An Introduction to Investment

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The Role of the Government and
Fiscal Policy
The I-S Curve and Fiscal Policy
Fourth Major Curve of the Course: IS curve

•   IS curve represents demand side of the economy drawn in {Y,r} space:

Y = C + I + G + NX

or (given definitions of disposable income and saving from lecture 1)

S(hh) + S(govt) = I + NX, or

S = I + NX

The IS curve is named as is because it documents the relationship between Saving and
Investment (holding NX constant).

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Fourth Major Curve of the Course: IS curve

•   C        is a function of PVLR (Y, Yf, W), tax policy, expectations (i.e., consumer
confidence), liquidity constraints

•   I        is a function of r, A, business confidence, liquidity constraints, and investment tax
policy.

•   G        is a function of government policy (we will discuss this shortly)

•   NX       we will model in the last lecture of the course (for the U.S., NX is small)

•   The IS curve relates Y to r. How do interest rates affect Y?

– As r falls, Investment increases (due to MPK and firm profit maximization behavior).
– IS curve is downward sloping in {r, Y} space.

•   For next week or two we will IGNORE the supply side of the economy (just to build
intuition) --- after that, we will put demand and supply together.              4
Demand Side Analysis (IS Curve)

r

r*                                                                r*

IS

Y*                                 Y
Suppose r is set by the Fed at the level of r* (we will explore this in depth later in the course).
For a given r, we can solve for the level of output desired by the demand side of the economy.

We represent the demand side of the economy, drawn in {r,Y} space as the I-S curve. Why IS?
Because the demand side of the economy can be boiled down to I = S (when NX is zero)
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Note: Y need not equal Y* - I drew it this way for illustrative purposes.
Some Thoughts on IS Curve

What shifts the IS curve?

Anything that causes C, I or G to change (or NX when we model it).

What shifts IS curve to the right? (i.e., makes Y higher on the demand side of the economy)

Increase in consumer confidence (expectations of future PVLR)
Permanent increase in stock market wealth.
A permanent reduction in income taxes (if households are PIH or Keynesean)
A temporary reduction in income taxes (if households are Keynesean or Liquidity
Constrained PIH).
An expected future increase in TFP (stimulates investment demand).
An increase in government spending (i.e., war).

•   Changes in r WILL NOT cause IS curve to shift (causes movement along IS curve).

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•   You should be able to answer:   Why does the IS curve slope down?
Suppose Consumer Confidence Falls

Suppose consumer confidence falls (and no effect on Y*). IS curve will shift in.

r

C falls

r*                                                        r*

IS1
IS
Y
Y*
Y1

Assume that investment, NX, and G do not change!
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Fiscal Policy

• Fiscal policy is the use of government spending (G) and taxes (tn) to
stabilize the economy.

•   Governments can have:
– Output targets
– Price targets
– Unemployment targets.

•   Stabilizing the economy means moving the economy towards its targets. We will ignore
price targets for now (we have no prices in our model yet).

•   Suppose the government has an output target and suppose that target is Y* (we will also
explain why Y* is a good target later in the course).

•   Fiscal policy then would be the manipulation of G and tn to move the economy towards
Y*. (Assumes government knows where Y* is - we will discuss other drawbacks to
fiscal policy later in the course).                                             8
Example of Fiscal Policy: Consumer Confidence Falls

Government can undo the decline in consumer confidence by increasing G or decreasing
tn - this is fiscal policy
r

C falls

r*                                                        r*
G increases

IS1
IS = IS2
Y
Y*
Y1

Compute Change in G: If ΔG = -Δ consumer confidence,
Y will remain unchanged (taking r as fixed)
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A Look at U.S. Debt and Deficits
U.S. FEDERAL DEFICIT (RELATIVE TO GDP)
U.S. FEDERAL DEFICIT (RELATIVE TO GDP)
SINCE 2006
U.S. FEDERAL DEBT (RELATIVE TO GDP)
SINCE 1900
U.S. TOTAL GOVERNMENT DEBT (RELATIVE TO
GDP), INCLUDING STATE AND LOCAL SINCE 1900
U.S. FEDERAL DEBT (RELATIVE TO GDP)
SINCE 2006
The Cyclicality of Government Budget Deficits
Some Additional Structure on Taxes and Transfers

Let us start with some definitions about debts and deficits.

Tax Revenues          = tnY          (where tn is the marginal tax rate on income)

Transfers Payments = Tr – g Y        (where g is the relationship between transfers
and income)

Rationale for specifications:

1.   When Y increases, taxes revenues increase (more earnings in economy).

-   This is built into the tax code.
-   You are taxed based upon what you earn.

2.   When Y increases, transfers payments fall (less people on welfare)

-   This is built into our social programs.
-   We transfer more money to people when their income is low.            17
Some Deficit Terminology

Actual Government Deficits

= Outlays (G and Tr) – Revenues (T)
= G + Tr – g Y - tnY = G + Tr – (g + tn)Y

Note:    For now, ignore other government revenues and expenses (like interest on
government debt). See text for further discussion if interested.

Definition:       Structural Budget Deficit is the deficit that would exist if the
economy were at Y*:

Structural Budget Deficit = G + Tr – (tn + g)Y*

Note:    Difference between structural deficits and actual deficits is only due to
differences between Y and Y*.

Cyclical Budget Deficits = Actual Budget Deficits - Structural Budget Deficits.
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Cyclical deficits occur anytime Y does not equal Y*!
The Nature of Deficits

•   Deficits are countercyclical! (They rise when Y falls and fall when Y rises)

•   Even if the government has a policy (combination of G and T) that would lead to no
deficits at Y* (the target level of output for the economy), deficits could still occur.

The reason: Y does not always equal Y*.

•   Why do we get countercyclical deficits?

Welfare Payments, Unemployment Insurance, and Tax System dampen the effects of
consumption over the business cycle.

– T goes up when times are good (like in the late 1990s).
– G/Tr goes up when times are bad (welfare payments).
– We refer to such policies that dampen consumption as “automatic stabilizers”

•   Given “automatic stabilizers” (and potentially proactive governmental fiscal policies),
cyclical deficits seem to be an inherent part of our economy.
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Graphing Deficits When Policy Is Constant (ie, G, T0, Tr0, g, tn fixed)
Even when the structural deficit is close to zero ((G +Tr )/(tn + g) = Y*), actual deficits can be large
when Y < Y*!

Deficit

Structural Deficit =
G +Tr – (tn + g)Y*

Y*                                         Y

Actual Deficit =
G +Tr – (tn + g)Y

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Graphing Deficits When Policy Changes

What happens to actual and structural deficits when G increases to G’?

Deficit
G’+Tr

G+Tr

Structural Deficit =
G +Tr – (tn + g)Y*

Y*                                        Y

Actual Deficit =
G +Tr – (tn + g)Y

Changing government policy affects both structural and actual deficits!
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Should Governments Try To Prevent Deficits?
•   Examples: U.S. Balanced Budget Amendment. Maastricht criteria for entry to
European Economic and Monetary Union (EMU) that deficit/GDP be 3% or less and
that debt/GDP be 60% or less.

•   Benefits: Limit Spending: If spend today, government must;

1) Raise Taxes Now         (changing taxes frequently creates economic uncertainty)
2) Raise Taxes in Future   (higher taxes cause disproportionately more distortions )
3) Print Money In Future   (could lead to inflation)

•   Is there a cost? Yes - balanced budget amendments can make economic situations
worse. Refer back to the example earlier in this lecture when consumer confidence fell.

As Y fell, tax revenues fell. As tax revenues fell, deficits (cyclical) increased. If the
government had to balance the budget, they would either have to cut G or increase T -
both of which would cause the IS curve to shift further to the left.

Conclusion - it may be bad to have policies requiring governments to eliminate all deficits,
but there may be some benefits from eliminating structural deficits (see below). 22
Government Spending at Y* (model preview)
Increase in G at Y* - Investment Adjusts

LRAS = Y =Y*=f(A,K,N*)

r1

r*

IS = Y=C+I+G

Y*                        Y

Suppose we start at Y* such that Y is pinned down by the supply side
(i.e., labor markets clear, all resources used efficiently)

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Increase in G at Y* - Investment Adjusts

LRAS = Y =Y*=f(A,K,N*)

r1

I
r*
G
IS1 = C+I1 +G1

IS = Y=C+I+G

Y*                             Y

Assumption:     Increase in G has no effect on A!

Model:          Increase in G has no effect on N* (no effect on labor supply or
labor demand).
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What is the Effect of Running a Deficit at Y*?

Situation 1:        Crowding Out of Investment:

Equation 1:      Y=C+I+G                         Equation 2: SHH + Sgvt = I (if NX = 0)

If Y is pinned down by supply side of economy (such that ΔY = 0 if G increases), then
either C or I must fall to offset increase in G (i.e., ΔG = - ΔI).

Why would I fall? Increase in interest rates (we will prove once we build a model of
money market).

What is the effect of falling I (due to increased G) on future generations? Lower I today,
means lower K tomorrow. Lower K tomorrow means lower Y* tomorrow (lower
economic growth).

If at Y*, increase in deficit will hurt future generations unless the deficit has a non-trivial
effect on A (given Cobb Douglas Production: If %ΔA > 0.3 * %Δ K, then deficit
could help future generations.)
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What is the Effect of Running a Deficit at Y*?

Situation 2:        Ricardian Equivalence:

Adjustment occurs on C as opposed to I (to keep Y at Y*)

Definition:         Ricardian Equivalence: Theory that states that consumers’ behavior is
equivalent regardless if the government finances G (government
expenditures) through increased taxes or through increased debt

Key:                If the government floats debt to finance the spending today, consumers
realize that the government, at some time in the future, will have to raise
taxes to pay back the debt.

Summary:            A reduction in taxes today (an increase in G today) will be seen as being
accompanied by higher taxes in the future. Households will save today
to fund the future tax increases (they expect disposable income in the
future to fall). National Saving would remain unchanged.

In terms of equations:        Y is fixed, C falls and Shh goes up (prevents crowding out of
investment ; I can stay fixed)                          27
Does Ricardian Equivalence Hold?

For the most part, there is little evidence to support the existence of Ricardian Equivalence.

Why?                Myopia
Liquidity Constraints
High Levels of Impatience.
Do not care about bequests/future generations
Timing of Taxes is Important (taxes are not lump sum).

It does not mean that it will never hold (some people point to Japan in the mid 1990s).

For the rest of the course, we will assume consumers are “non Ricardian” unless told
otherwise. This means that consumers will not adjust their consumption downward
today in expectation of an increase in taxes tomorrow.

Ricardian consumers, however, would adjust their consumption downward today in
expectation of increases in taxes tomorrow (because PVLR falls).
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Government Spending During Recessions
Net Benefits of Using Government Spending to Influence Economy
Kevin Murphy outlined this simple model at a Booth seminar on the stimulus bill in
2009 (I will refer to this as the “Murphy Model”). I have augmented the model
slightly.

Define:
G =           Increase in government spending
1-α =         Value of dollar of government spending (α measures the
inefficiency of government spending relative to private sector
(α1), the multiplier effect of government spending via additional
private sector spending (α2), or the potential effect of government
spending on future TFP (α3).
f    =        Fraction of the output used by “idle” resources (i.e, not subject to
crowding out).
λ    =        The relative value of “idle” resources (some resources have value
even if they are not used in market production – i.e, value of
leisure or home production).
d    =        The deadweight cost per dollar of revenue from the taxation
required to pay for the spending (we have to pay back the 30
spending at some point).
Net Benefits of Using Government Spending to Influence Economy

Benefits of Government Spending (using above notation)

(1+α2+ α3) G    (the value of the extra spending – given the two “multipliers”)

Costs of Government Spending (using above notation)

α1 G            (the waste of the government spending due to “inefficiency”)

(1-f) G         (some of the resources (1-f) would have been used anyway ; (1-f)
measures the extent of “crowding out”)

λf G            (the resources that were “idle” still had some value denoted by λ)

dG              (the cost of society in terms of dead weight loss of having to
repay the debt in the future – by raising taxes or reducing some
other government spending).

Net Benefit:

(1+α2 +α3 - α1) G – (1-f)G - λf G - d G    = (f(1-λ) + α2 + α3 – α1 – d)G            31
Net Benefits of Using Government Spending to Influence Economy

Question:          When is it good to engage in government spending to
stimulate economy in recession?

Answer:            When the net benefit from doing so is positive!

According to the simple Murphy model, net benefit is positive when:

f(1-λ) + α2 + α3 > α1 + d

In words, government spending should be used to stimulate the economy in a
recession if:

1)     There are lots of idle resources in the economy (f is high)
2)     The value of those idle resources are small (λ is small)
3)     The multiplier effects of government spending are large (α2 + α3 > 0 )
4)     The government spending is not inefficient (α1 = 0) or
5)     Paying back the taxes is not too distortionary (d is small).
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Some Thoughts on Parameter Values (f)

Positive Net Benefit of Government Spending:           f(1-λ) + α2 + α3 > α1 + d

When Y < Y*:     f > 0 (some idle resources)

-    By definition, recessions are periods of idle resources.
-    For a given G, a bigger recession would yield a larger f (more idle
resources).

When Y = Y*:     f = 0 (no idle resources)

-    By definition, if we are at Y* there are no idle resources.
-    Positive Net Benefit of Government Spending:
α2 + α3 > α1 + d
-    This can only occur if α2 + α3– α1 is positive (given d is always positive)
-    α2 is likely to be smaller at Y* (more on this below – with few idle
resources it is hard to generate some “multiplier” effects)            33
Some Thoughts on Parameter Values (λ)

Positive Net Benefit of Government Spending:             f(1-λ) + α2 + α3 > α1 + d

Suppose Y < Y*, what is λ?

•   Most machines have very little value when sitting idle (perhaps it is the
foregone value of the depreciation)

–   This is almost certainly leads to λ being pretty small.

• The value of workers sitting idle is harder to measure.

– Not working (leisure) has some value – people do not like to work

– Temporarily not working is not like normal leisure time (need to find a job,
creates stress which reduces the enjoyment of normal leisure activities,
etc.).

– My sense that even in this case, λ is still relatively small.             34
Some Thoughts on Parameter Values (α1)

Positive Net Benefit of Government Spending:           f(1-λ) + α2 + α3 > α1 + d

The magnitude associated with α1, α2 and α3 are the most debated in the current
economic environment.

What is α1?:

α1 measures the inefficiency of government spending (the private sector may be
able to build a road for \$X while the government cost to build the same exact
road is \$2X).

-    Governments are not bound by profit maximization (which promotes
efficient use of resources).

-    Political reasons often get in the way of efficient resource allocation (think
of current resources put into Detroit).

-    Estimates suggest that α1 >> 0 (governments are really inefficient)
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Some Thoughts on Parameter Values (α2)

What is α2?

Government spending may lead to “multiplier effects” in the economy when Y
< Y*:

-    A dollar of spending will put money in someone’s pocket and
that may lead to increased spending on other goods and services,
etc.

-    If there are more ideal resources in the economy, a \$1 increase in
government spending can lead to even more than \$1 worth of
idle resources being used.

-    There needs to be idle resources for this multiplier to exist (otherwise, the
spending would have already taken place).

-    I will do an example of this in two slides

-    Implies α2 > 0                                                         36
Some Thoughts on Parameter Values (α3)

What is α3?

Government spending can promote TFP in the economy (by providing public
goods or undoing negative extranalities).

-    Government can improve infrastructure of economy.

-    Benefits of the infrastructure born by everyone.

-    Increases TPF (A).

-    Is only important to the extent that such infrastructure would not
have been provided by the private sector.

-    Even if economy is at Y*, this effect could be important.

-    Implies α3 > 0 (if effects on TFP are positive).
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Why is There a Potential “α2 multiplier” When Y < Y*?

Suppose we have the following model:
C = a + b(Y – T)               << assume some fraction of consumers are liquidity
constrained so they act Keynesian>>

I = I0 – I1 r                  <<Investment is negatively related to interest
rates>>

T = tn Y                       <<Marginal tax rate on labor income>>

Other assumptions:
Transfers = 0 ; G = G0 ;       Y << Y* ;     closed economy (NX = 0 always)

What is the equilibrium level of Y?
Y = C + I + G = a + b(Y – tnY) + I0 – I1 r + G0

Solve for Y (Use algebra – one equation, one unknown)

Y = [a + I0 – I1 r + G0] / [1-b(1-tn)]                                          38
What is the “α2 multiplier” in the Simple Model?

Given the Simple Economy on Previous Page:

Y = [a + I0 – I1 r + G0] / [1-b(1-tn)]

What is the multiplier of a change in government spending (G) on Y?

dY/dG = 1/[1-b(1-tn)]

What is b?         Some estimates range from 0.3-0.4 in recession.
Where are the estimates from? -- Micro data analyzing tax rebates (a
change in taxes not a change in government spending).

What is t?         Marginal tax rate – roughly 0.25-0.35

What is the government spending multiplier in this simple model?

dY/dG is approximately 1.3 (if b = 0.35, t=0.3)  α2 ≈ 0.3
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Intuition on α2 Multiplier

What is the intuition of the government spending multiplier?

By increasing government spending, it puts money into the economy. (If the
government hires a worker to build a road, it will put money in that worker’s pocket. If
that worker was liquidity constrained before, he will now spend that money at your store
putting money in your pocket (and so on)).

A dollar of government spending can lead to more than a dollar of economic activity
because it can stimulate spending by consumers (who plan to consume the fraction b of
that dollar (net of taxes)).

Assumptions needed for the multiplier to hold:

Y needs to be well below Y* (resources have to be sitting idle).

Consumers need to be liquidity constrained (b > 0 - they cannot be standard non
liquidity constrained PIH).

Short run aggregate supply effects (i.e., price effects) must be small << we have not
done this – it is just for full disclosure – we can discuss this later when we make our
short run aggregate supply curve>>.                                                  40
Estimating “Net” Multipliers in Policy Discussion

Christy Romer (Former Chair of the President’s Council of Economic Advisors)

-     Estimates the new government spending multiplier to be around 1.6
-     Does so by using time series analysis of large government spending changes (like
wars)
-     I do not believe the time series analysis (too much other stuff going on – standard
errors are huge)
See:
http://alaskakid.wordpress.com/2009/02/28/christy-romer-02-27-09-fiscal-stimulus-
likely-effects-of-the-arra/

Robert Barro (Harvard Professor – Potential Soon to be Nobel Prize Winner)

-     Estimates the net government spending multiplier to be around 0.8
-     Also uses time series analysis (roughly same data as Romer – different empirical
approach)
-     I still do not believe the time series analysis
See:
http://online.wsj.com/article/SB123258618204604599.html                            41
My Thoughts

1.   Multipliers are likely much higher in recessionary times than in non-recessionary times.
The simple calculation we did earlier makes me think the recessionary multiplier could
be around 1.3 (all else equal) (α2 ≈ 0.3).

2.   All else is not equal: The government spending is not efficient (α1 > 0).

-    With the past big stimulus program, I think the inefficiency was likely even higher
than in the past. Have you ever tried to spend \$400 billion quickly AND
efficiently? There is no chance that this was successful.

-    My sense is the inefficiently could be large (all else equal α1 ≈ 0.5). A lot of the
government spending will be wasted.

3.   Some of the spending – however – may actually increase future TFP (a multiplier on
Y* instead of Y).

-    With the current stimulus, some spending may increase future TFP. I am not sure
how big this will be. Suppose , all else equal, α3 ≈ 0.1 - 0.2 higher because of
effects on TFP).

My best guess on (α1 + α2 + α3) was probably close to zero or negative!                  42
My Thoughts (Continued)

Bottom line

Is it good to have a large fiscal stimulus in the current economic environment? If α1 =
α2 + α3 and λ is close to zero, the Murphy equation becomes:

f >d

What does this mean? We compare the benefit of using idle resources to the cost of
distortions that will occur because we have to pay the debt back at some point later.

However, a big stimulus (G) and being closer to Y* both suggest that the increase in
government spending will be detrimental to the U.S. economy in the long run.

Why?

Inefficiency costs increase (α goes up – it is hard to spend more money efficiently)
Less likely that there will be idle resources (f goes down)

I would have thought harder about projects that increase TFP in the long run and
allocated my G towards them!
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Definition: Supply Side Economics
Supply Side Economics

Any fiscal policy designed to stimulate the supply side of the economy (A, K and
N)

Examples:

1)   Changing marginal tax rates (stimulate N)

As discussed before , these policies may not have big effects (off setting
income effects and substitutions effects ; empirically small estimates of
labor supply response).

2)   Subsidizing A and K (investment tax credits, research and
development subsidies, subsidizing education, etc.)

These programs have been shown as being effective ways to promote
economic growth within an economy.
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