The Role of the Government and Fiscal Policy

Transcription

1 TOPIC 4 The Rle f the Gvernment and Fiscal Plicy

2 The I-S Curve and Fiscal Plicy

3 The demand side f the ecnmy: Sme Equatins Frm Lecture 1 Y = C + I + G + NX Given the demand side f the ecnmy and definitins fr dispsable incme and gvernment deficits, we have: S(hh) + S(gvt) = I + NX S = I + NX The furth curve in ur class is the IS curve. The IS curve is s named because it dcuments the relatinship between saving and investment n the demand side f the ecnmy (hlding NX cnstant). 3

4 The IS Curve The IS curve is the representatin f the demand side f the ecnmy drawn in {Y,r} space. Highlights the relatinship between interest rates and aggregate expenditure (Y). Interest rates affect demand thrugh its affect n investment (I). Key equatin: Y = C(.) + I(.) d I r+ G + NX Remember: I = I(.) d I r (given ur linearizatin assumptin in Tpic 3) Remember: C= C(.) (given ur discussin in Tpic 3) 4

5 Furth Majr Curve f the Curse: IS curve C(.) is a functin f PVLR (Y, Y f, W), tax plicy, expectatins (i.e., cnsumer cnfidence), liquidity cnstraints. (Cnsumptin can be endgenus in mdel) I(.) is a functin f A, business cnfidence, liquidity cnstraints, uncertainty, and investment tax plicy. (Ttal investment is endgenus t ur mdel) G is a functin f gvernment plicy (we will discuss this shrtly). (G is exgenus in ur mdel.) NX will be set t zer until Tpic 8. The IS curve relates Y t r. Hw d interest rates affect Y? As r falls, Investment increases (due t MPK and firm prfit maximizatin behavir). IS curve is dwnward slping in {r, Y} space. 5

6 Demand Side Analysis (IS Curve) r r* r* Y* Y Suppse r is set by the Fed at the level f r* (we will explre this in depth later in the curse). Fr a given r, we can slve fr the level f utput desired by the demand side f the ecnmy. Ignre the supply side f the ecnmy fr awhile. Will return t it in Tpic 6. IS Nte: Y need nt equal Y* - I drew it this way fr illustrative purpses. 6

7 Sme Thughts n IS Curve What shifts the IS curve? Anything that causes C(.), I(.) r G t change (r NX when we mdel it). What shifts IS curve t the right? (i.e., makes Y higher n the demand side f the ecnmy) Increase in cnsumer cnfidence (expectatins f future PVLR) Permanent increase in stck market wealth. A permanent reductin in incme taxes (if husehlds are PIH r Keynesean) A temprary reductin in incme taxes (if husehlds are Keynesean r Liquidity Cnstrained PIH). An expected future increase in TFP (stimulates investment demand). An increase in gvernment spending (i.e., war). Changes in r WILL NOT cause IS curve t shift (causes mvement alng IS curve). 7

8 Suppse Cnsumer Cnfidence Falls Suppse cnsumer cnfidence falls (and n effect n Y*). IS curve will shift in. r C(.) falls r* r* Y 1 IS 1 Y* IS Y Assume that I(.), NX, and G d nt change (all else is equal) 8

9 Fiscal Plicy Fiscal plicy is the use f gvernment spending (G), taxes (t n, t c ) and transfers (Tr) t stabilize the ecnmy. Gvernments can have: Output targets Price targets Unemplyment targets Stabilizing the ecnmy means mving the ecnmy twards its targets. We will ignre price targets fr nw (we have n prices in ur mdel yet). Suppse the gvernment has an utput target and suppse that target is Y* (we will als explain why Y* is a gd target later in the curse). Fiscal plicy then wuld be the manipulatin f G, taxes and transfers t mve the ecnmy twards Y*. (Assumes gvernment knws where Y* is - we will discuss ther drawbacks t fiscal plicy later in the curse). 9

10 Example f Fiscal Plicy: Cnsumer Cnfidence Falls Gvernment can und the decline in cnsumer cnfidence by increasing G r decreasing t n - this is fiscal plicy r C(.) falls r* r* G increases Y 1 IS 1 Y* IS = IS 2 Y Cmpute Change in G: If ΔG = -ΔC(.), Y will remain unchanged (taking r as fixed) 10

11 A Lk at U.S. Debt and Deficits

12 U.S. FEDERAL DEFICIT (RELATIVE TO GDP)

13 U.S. FEDERAL DEFICIT (RELATIVE TO GDP)

14 U.S. TOTAL PUBLIC DEBT (RELATIVE TO GDP)

15 US FEDERAL SPENDING 2016

16 U.S. PUBLIC INTEREST PAID (RELATIVE TO GDP)

17 WHO OWNS U.S. DEBT?

18 The Cyclicality f Gvernment Budget Deficits

19 Sme Additinal Structure n Taxes and Transfers Let us start with sme definitins abut debts and deficits. Tax Revenues = t n Y (where t n is the marginal tax rate n incme) Transfers Payments = Tr g Y Ratinale fr specificatins: (where g prxies fr hw transfers g up when aggregate incme falls i.e., welfare transfers are higher in recessins) 1. When Y increases, tax revenues increase (mre earnings in ecnmy). - This is built int the tax cde. - Yu are taxed based upn what yu earn. 2. When Y increases, transfers payments fall (less peple n welfare) - This is built int ur scial prgrams. - We transfer mre mney t peple when their incme is lw. 19

20 Actual Gvernment Deficits Sme Deficit Terminlgy = Outlays (G and Tr) Revenues (T) = G + Tr g Y - t n Y = G + Tr (g + t n )Y Nte: Fr nw, ignre ther gvernment revenues and expenses (like interest n gvernment debt). See text fr further discussin if interested. Definitin: Structural Budget Deficit is the deficit that wuld exist if the ecnmy were at Y*: Structural Budget Deficit = G + Tr (t n + g)y* Nte: Difference between structural deficits and actual deficits is nly due t differences between Y and Y*. Cyclical Budget Deficits = Actual Budget Deficits - Structural Budget Deficits. Cyclical deficits ccur anytime Y des nt equal Y*! 20

21 The Nature f Deficits Deficits are cuntercyclical! (They rise when Y falls and fall when Y rises) Even if the gvernment has a plicy (cmbinatin f G and T) that wuld lead t n deficits at Y* (the target level f utput fr the ecnmy), deficits culd still ccur. The reasn: Y des nt always equal Y*. Why d we get cuntercyclical deficits? Welfare Payments, Unemplyment Insurance, and Tax System dampen the effects f cnsumptin ver the business cycle. T ges up when times are gd (like in the late 1990s). G/Tr ges up when times are bad (welfare payments). We refer t such plicies that dampen cnsumptin as autmatic stabilizers Given autmatic stabilizers (and ptentially practive gvernmental fiscal plicies), cyclical deficits seem t be an inherent part f ur ecnmy. 21

22 Shuld Gvernments Try T Prevent Deficits? Examples: U.S. Balanced Budget Amendment. Maastricht criteria fr entry t Eurpean Ecnmic and Mnetary Unin (EMU) that deficit/gdp be 3% r less and that debt/gdp be 60% r less. Benefits: Limit Spending: If spend tday, gvernment must: 1) Raise Taxes Nw (changing taxes frequently creates ecnmic uncertainty) 2) Raise Taxes in Future (higher taxes cause disprprtinately mre distrtins ) 3) Print Mney In Future (culd lead t inflatin) Is there a cst? Yes - balanced budget amendments can make ecnmic situatins wrse. Refer back t the example earlier in this lecture when cnsumer cnfidence fell. As Y fell, tax revenues fell. As tax revenues fell, deficits (cyclical) increased. If the gvernment had t balance the budget, they wuld either have t cut G r increase T - bth f which wuld cause the IS curve t shift further t the left. Cnclusin - it may be bad t have plicies requiring gvernments t eliminate all deficits, but there may be sme benefits frm eliminating structural deficits. 22

23 Gvernment Spending at Y* (mdel preview)

24 Revisiting Ptential Output (Y*) Ptential utput is the level f utput in the ecnmy when the labr market clears Frmally: Y* = A K 1-α (N*) α Where we are heading: Shrt run: perid f time when the labr market des nt clear Lng run: perid f time when the labr market clears (given A, K and ther inputs). Frm tpic 2, market clearing N* depends n: Labr Supply: PVLR, taxes, ppulatin, value f leisure Labr Demand: A and K (and eventually ther inputs like il prices) 24

25 Increase in G at Y*: Investment Adjusts LRAS = Y =Y*=f(A,K,N*) r 1 r* IS = Y=C+I+G Y* Y Suppse we start at Y* such that Y is pinned dwn by the supply side (i.e., labr markets clear, all resurces used efficiently) 25

26 Increase in G at Y*: Investment Adjusts LRAS = Y =Y*=f(A,K,N*) r 1 r* G I IS 1 = C+I 1 +G 1 IS = Y=C+I+G Y* Y Assumptin: Mdel: Assume increase in G has n effect n A (fr nw) Increase in G has n effect n N* (n effect n labr supply r labr demand (hlding A fixed)). S, n effect n Y*. 26

27 What is the Effect f Running a Deficit at Y*? Situatin 1: Crwding Out f Investment: Equatin 1: Y = C + I + G Equatin 2: S HH + S gvt = I (if NX = 0) If Y is pinned dwn by supply side f ecnmy (such that ΔY = 0 if G increases), then either C r I must fall t ffset increase in G (i.e., ΔG = - ΔI). Why wuld I fall? Increase in interest rates (we will prve nce we build a mdel f mney market). What is the effect f falling I (due t increased G) n future generatins? Lwer I tday, means lwer K tmrrw. Lwer K tmrrw means lwer Y* tmrrw (lwer ecnmic grwth). If at Y*, increase in deficit will hurt future generatins unless the deficit has a nn-trivial effect n A (given Cbb Duglas Prductin: If %ΔA > 0.3 * %Δ K, then deficit culd help future generatins.) 27

28 What is the Effect f Running a Deficit at Y*? Situatin 2: Ricardian Equivalence: Adjustment ccurs n C as ppsed t I (t keep Y at Y*) Definitin: Key: Summary: Ricardian Equivalence: Thery that states that cnsumers behavir is equivalent regardless f whether the gvernment finances G (gvt. expenditures) thrugh increased taxes r thrugh increased debt If the gvernment flats debt t finance the spending tday, cnsumers realize that the gvernment, at sme time in the future, will have t raise taxes t pay back the debt. A reductin in taxes tday (r an increase in G tday) will be seen as being accmpanied by higher taxes in the future. Husehlds will save tday t fund the future tax increases (they expect dispsable incme in the future t fall). Natinal Saving wuld remain unchanged. In terms f equatins: Y is fixed, C falls and S hh ges up (prevents crwding ut f investment ; I can stay fixed) 28

29 Des Ricardian Equivalence Hld? Fr the mst part, there is little evidence t supprt the existence f Ricardian Equivalence. Why? Mypia Liquidity Cnstraints High Levels f Impatience D nt care abut bequests/future generatins Timing f Taxes is Imprtant (taxes are nt lump sum) Even if taxes g up in the future, nly adjust savings by small amunts each perid. Fr the rest f the curse, we will assume cnsumers are nn Ricardian unless tld therwise. This means that cnsumers will nt adjust their cnsumptin dwnward tday in expectatin f an increase in taxes tmrrw. Ricardian cnsumers, hwever, wuld adjust their cnsumptin dwnward tday in expectatin f increases in taxes tmrrw (because PVLR falls) in respnse t a permanent increase in G. 29

30 Summary: Effects f Deficit Financed Gvernment Spending at Y* Benefits: Can ptentially increase future grwth if it increases future TFP (think infrastructure spending). Csts: Crwds ut private investment (which hurts future generatins) Have t pay distrtinary future taxes (which hurts future generatins) Gvernment spending is ften inefficient (which wastes resurces) Caveats: There is anther margin f adjustment in an pen ecnmy: brrw frm the wrld. Hurts future generatins because sme future incme will flw ut f the cuntry t repay the debt. Equity issues within current generatin may be imprtant but thse are separate frm deficit issues. Deficits fcus n equity acrss generatins. 30

31 Gvernment Spending During Recessins

32 Summary: Effects f Deficit Financed Gvernment Spending During Recessins Benefits: Can ptentially increase future grwth if it increases future TFP (think infrastructure spending). Can utilize slack resurces in the ecnmy If ecnmy is belw ptential, gvernment spending can generate mre utput. Csts: Crwds ut private investment (which hurts future generatins) Have t pay distrtinary future taxes (which hurts future generatins) Gvernment spending is ften inefficient (which wastes resurces) Nte: Other csts and benefits are the same as increasing G at Y* 32

33 Gvernment Spending Multiplier Tries t measure the net change in GDP tday frm a given change in gvernment spending tday. Measured by Y/ G By cnstructin, nly includes current GDP Mbilizing slack resurces Crwding ut f investment Ignres ptential future csts Des nt include ptential effects n future prductivity Des nt include effect f ptential distrtinary tax increase in future Ignres that slack resurces als have value Slack wrkers value leisure and slack machines frg depreciatin. 33

34 Hw Big Can the Multiplier Be? In the lng run (when Y = Y*), the multiplier is zer Interest rates adjust and crwds ut investment Output is pinned dwn by the supply side f the ecnmy When ecnmy is belw Y* (recessin), the multiplier can be significant Slack resurces are mbilized Interest rate effect is smaller such that investment is nt perfectly crwded ut. Output determined in part by demand side f the ecnmy. This simple mdel underlies the ld Keynesian intuitin ften seen in the ppular press advcating increased gvernment spending during recessins. 34

35 A Simple Mdel f a Gvernment Spending Multiplier Fcus n demand side nly (n link t supply side) Assume interest rates d nt adjust t change in gvernment spending A crazy assumptin (we will mdel interest rates next week). Nt s crazy when interest rates are stuck at zer (what ecnmists call the Zer Lwer Bund). Ignring interest rate changes assumes away the crwding ut f investment. Assume cnsumers d nt adjust spending t changes in gvernment spending. Implies cnsumers are nt Ricardian. 35

36 Why is There a Ptential multiplier When Y < Y*? Suppse we have the fllwing mdel: C = a + b(y T) I = I 0 I 1 r T = t n Y << assume sme fractin f cnsumers are liquidity cnstrained s they act Keynesian>> <<Investment is negatively related t interest rates>> <<Marginal tax rate n labr incme>> Other assumptins: Transfers = 0 ; G = G 0 ; Y << Y* ; clsed ecnmy (NX = 0 always) What is the equilibrium level f Y? Y = C + I + G = a + b(y t n Y) + I 0 I 1 r + G 0 Slve fr Y (Use algebra ne equatin, ne unknwn) Y = [a + I 0 I 1 r+ G 0 ] / [1-b(1-t n )] 36

37 What is the private sectr multiplier in the Simple Mdel? Given the Simple Ecnmy n Previus Page: Y = [a + I 0 I 1 r+ G 0 ] / [1-b(1-t n )] What is the multiplier f a change in gvernment spending (G) n Y? dy/dg = 1/[1-b(1-t n )] What is b? Sme estimates range frm in recessin. Where are the estimates frm? -- Micr data analyzing tax rebates (a change in taxes nt a change in gvernment spending). What is t? Marginal tax rate rughly What is the gvernment spending multiplier in this simple mdel? dy/dg is apprximately 1.3 (if b = 0.35, t=0.3) 37

38 The Simple Keynesian Multiplier Upper bund n the true (r net) gvernment spending effect n utput. Ignres the crwding ut f investment by hlding interest rates fixed. Ignres cnsumer respnses by impsing Ricardian equivalence. Ignres any supply side effects (prices may adjust mre n that when we build a mdel f prices). Gvernment spending multipliers will be higher in recessins Mre slack resurces can be mbilized withut crwding ut investment. 38

39 Estimated Gvernment Plicy Multipliers in the Data Typically estimated by lking at crrelatin between G and Y in time series data. Difficult because gvernment mainly tries t stimulate ecnmy in recessins (build in negative crrelatin) Hwever, need t fcus n gvernment spending in recessins because multipliers are different when Y=Y* and Y < Y*. Hard t d prper cunterfactuals Tw famus papers using wars as instrument: Christy Rmer: 1.6; Rbert Barr: 0.6. Sme recent studies lk at state-level spending Large multipliers; But, by cnstructin, n interest rate respnse (n crwding ut) 39

40 My Thughts 1. In the lng run, multiplier clse t zer Output determined by supply side f the ecnmy Mst gvernment spending des nt increase TFP 2. In recessins, multiplier psitive but likely small Output determined by demand side f ecnmy (utilizes idle resurces) But typically interest rates adjust, s investment partially crwded ut. Als, inefficiencies likely t be huge hw d yu spend $800 billin quickly and efficiently. 3. Often a mismatch between slack resurce effect and increasing TFP effect Lts f slack resurces in Detrit. D we need mre rads in Detrit? 40

41 Tax Cuts During Recessins Anther way t stimulate the ecnmy during recessin is cut taxes Cnsumptin: labr incme taxes, cnsumptin taxes Investment: crprate incme taxes, investment tax credits Cmmn view is that tax cuts are less effective at stimulating GDP (fr a given $1 increase in deficit) Lwer bang fr buck D nt get direct effect f gvernment spending Recent research says they can be effective: Tax rebates t husehlds (C) Firms are very respnsive t bnus depreciatin allwance (I) Different efficiency trade-ffs (less wasteful, n direct effect n TFP) 41

42 Definitin: Supply Side Ecnmics

43 Supply Side Ecnmics Any fiscal plicy designed t stimulate the supply side f the ecnmy (A, K and N) Examples: 1) Changing marginal tax rates (stimulate N) As discussed befre, these plicies may nt have big effects (ff setting incme effects and substitutins effects ; empirically small estimates f labr supply respnse). 2) Subsidizing A and K (investment tax credits, research and develpment subsidies, subsidizing educatin, etc.) These prgrams have been shwn as being effective ways t prmte ecnmic grwth within an ecnmy. 43

44 A Discussin f Inequality

45 Inequality Mania Recent empirical wrk shwing inequality is increasing: Incme inequality (Kevin Murphy, Larry Katz, Emmanuel Saez, Thmas Piketty, Ed Glaeser). Cnsumptin Inequality (Steve Davis, Me) Emplyment Inequality (Kevin Murphy, Bb Tpel, Me) Wealth Inequality (Thmas Piketty, Emmanuel Saez) What are the causes f increased inequality? Is increased inequality detrimental t a sciety? 45

46 Thmas Piketty Capital in the Twenty First Century Bk: Capital in the Twenty First Century - Wrldwide best seller. Dcuments wealth inequality increases arund the develped wrld. Claim: ecnmic cnditins are such that eventually mst wealth will be cncentrated in the hands f the rich. Frces will cntinue t make inequality grw. Reasn: rate f return n capital > incme grwth (i.e., r > g) Plicy prescriptin: Tax wealth What we will d: Walk thrugh the Piketty argument and discuss necessary assumptins (and plausibility f assumptins). Draw n discussin by Justin Wlfers ( 46

47 U.S. Incme Inequality: Tp 10% Kuznet s Curve 47

48 Crss-Cuntry Incme Inequality: Tp 1% 48

49 OECD Crss-Cuntry Incme Inequality: Rati 49

50 U.S. Wealth Inequality 50

51 Sme Key Ingredients fr the Piketty Stry t hld An identity: Define ω t as the capital share f ttal incme in year t. By definitin, that is: t r t * K Y t t This is nt cntrversial. By definitin: Y ( w / p ) N r K t t t t t t Nte: Under a Cbb-Duglas prductin functin, ω t =1-α and is fixed ver time (at sme number like 0.3). Nte: r t is an average return acrss different types f capital. 51

52 Sme Key Ingredients (in bld) fr the Piketty Stry t hld Start with ur identity and assume interest rates are cnstant ver time: t r K Y t t Assume there is n depreciatin f the capital stck such that ΔK t = I t : Kt 1 t r Yt I t Assume saving is a cnstant fractin f incme (remember S = I): K s Y t 1 t r Yt t 52

53 Sme Algebra.(and ne mre assumptin) Kt 1 t r Yt sy t ( Kt 2 s Yt 1) s Yt t r Yt Assume Y grws at a cnstant rate g Kt 2 s (1 g) Y t s Y t r Y t t 2 t 3 s ( 1 g) Yt ( 1 ) t r Yt K s g Y s Y r t t (1 g)t t 0 s Y Y t t 53

54 Piketty s Argument s t r g Piketty argues that g will fall ging frward due t technlgical prgress slwing dwn r aging f ppulatin. Since r and s are assumed fixed, this will increase the capital share ging frward Since rich wn capital, this will increase share f ttal incme accruing t the rich Cncludes increasing inequality as a fundamental law f capitalism 54

55 Three Key Ingredients f Piketty s Argument s t r g Interest rates are cnstant ver time In ur mdel, interest rates equal MPK As capital increases, MPK falls, s interest rates fall (lwer capital share) 55

56 Three Key Ingredients f Piketty s Argument r t s g N depreciatin f capital stck Capital stck depreciates ver time Crrect frmula with depreciatin: s t r g Implies capital share rises mre slwly as g decreases (mre capital investment is needed t replace depreciated capital) 56

57 Three Key Ingredients f Piketty s Argument s t r g Natinal saving is a cnstant fractin f incme Savings nt cnstant Accrding t PIH, as PLVR f rich increases ging frward, savings rate will decrease (cnsume mre tday). Rich will eat sme f their extra anticipated future incme. 57

58 Sme Other Issues Mst f the increased inequality within the U.S. NOT due t changes in capital incme. The rich are getting richer because f labr incme. Hw d we think abut labr incme vs. capital incme fr the really rich? High salary grwth in finance, skilled prfessinals, CEOs, etc. Has nthing t d with the increase in capital incme. D we nly care abut the tp 1% (r 10%) relative t the median? What abut the gap between the 75 th percentile and the 25 th percentile? That has grwn dramatically as well (cllege vs. nn-cllege premium). What is the ptimal plicy respnse if we care abut inequality? Taxing the rich? Helping t educate the pr? Allwing high skilled immigratin? 58

59 Outside Piketty: Sme Final Thughts Are there benefits t incme inequality? In human capital mdels, unequal returns t skill are necessary t induce peple t invest in human capital. The widening inequality in earnings and the buyant demand fr skilled wrkers als indirectly encurages greater grwth in the ecnmy by increasing the incentives fr yung peple t invest in themselves. Gary Becker, The Ecnmics f Life 59

60 Outside Piketty: Sme Final Thughts Is incme inequality detrimental t sciety? The ecnmic literature has fcused n dcumenting trends in inequality and mdeling the determinants f incme inequality. Hwever, the cnsequences f inequality are relatively understudied due t sme challenges in research design. Hw d we think abut: The health f scieties that are unequal? Intergeneratinal mbility? Incme segregatin (d pr and rich peple chse t live next t each ther)? Plitical participatin (wh vtes? wh gives mney t candidates?) 60