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902mit03.pptIntroduction to Macro Policy and Models

Fiscal Policy:

Government Taxation,

Spending and Deficit

Impacts on the Macroeconomy

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902mit03.ppt

Focus Today

Setting up the questions regarding fiscal policy

Understanding preliminary answers and their basis

Applying this knowledge to a contemporary issue, the emergence of a budget surplus following huge deficits

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902mit03.ppt

The Central Model

The Key Behavioral Actors:– Domestic Households, buying

consumer goods and housing– Domestic Businesses, buying machines

or building factories & offices or stocking goods in inventory

– Foreign buyers and suppliers– Some Government Agencies Whose

Behavior is “Regular”

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902mit03.ppt

The Central Model

The Key Exogenous Influences– Domestic Government tax, transfer and

purchasing decisions (that change on an irregular basis)

– Domestic Central Bank “control” of the money supply and interest rates

– The International Counterparts to these– International Commodity Markets and

Cartel Behavior

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902mit03.ppt

A First Model

7 Endogenous/ Behavioral Variables (Including ID’s) and 7 Equations– Consumer Spending : C=f ( YD, i ) – Business Spending : I = f ( d GNP, i)– Imports : M = f ( C, I , i )– Exports : X = f ( GNPW, i )– Total Output=Spending :

GNP = C+I+X-M+G

– After-tax Income : YD = GNP - T– Inflation : R P = f ( GNP )

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902mit03.ppt

A First Model

4 Exogenous/Policy Variables– Government Purchases : G– Taxes (Net of Transfers) : T– Interest Rate : i– Rest-of-World Demand : GNPW

Omitted Variables– Wealth– Supply Capacity

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902mit03.pptThe Reduced Forms of the 7 Behavioral Equations

C=C ( G, T, i, GNPW ) I = I ( G, T, i, GNPW ) M = M ( G, T, i, GNPW ) X = X ( G, T, i, GNPW ) GNP = C+I+X-M +G

= GNP ( G, T, i, GNPW ) YD = GNP - T RP = RP ( GNP) = RP( G, T, i, GNPW )

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902mit03.pptThe GNP Reduced Form Equation is a Useful Summary

GNP = C+I+X-M +G= GNP ( G, T, i, GNPW )

i=INTERESTRATE

GNP2=GNP(G2,T1)

GNP1=GNP(G1,T1)

GNP=NATIONAL SPENDING/OUTPUT

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902mit03.pptThe GNP Reduced Form Equation is a Useful Summary

GNP = C+I+X-M +G= GNP ( G, T, i, GNPW )Why does GNP=GNP(i) slope down?

Both Consumers (C) and Businesses (I) spend less if credit costs are higher.Higher interest rates tend to boost the exchange rate, which cuts Exports (X) and boosts Imports (M)

How do changes in G, T shift GNP(i)?For any given C or I , less G subtracts from GNP, and sets up multiplier, feedback effectsExtra T reduces YD which reduces C and thus cuts GNP.

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902mit03.pptIf interest rates are fixed at i1, reducing G cuts GNP by a “multiple” of G

GNP = C+I+X-M +G= GNP ( G, T, i, GNPW )

i=INTERESTRATE

GNP2=GNP(G2,T1)

GNP1=GNP(G1,T1)

GNP=NATIONAL SPENDING/OUTPUT

i1

GNP2 GNP1

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902mit03.pptWhat if lower GNP implies lower i due to Fed or market reactions?

i=INTERESTRATE

GNP2=GNP(G2,T1)

GNP=NATIONAL SPENDING/OUTPUT

i=i(GNP)

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902mit03.ppt

i1

i2

GNP2 GNP1

What if lower GNP implies lower i due to Fed or market reactions?

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902mit03.pptWhat if the Fed has a strict inflation target and thus a fixed GNP target?

i1

i2

GNP2 GNP1

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902mit03.pptDeficit ReductionWill Change the Economy

But it might not boost unemployment. What sectors will offset lower G? What does the Fed need to do? What might change the equilibrium level

of GNP? Who gains and loses, considering

incomes, wealth, skill-building? Is a constitutional amendment necessary?

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902mit03.ppt

Build a Model

Build a basic model of an economy from the following description:1. Businesses

For each $100 dollars of revenue (GDP) they receive, they have costs and profits of: GDP$75 wages W$25 profit, and this is paid as dividends to consumer households Profit=DividendThey buy new plant and equipment equal to profits each year, plus I

$10 extra(less) for each 1 percentage point the interest rate is below(above) 5%.r (interest rate)Hint: r, the interest rate, enters the equations as a whole number like 4,5, or 6 and not .04, .05, .06.

2. Consumers Pay a flat 1/3 of their gross wages and profits in taxes. W, Profit, TBuy consumer goods equal to 75% of their after-tax wage and dividend income, EXCEPT....C...they reduce purchases by $20 for each 1 percentage point interest rates exceed 5% r (interest rate)

( and symmetrically raise purchases when rates fall below 5%)Hint: r, the interest rate, enters the equations as a whole number like 4,5, or 6 and not .04, .05, .06.

3. GovernmentThe Government buys $250 in goods. GNo taxes other than income taxes are collected. T

4. Foreign Buyers and Sellers are excluded from this first economy.

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902mit03.ppt

Build a Model

T=(1/3)*(W+D)C=(3/4)*(W+D-T)-20*(r-5)=((3/4)*(2/3))*(W+D)-20*(r-5)W=.7*GDPD=.3*GDPI=.25*GDP-10*(r-5)Reduced form equation: the endogenous variable is a function of only exogenous variablesGDP=C+I+Gsubstitute for W, D to derive the C reduced form equationC = ((3/4)*(2/3))*(W+D)-20*(r-5)

= ((3/4)*(2/3))*(.7*GDP+.3*GDP)-20*(r-5) = .5*GDP - 20r + 100

simply the I function to derive the I reduced form equationI = .30*GDP-10*(r-5)

= .30 * GDP - 10*r + 50Add together to obtain the GDP reduced form equation----the "IS" curveGDP = .5*GDP - 20r + 100 + .30 * GDP - 10*r + 50 + G

= .80* GDP - 30 r + 150 + G= 750 + 5 G -150 r

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902mit03.ppt

Build a Model

GDP = .5*GDP - 20r + 100 + .30 * GDP - 10*r + 50 + G= .80* GDP - 30 r + 150 + G= 750 + 5 G -150 r

Change G in Year 4 and note the results

Year 1 2 3 4 5 6 7 8 9 10 C 625 625 625 500 500 500 500 500 500 500 I 375 375 375 300 300 300 300 300 300 300 G 250 250 250 200 200 200 200 200 200 200 GDP 1,250 1,250 1,250 1,000 1,000 1,000 1,000 1,000 1,000 1,000 W 875 875 875 700 700 700 700 700 700 700 D 375 375 375 300 300 300 300 300 300 300 T 417 417 417 333 333 333 333 333 333 333 W+D-T 833 833 833 667 667 667 667 667 667 667

r 5 5 5 5 5 5 5 5 5 5

change in GDP from year 1 - (250) (250) (250) (250) (250) (250) (250) change in G from year 1 - (50) (50) (50) (50) (50) (50) (50) multiplier 5.0 5.0 5.0 5.0 5.0 5.0 5.0

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902mit03.ppt

Build a ModelNow, assume no lag in consumer response to income and ratesAssume a 1 year lag in business response to profit and rates

Year 1 2 3 4 5 6 7 C 625 625 575 545 527 516 510 I 375 375 375 345 327 316 310 G 250 250 200 200 200 200 200 GDP 1,250 1,250 1,150 1,090 1,054 1,032 1,019 W 875 875 805 763 738 723 714 D 375 375 345 327 316 310 306 T 417 417 383 363 351 344 340 W+D-T 833 833 767 727 703 688 680

r 5 5 5 5 5 5 5Note the multiplier starts at 2 and rises toward 5.

change in GDP from year 1 (100) (160) (196) (218) (231) change in G from year 1 (50) (50) (50) (50) (50) multiplier 2.0 3.2 3.9 4.4 4.6

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Build a Model

Year 9 10 11 12 13 14 15 16 17C 503 542 563 576 584 588 591 593 594 I 303 302 323 336 344 348 351 353 354 G 200 200 200 200 200 200 200 200 200 GDP 1,007 1,044 1,087 1,112 1,127 1,136 1,142 1,145 1,147 W 705 731 761 778 789 795 799 802 803 D 302 313 326 334 338 341 343 344 344 T 336 348 362 371 376 379 381 382 382 W+D-T 671 696 724 741 751 758 761 763 765

r 5 4 4 4 4 4 4 4 4

change in GDP from year 1 (243) (206) (163) (138) (123) (114) (108) (105) (103) change in G from year 1 (50) (50) (50) (50) (50) (50) (50) (50) (50) multiplier 4.9 4.1 3.3 2.8 2.5 2.3 2.2 2.1 2.1

Now, let interest rates respond to GDP, dropping from 5% to 4%: