Keynesian Economics and Fiscal Policy

							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:
     Up SLIGHTLY to 49.9
      – Figure released
        November.
      – DECEMBER: UP 52.9
     Lowest February, 1983.
     17.3
      How do they create the CCI?
Each month The Conference Board surveys 5,000 U.S. households. The survey
consists of five questions that ask the respondents' opinions about the
following:[2]
     1.Current business conditions
     2.Business conditions for the next six months
     3.Current employment conditions
     4.Employment conditions for the next six months
     5.Total family income for the next six months
Survey participants are asked to answer each question as "positive", "negative"
or "neutral". The preliminary results from the Consumer Confidence Survey are
released on the last Tuesday of each month at 10am EST.
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 45-
  degree 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 $50-
  million 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 60-
    cents.
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
US Fiscal Budgets
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.