in autonomous expenditure Equilibrium changed from $4,800 to $4,750 A $10 change in autonomous expenditures caused a $50 change in output Multiplier = The larger the mpc, the greater the multiplier 22­33 Stabilization Policy • Stabilization policies are government policies that are used to affect planned aggregate expenditure, with the objective of eliminating output gaps – – – – Expansionary policies increase planned expenditure Contractionary policies decrease planned expenditure Fiscal policy uses changes in government spending, transfers, or taxes Monetary policy uses changes in the money supply 22­34 Government Spending • • Government spending is part of planned spending – Changes in government spending will directly affect planned aggregate expenditures Suppose planned spending decreases $10 from Y = 960 + 0.8 Y to Y = 950 + 0.8 Y – Equilibrium Y decreases from $4,800 to $4,750 • • Recessionary gap is $50 Stabilization policy indicates a $10 increase in government spending will restore the economy to Y* at $4,800 22­35 Planned aggregate expenditure (PAE) $10 Fiscal Stimulus Y = PAE PAE = 960 + 0.8Y PAE = 950 + 0.8Y E F 960 95 45o 4,750 4,800 Y* Output Y 22­36 U.S Military Spending 2010 2005 2000 1995 1990 1985 1980 1975 1970 1965 1960 1955 1950 1945 1940 • Military spending as a share of GDP decreased sharply after World War II – Peaks for wars and Reagan military buildup Added demand from military spending helped end the Great Depression 45 40 – Recessions 35Defense spending/GDP 30 associated with 25 declines in military 20 15 spending 10 – Increases in G help stimulate the Year economy Share of GDP (% ) • 22­37 Taxes and Transfers • • Net tax (T) = total taxes – transfer payments – government interest payments Planned aggregate expenditures are influenced by changing total taxes and/or transfer payments – The effect is indirect, channeled through the effects on disposable income • • Lower taxes or higher transfers increase disposable income Increases in disposable income lead to higher C 22­38 Using Tax Cuts to Close a Recessionary Gap – An Example • • • • Original planned spending Y = 960 + 0.8 Y Autonomous spending decreases Y = 950 + 0.8 Y Recessionary gap is $50 Tax cut to close the gap must be bigger than $10 – Increase disposable income to cause initial increase in spending to be $10 • Taxes will have to go down by $12.5 Output (Y) Net Taxes (T) Disposable Income (Y – T) Consumption 610 + 0.8 (Y – T) 4,750 250 4,500 4,210 4,750 237.5 4,512.5 4,220 22­39 U.S Federal Tax Rebates - 2001 • Economy showed signs of slowing in early 2001 – Federal government rebated $300 to individual and $600 to couples • – Total rebates were about $38 billion Also made cuts in tax rates • • Two-thirds of the rebates were spent by households within six months Successful policy 22­40 U.S Fiscal Policy During the 2007 – 2009 Recession • Economic Stimulus Act of 2008 – – $100 billion in tax cuts $60 billion government spending increase • American Recovery and Reinvestment Act of 2009 – – • • $200 billion in tax cuts $600 billion government spending increase Both were effective at raising consumption spending Real GDP higher than it would have been otherwise 22­41 Supply-Side Effects of Fiscal Policy • Fiscal policy may affect potential output as well as potential spending – – • • Investment in infrastructure increases Y* Taxes and transfers affect incentives and can change potential output, Y* Supply-side economists emphasize the supplyside effects of fiscal policy Current thinking is more moderate – – Demand-side effects of spending matter Supply-side effects also matter 22­42 Fiscal Policy and Deficit Spending • Government deficit is the difference between government spending and net taxes, (G – T) – Large and persistent budget deficits reduce national saving • • Less saving means less investment which means less growth Managing the impact of the deficit limits the government's ability to use fiscal policy as a stimulus – Political considerations make it difficult to use contractionary fiscal policy 22­43 Fiscal Policy Flexibility • Two limits to fiscal policy flexibility – The legislative process requires time • – Change in fiscal policy may be slow Competing political objectives • • National defense Entitlements such as Medicare and income support 22­44 Fiscal Policy Can Be Effective • Automatic stabilizers increase government spending or decrease taxes when real output declines – – • Built into laws so no decision is required Unemployment compensation, progressive income tax Fiscal policy may be useful to address prolonged periods of recession – Monetary policy is more often used to stabilize the economy 22­45 Spending and Output in the Short Run Short-Run Spending and Output Multiplier Keynesian Model Planned Aggregate Expenditures (PAE) Consumption Function Output Gaps Short-Run Equilibrium Changes in Equilibrium Fiscal Policy Limitations 22­46 ... IP + G + NX 22 9 Consumption Expenditures • Consumption (C) accounts for two-thirds of total spending – – Powerful determinant of planned aggregate expenditure Includes purchases of goods, services,... local governments Net exports (NX) equals exports minus imports 22 7 Planned Investment Example • Fly-by-Night Kite produces $5 million of kites per year – – • If actual sales are only $4.6 million... or ability to spend declines Laid-off workers reduce their spending Insufficient spending to support the normal level of production Conventional economic policy of the 1920s and 1930s would not