Introduction to Economics Lecture 6 Fiscal Policy (Government Spending) PDF

Introduction to Economics Lecture 6 Macroeconomics: Fiscal Policy (Government Spending) Curtis & Irvine: (2020) “Principles of Macroeconomics” ch.6 & 7 sections 7.4 –...

Introduction to Economics Lecture 6 Macroeconomics: Fiscal Policy (Government Spending) Curtis & Irvine: (2020) “Principles of Macroeconomics” ch.6 & 7 sections 7.4 – 7.7  Review & Reminder: THREE CURVES: Aggregate Supply (Short-Run) Aggregate Demand Potential GDP (= Long-Run Aggregate Supply)  Inflationary Gap SR Equilibrium ABOVE Price ASLR potential GDP ASSR Level equilibrium real GDP exceeds E potential GDP P* the economy is above AD full-employment level Real YP Y* GDP  Deflationary Gap SR Equilibrium BELOW Price ASLR potential GDP ASSR Level potential GDP exceeds E equilibrium real GDP P* the economy is below AD full-employment level Real Y* YP GDP  Policies Terminology Expansionary Policy: policies intended to result in an increase in output to compensate for the output gap Contractionary Policy: policies intended to result in a short-term decrease in output to counter excessive economic expansion  CLASSICAL PERSPECTIVE: IF flexible prices & free markets: Short-term changes quickly adjust back to full employment (no need for active government policy) expansionary fiscal or monetary policy would only cause inflation, rather than increase GDP KEYNESIAN PERSPECTIVE: aggregate demand is not stable … it can change unexpectedly Government should intervene to adjust aggregate demand  Policy Options Fiscal policy: use of taxation and government spending to influence the economy (government revenue collection and expenditure) legislature & executive branches of government Monetary policy: using control of the supply of money to promoting economic growth and stability (interest rates and open market operations) central banks & finance ministries  Aggregate Demand Aggregate Expenditure Y = C + I + G + NX Keynes identified three factors that affect CONSUMPTION: by households Disposable income Expected future income Wealth or credit  Aggregate Demand Aggregate Expenditure Y = C + I + G + NX factors that determine the level of INVESTMENT: by firms (businesses) Expected future profits interest rates (cost to borrow money)  If the Interest rate is 2.5% 2% return 3% return 4% return If the Interest rate is 3.5% 2% return 3% return 4% return Fiscal policy: Government budget SPENDING: government purchases & transfers INCOME: taxes collected by the government surplus: INCOME > SPENDING deficit: SPENDING > INCOME Discretionary Fiscal Policy: decision made by legislature Automatic Fiscal Policy: triggered by economic conditions  Marginal Propensity to Consume Marginal Propensity to Consume (MPC): % of additional income that a household consumes rather than saves MPC = Example: MPC =  Increase Increase in Cumulative increase Round in AD production in income, ΔY 1 ΔG ΔG ΔG 2 MPC × ΔG MPC × ΔG ΔG + MPC × ΔG MPC × ΔG + (MPC × ΔG) + 3 MPC × (MPC×ΔG) (MPC × ΔG) MPC × (MPC × ΔG) ΔG + (MPC × ΔG) + n+1 MPCn × ΔG MPCn × ΔG (MPC × (MPC × ΔG)) + … + MPCn × ΔG ΔY = ΔG * (1+ MPC + MPC2 +...+ MPCn )  MULTIPLIERS GOVERNMENT EXPENDITURE MULTIPLIER  G (gov’t spending)   AD [+] TAX MULTIPLIER  T (gov’t spending)   AD [-] BALANCED BUDGET MULTIPLIER {G & T equal} impact on  ?  AD [?]  “Multiplier” as Policy Tool GDP responds in proportion to a change in government spending or taxes… bigger the multiplier, the more impact any change in gov’t spending & taxes have. KEY CONSIDERATIONS: – Who receives the stimulus money (different MPC) – State of the economy (unemployment & unused capacity)… multiplier is larger when the economy is in a recession  Aggregate Demand Price ASSR0 Level E1 P1* P0* E0 +G AD1 AD0+G AD0 Real Y1* Y2* =YP GDP  Short-Run Aggregate Supply: MORE REALISTIC CURVE SHAPE ASSR Price Level P* All workers have unemployed workers have jobs Real YP GDP Below potential GDP, easy to Hire workers & increase output  Short-Run Aggregate Supply: MORE REALISTIC CURVE SHAPE ASSR Price Level P* Real Y* GDP Below potential GDP, capacity to increase output C I G NX  Keynsian Model: Sticky Prices and Falling Demand in the Labour and Goods Market  The Neoclassical Perspective Belief in efficiency and equilibriums Potential GDP drives equilibrium in the Long Run !  Emphasis: long-term growth … recessions will fade & long-term growth ultimately determines the standard of living  Macroeconomics: Money & Monetary Policy Curtis & Irvine: (2017) “Principles of Macroeconomics” ch.8 & 10 sections 8.1, 8.4, 8.5 + 10.2-10.5 OpenStax College: ch. 27-28 Rittenberg&Tregarthen: ch. 24-26 The Use of Money Tool to enable Preferred Characteristics: exchanges Portable = location Store of value Durable = long time Unit of account Divisible = sub-divide (standardised prices / value) Relatively scarce Accepted by everyone Liquidity: ability to convert an asset to cash quickly  Measuring “Money Supply” Liquidity: ability to convert an asset to cash quickly MONEY STOCK: quantity of money held by corporations, households and local governments. Does NOT include banks. M1: money that is very liquid such as cash, demand deposits (chequing), traveler’s checks M2: a bit less liquid; includes M1 plus savings and time deposits, certificates of deposits, money market funds M3: M2 plus long-term deposits, institutional funds and other larger liquid assets Measuring “Money Supply” https://www.boj.or.jp/statistics/outline/exp/exms.htm/ Role of Commercial Banks financial intermediary LOAN DEPOSITS DEPOSIT + interest LOAN + interest  The Price of Money Interest payment is the fee that borrowers pay to lenders for the use of their money for a certain amount of time. Interest rate is the annual interest payment on a loan as a percentage of the loan.  interest received per year  Interest rate     100  amount of the loan  market for loanable bank funds r SLoanable Funds (SAVERS) r* DLoanable Funds (BORROWERS) QLoanable Funds  The Market for Loanable Funds Market (supply & demand) for funds (money) that people / companies / organisations can borrow and lend. The supply of loanable funds comes from national saving (S). The demand for loanable funds comes from domestic investment (I) and net capital outflows (NCO).  Monetary system: Central bank Control over money supply Printing currency Serving as a banker to commercial banks Serving as a banker to the government Macroeconomic function: control (low) inflation & keep prices stable (inflation targeting) & promoting stable growth Microeconomic function: lender of last resort  Easy Monetary Policy Quantitative Easing: Implemented when the r MS MS’ economy is faced with the prospects of substantial unemployment or r* deflationary pressure r* MD MORE MONEY (stimulate economy) QM  Tight Monetary Policy Monetary Tightening: Enacted when the r MS’ MS economy is facing significant r* inflationary pressures r* LESS MONEY MD AVAILABLE QM (“COOL” THE ECONOMY)  Central Bank Tools Monetary Policy – control the money supply; targeting a rate of interest Open Market Operations Changing discount rates (the interest rate) Changing Reserve Requirements (reserve ratio for commercial banks)  Easy monetary policy: central bank policies to expand the money supply to stimulate the economy Tight monetary policy: central bank contracting of the money supply to reduce inflation and limit ‘excess’ economic activity  Open Market Operations CENTRAL BANK decides to: Money Supply Decrease SELLING GOV’T BONDS to public: “selling paper and collecting money” BUYING GOV’T BONDS from public: “buying paper and giving the public money” Money Supply Increase (treat the central bank as outside the money flow and banking system)  Reserve Requirement ratio of reserves to deposits that banks wish to hold so that they are sure to have Reserves: the money held back by the commercial banks and NOT LENT OUT enough cash to cover withdrawals by their customers  Role of Commercial Banks financial intermediary LOAN DEPOSITS to public.90.10 DEPOSIT + interest LOAN + interest Example: “US Fed” Reserve Requirements As of 1980 : reserve requirement set the same for all depository institutions 3% of the first $48.3 million of checkable deposits; 10% of checkable deposits over $48.3 million The Fed can vary the 10% requirement between 8% to 14%  Deposit Multiplier Example 10% reserve ratio Original deposit $100 $ 100 1st bank’s lending + ($100*.9) + $ 90 2nd bank’s lending + ($90*.9) + $ 81 3rd bank’s lending + ($81*.9) + $ 72.90 4th bank’s lending + ($72.90*.9) + $ 65.61 5th bank’s lending + ($65.61*.9) + $ 59.32 Etc. + … + …  Deposit Multiplier Example 10% reserve ratio  Demand for Money quantity of money people want to hold money demand: depends of the opportunity cost of holding money over time price of money you hold is the interest rate r P Demand Q QM  Money Supply r MS Money Supply is Vertical QM The Equilibrium Interest Rate r MS r* MD QM  Shift of Money Demand output (income) rises price level rises r r MS MS MD at higher Y MD at higher P MD at lower Y MD at lower P QM QM Shifts in the Money Demand Curve An increase in aggregate output (income) shifts the money demand curve, which raises the equilibrium interest rate. An increase in the price level will do the same (MD↑  r↑).  Easy Monetary Policy Quantitative Easing: Implemented when the r economy is faced with MS MS’ the prospects of substantial unemployment or deflationary pressure r* r* INCREASE IN THE MONEY MD AVAILABLE TO STIMULATE THE ECONOMY. QM  Tight Monetary Policy Monetary Tightening: Enacted when the r economy is facing MS’ MS significant inflationary r* pressures r* DECREASE THE MONEY AVAILABLE IN ORDER MD TO “COOL” THE ECONOMY. QM  Money in market for the loanable bank economy funds r r MS SLoanable Funds r* r* DLoanable Funds MD QM QLoanable Funds  Monetary Policy: Effect on Interest Rates market for loanable bank funds  Monetary Policy: Effect on AGGREGATE DEMAND  Mechanism for Monetary Policy “Transmission Mechanism” Demand for Loans & reminder through AD: Money Supply Price of Money Supply of Savings GDP = Y = C+ I + G + NX monetary policy should be countercyclical