Goods Markets PDF 2024

30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi Topic 5: THE MULTIPLIER MODEL AND FISCAL POLICY...

30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi Topic 5: THE MULTIPLIER MODEL AND FISCAL POLICY 1 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi Consumption (𝑪𝑪): goods and services purchased by final consumers; we distinguish between durable and non-durable consumption Gross Capital Formation (𝑰𝑰), or Investment tout court: Fixed Investment: non-residential investment (the purchase by firms of new plants or new machines) + residential investment (the purchase by people of new dwellings) Firms buy machines or plants to produce output in the future (i.e. to get capital services in the future) People buy dwellings to get housing services in the future Change in inventories: inventories are goods held by a firm prior to sale or use, including raw materials and partially-finished or finished goods intended for sale 2 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi Government Spending (G): the purchases of goods and services by the government: Government consumption: purchases that are used for the direct satisfaction of individual or collective current needs of members of the community Note that government consumption includes the value of services provided by government employees, i.e. the corresponding labour cost Government investment: purchases intended to create future benefits, such as infrastructure investment or research spending Note that 𝐺𝐺 does not include government transfers (benefits and public pensions) nor interest payments on public debt (why?) 3 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi Imports (𝑴𝑴): the purchases of foreign goods and services by local consumers, firms, and the government Exports (𝑿𝑿): the purchases of local goods and services by foreigners (𝑿𝑿 – 𝑴𝑴): Net Exports (𝑵𝑵𝑵𝑵) or trade balance (trade surplus if > 0, trade deficit if < 0) The sum of all components of spending is known as the aggregate demand (𝐀𝐀𝐀𝐀) for domestic goods: 𝐴𝐴𝐴𝐴 ≡ 𝐶𝐶 + 𝐼𝐼 + 𝐺𝐺 + 𝑋𝑋 − 𝑀𝑀 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑁𝑁𝑁𝑁𝑁𝑁 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 By construction, aggregate demand (𝑨𝑨𝑨𝑨) = GDP (𝒀𝒀), and this leads us to the national accounting identity (identity, not equation!!): 𝒀𝒀 ≡ 𝑪𝑪 + 𝑰𝑰 + 𝑮𝑮 + 𝑵𝑵𝑵𝑵 4 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi Italy EU (28 countries) Millions of € % GDP Millions of € % GDP Gross domestic product (2019) 1.787.664 16.464.168 Domestic demand 1.732.748 96,9% 15.967.538 97,0% Final consumption expenditure 1.411.552 79,0% 12.397.693 75,3% Households (C) 1.075.404 60,2% 9.050.593 55,0% General government (G) 336.148 18,8% 3.347.099 20,3% Gross capital formation (I) 321.196 18,0% 3.569.845 21,7% Gross fixed capital formation 322.724 18,1% 3.512.618 21,3% Changes in inventories -1.528 -0,1% 57.227 0,3% External balance (NX) 54.916 3,1% 496.630 3,0% Exports (X) 565.004 31,6% 7.679.754 46,6% Imports (M) 510.087 28,5% 7.183.124 43,6% 5 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi Again, note that our accounting identity holds by construction: no causality can be inferred without additional behavioural assumptions We will now clarify the economic determinants of each component of aggregate demand in turn Starting with consumption, assume that the aggregate consumption expenditure depends on disposable income only Disposable Income (𝒀𝒀𝑫𝑫) is defined as income, 𝑌𝑌, minus taxes (net of government transfers), 𝑇𝑇, so that 𝑌𝑌𝐷𝐷 ≡ 𝑌𝑌 − 𝑇𝑇 More formally, assume the following simple aggregate consumption function: 𝐶𝐶 𝑌𝑌𝐷𝐷 = 𝑐𝑐0 + 𝑐𝑐1 𝑌𝑌𝐷𝐷 6 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi Consumption depends positively on 𝑌𝑌𝐷𝐷 the parameter 𝑐𝑐1 > 0 represents the Marginal Propensity to Consume (𝑀𝑀𝑀𝑀𝑀𝑀, the effect that an additional unit of disposable income has on 𝐶𝐶) Assume that 𝑐𝑐1 < 1: an increase in 𝑌𝑌𝐷𝐷 stimulates consumption, but less than proportionally The parameter 𝑐𝑐0 > 0 represents the autonomous consumption level Autonomous consumption captures all the other influences on consumption that are not related to disposable income (for example, the expectations about future income) 7 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi The consumption function’s slope is positive, but less than 45° 𝐶𝐶 𝑀𝑀𝑀𝑀𝑀𝑀 = 𝑐𝑐1 < 1 𝐶𝐶 = 𝑐𝑐0 + 𝑐𝑐1 𝑌𝑌𝐷𝐷 𝑐𝑐0 𝑌𝑌 = Income 8 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi Regarding the other components of aggregate demand, we impose some strong assumptions, for the sake of exposition (some of them will be relaxed later): Investment is exogenously fixed at 𝑰𝑰 > 𝟎𝟎 = 𝟎𝟎 Government expenditure is exogenously fixed at 𝑮𝑮 = 𝟎𝟎 Taxes are exogenously fixed at 𝑻𝑻 The economy is closed to foreign trade (𝑵𝑵𝑵𝑵 = 𝟎𝟎) Hence, consumption remains the only endogenous component of 𝐴𝐴𝐴𝐴 The national accounting identity collapses to: 𝑌𝑌 ≡ 𝐶𝐶 + 𝐼𝐼 ̅ 9 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi We know from the Circular Flow model that 𝐴𝐴𝐴𝐴 = 𝑌𝑌, so that 𝒀𝒀 must lie on the 45° line depicted in the chart below …but where, exactly, along the line? 𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴 = 𝑌𝑌 45° 𝑌𝑌 10 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi We will now introduce a key assumption, that identifies our current approach as Keynesian Firms do not operate at full capacity utilization: they are willing (and capable) to supply any amount of goods and services demanded In other words, there are underutilized resources in the form of spare capacity in production facilities and unemployed labour We will later discuss what happens when the economy reaches full capacity utilization Hence, from a traditional Keynesian perspective, we are assuming that “demand creates its own supply” 11 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi The equilibrium condition 𝑌𝑌 = 𝐴𝐴𝐴𝐴 (this is an equation, not an identity!) can be explicitly written as: 𝒀𝒀 = 𝑐𝑐0 + 𝑐𝑐1 𝒀𝒀 + 𝐼𝐼 ̅ Output Income (= income) (= output) Again, the Circular Flow model shows that, at the aggregate level, 𝐺𝐺𝐺𝐺𝐺𝐺 = income = expenditure, so that the same variable, 𝑌𝑌, shows up on both sides of the equilibrium condition We can therefore solve for the unique output level that guarantees equilibrium in the goods market: 1 𝑌𝑌 = 𝑐𝑐0 + 𝐼𝐼 ̅ 1 − 𝑐𝑐1 12 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi Let 𝐴𝐴̅ ≡ 𝑐𝑐0 + 𝐼𝐼 ̅ denote the autonomous demand, i.e. the component of aggregate demand not affected by income The equilibrium output level obtains graphically as: 𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴 = 𝐴𝐴̅ + 𝑐𝑐1 𝑌𝑌 𝐴𝐴̅ 45° 1 𝑌𝑌 𝐴𝐴̅ 1 − 𝑐𝑐1 13 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi The equilibrium condition can be compactly summarized as: 1 𝑌𝑌 = 𝐴𝐴̅ 1 − 𝑐𝑐1 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 The ratio 1−𝑐𝑐 1 is known as the multiplier of aggregate demand 1 The equilibrium output level is equal to the multiplier times the level of autonomous demand, 𝐴𝐴̅ Note that the multiplier is larger than one, being 𝑐𝑐1 < 1 Hence, any increase in autonomous demand will generate a more than proportional increase in output How does the mechanism work? 14 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi The intuition is straightforward: consider an increase in autonomous spending 𝐴𝐴̅ (driven for instance by an increase in 𝐼𝐼)̅ This increase in has two effects on 𝐴𝐴𝐴𝐴: Direct effect: on impact, the increase in 𝐴𝐴̅ obviously causes a one-to-one increase in 𝐴𝐴𝐴𝐴, being the former a component of the latter, and therefore in output, 𝑌𝑌 Indirect effect: The initial rise in 𝑌𝑌 generates a less-than-proportional increase in 𝐶𝐶 (recall than 𝑐𝑐1 < 1) The rise in 𝐶𝐶 cause a further increase in 𝑌𝑌, which drives 𝐶𝐶 up again, and so on and so forth Note that each additional rise in 𝑌𝑌 is smaller than the previous one, so that the indirect effect vanishes in the limit 15 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi For each unit of additional autonomous demand, after 𝑛𝑛 rounds the equilibrium output increases by: 𝑛𝑛 𝑐𝑐 𝑗𝑗 = 1 + 𝑐𝑐1 + ⋯ + 𝑐𝑐1𝑛𝑛 𝑗𝑗=0 Note that, being 𝑐𝑐1 < 1: 𝑛𝑛 1𝑗𝑗 lim 𝑐𝑐 = 𝑛𝑛→∞ 𝑗𝑗=0 1 − 𝑐𝑐1 Hence, the multiplier is just the sum of all these successive increases in production driven by the initial rise in 𝐴𝐴̅ 16 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi A graphical representation of the multiplier process: 𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴 = 𝐴𝐴′̅ + 𝑐𝑐1 𝑌𝑌 𝐴𝐴𝐴𝐴 = 𝐴𝐴̅ + 𝑐𝑐1 𝑌𝑌 𝐴𝐴′̅ 𝐴𝐴̅ 45° 𝑌𝑌 𝑌𝑌𝑌 𝑌𝑌 17 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi Consider the national accounting identity again (under our simplifying assumptions): 𝑌𝑌 ≡ 𝐶𝐶 + 𝐼𝐼 ̅ + 𝐺𝐺̅ from both sides and rearrange terms: Subtract taxes, 𝑇𝑇, 𝑌𝑌𝐷𝐷 − 𝐶𝐶 + 𝑇𝑇 − 𝐺𝐺̅ ≡ 𝐼𝐼 ̅ 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 Let 𝑆𝑆𝑃𝑃 ≡ 𝑌𝑌𝐷𝐷 − 𝐶𝐶 denote private savings (i.e. income not spent), 𝑆𝑆𝐺𝐺̅ ≡ 𝑇𝑇̅ − 𝐺𝐺̅ public savings, and 𝑆𝑆 ≡ 𝑆𝑆𝑃𝑃 + 𝑆𝑆𝐺𝐺̅ savings tout court This takes us to the time-honoured “IS relation,” stating that at the aggregate level investment is identically equal to savings: 𝑰𝑰 ≡ 𝑺𝑺 18 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi For some reason, consumers decide to increase private saving by decreasing the autonomous consumption 𝑐𝑐0 How does the equilibrium output level react? And what about savings? Obviously, the equilibrium output level drops! However, private saving is not affected: recall the 𝐼𝐼𝐼𝐼 relation, and note that 𝐼𝐼 and 𝑆𝑆𝐺𝐺 remain exogenously fixed … 𝑺𝑺 cannot change! 𝐼𝐼̄ = 𝑆𝑆𝑃𝑃 + 𝑆𝑆𝐺𝐺̅ This result is a version of Paradox of Thrift: consumers try to save more, reduce aggregate demand, induce a drop in income, and end up saving the same amount as before! This is one of the best known example of Fallacy of Composition’s role in economics: “what is true of the parts must be true of the whole!” 19 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi There are three main ways that government’s spending and taxation can dampen the business cycle: Sheer size of the government sector: unlike private investment and consumption, government investment and consumption is usually stable Unemployment benefits (and other automatic stabilizers): unemployment benefits, and other programs to redistribute income to the poor, help households to smooth consumption Fiscal policy: the government can directly and deliberately intervene to stabilize aggregate demand When a government cuts taxes 𝜏𝜏 or increases government spending 𝐺𝐺 in a recession, it is called a fiscal stimulus, aimed at counteracting, via the multiplier, the fall in aggregate demand from the private sector 20 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi An increase in 𝐺𝐺 constitutes a fiscal stimulus: aggregate demand, and income in equilibrium, will increase 𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴 = 𝑐𝑐0 + 𝐼𝐼 ̅ + 𝐺𝐺′̅ + 𝑋𝑋 + 𝑐𝑐1 𝑌𝑌 𝐴𝐴𝐴𝐴 = 𝑐𝑐0 + 𝐼𝐼 ̅ + 𝐺𝐺̅ + 𝑋𝑋 + 𝑐𝑐1 𝑌𝑌 𝐴𝐴′ 𝐴𝐴̅ 45° 𝑌𝑌 𝑌𝑌𝑌 𝑌𝑌 21 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi Assuming a fixed investment level is eminently unrealistic! It is time to provide a more realistic description Firms invest (i.e. purchase investment goods that increase the capital stock) in order to build additional productive capacity or maintain the existing one The return of investment in productive capacity is the expected (after-tax) profit rate on investment, 𝜋𝜋 The interest rate, 𝑟𝑟, is the opportunity cost of investment: If you have money available, you could save it with a return of 𝑟𝑟 instead of investing it If you do not have money available, the cost of borrowing is also 𝑟𝑟 A profit-maximizing firm will invest as long as the expected rate of return exceeds the interest rate 22 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi If we rank investment projects by their expect rate of profit, 𝜋𝜋, then a lower interest rate, 𝑟𝑟, increases the number of projects for which 𝜋𝜋 > 𝑟𝑟 We can therefore conclude that: A higher interest rate reduces aggregate investment spending, ceteris paribus A higher expected rate of profit raises aggregate investment spending, ceteris paribus These conclusions can be summarized by an aggregate investment function of the form: 𝐼𝐼 𝑟𝑟, 𝜋𝜋 = 𝑖𝑖0 𝜋𝜋 − 𝑖𝑖1 𝑟𝑟 The parameters 𝑖𝑖0 and 𝑖𝑖1 are strictly positive 23 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi As far as the government is concerned, we assume that: Government expenditure remains fixed at some 𝐺𝐺̅ > 0 Taxes are levied as a proportional tax on income, τ 𝑌𝑌, where 0 < 𝜏𝜏 < 1 is the tax rate The closed economy assumption can be easily generalized too If the home economy is open to trade, we need to describe how imports and exports evolve: Exports are exogenously fixed at 𝑋𝑋 Imports, instead, depend on domestic income, so that 𝑀𝑀 = 𝑚𝑚 𝑌𝑌 , where 0 < 𝑚𝑚 < 1 denotes the marginal propensity to import 24 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi Putting together each of the components of 𝐴𝐴𝐴𝐴 we obtain our full-blown model: 𝑌𝑌 = 𝑐𝑐0 + 1 − 𝜏𝜏 𝑐𝑐1 𝑌𝑌 + 𝐼𝐼 𝑟𝑟, 𝜋𝜋 + 𝐺𝐺̅ + 𝑋𝑋 − 𝑚𝑚𝑚𝑚 Again, we can easily solve for the equilibrium output level: 1 𝑌𝑌 = 𝑐𝑐0 + 𝐼𝐼 𝑟𝑟, 𝜋𝜋 + 𝐺𝐺̅ + 𝑋𝑋 1 − 1 − 𝜏𝜏 𝑐𝑐1 + 𝑚𝑚 Note that introducing proportional taxation and opening up the economy reduces the size of the multiplier (why?): 1 1 < 1 − 1 − 𝜏𝜏 𝑐𝑐1 + 𝑚𝑚 1 − 𝑐𝑐1 Finally, note that the size of the multiplier is inversely related to the tax rate and the marginal propensity to import 25 30545 - Foundations of Economic Sciences © 2024 Marco Maffezzoli – Università Bocconi The multiplier model developed in the previous slides is simple and remarkably useful, but has some obvious limitations Probably the most important one stems from the Keynesian assumption that the economy does not operate at full capacity, so that there are some underutilized resources If the economy instead is operating at or near full capacity, and unemployment is low, the size of the multiplier can be different With fully employed resources, an increase in government spending would displace, or crowd out, some private spending, reducing possibly to zero the multiplier’s effect The size of the multiplier will also depend on the expectations about the future of households, firms, and businesses Recent empirical evidence supports the view that fiscal policy multipliers are larger in a recession than in an expansion 26