RAINER MAURER, Pforzheim Prof. Dr. Rainer Maurer. RAINER MAURER, Pforzheim. Prof. Dr. Rainer Maurer. RAINER MAURER, Pforzheim

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1 Macroeconomics Macroeconomics Macroeconomics The Keynesian Model with Capital Market side Shocks Reduction of the Propensity to Consume Reduction of the Propensity to Invest Consequences for the Labor Market 4.3. Fiscal and Monetary Policy in the Keynesian Model Fiscal Policy 4.4. The Long-run Implications of the Keynesian Model 4.5. Policy Conclusions Case Study: Fiscal Policy in Germany Limits of Government Debt Case Study: Economic Policy in the Great Recession 4.6. Questions for Review The Crisis of Neoclassical Theory Until the world economic crisis of 1929, the neoclassical model was the consensus model of market oriented economists. This appraisal of the neoclassical theory was altered by the world economic crisis. Such a sharp and lasting break of economic development was inconsistent with the neoclassical hypothesis of the immanent stability of market economies. Rising unemployment, bankrupt companies and decreasing incomes caused social problems that called for new solutions Literature: Macroeconomics Chapter 9, 10, 11, 13, 14 Mankiw, Gregory; Macroeconomics, Worth Publishers. Kapitel 10, Baßeler, Ulrich et al.; Grundlagen u. Probleme der Volkswirtschaft, Schäfer-Pöschel. The World Economic Crisis Cause of the crisis was the collapse of the New ork Stock Exchange at October 24 in Cause of the stock market collapse was an overvaluation of stocks (speculative bubble), which was driven by upcoming new technologies similar to the New-Economy-Crash (or "dotcom crash") at the start of Surprising and new was, however, not the stock market collapse but its long and lasting effect on the real economy

2 The Development of the Dow Jones Index Quelle: Such a strong and sustained collapse of the economic development was contradictory to basic results of the neoclassical theory: As analyzed in Chapter 2, a reduction of consumption should increase savings supply and reduce the interest rate, such that investment demand grows and compensates for the decrease of consumption. However, during the world economic crisis, not only consumption demand but also investment demand decreased, because of the worsening of economic prospects of firms. As a result, the saved money was not invested but hoarded. In such a case, the neoclassical model predicts a demand gap on the market for goods, which causes a decrease of the price level for goods P. This reduction of goods prices should increase the value of real money supply (M/P ), so that the capital market interest rate decreases i. This decrease of the interest rate should then cause an increase of consumption C(i ) and investment goods demand I(i ). This built-in stabilization mechanism (called Pigou Effect ) should restore the economic equilibrium after a demand shock has hit the economy The analysis of demand shocks in the neoclassical model has revealed that a reduction of consumption demand should lead to an increase in savings, which should reduce the interest rate such that demand for investment goods grows and replace the reduction in consumption (and vice versa). This mechanism did not work in the world economic crisis! Hence according to the neoclassical theory, the self-healing capacities of a market economy should autonomously overcome a collapse of the demand for goods. However, these forces did not work: From 1929 to 1932 production of goods and services decreased by more that 10% per year. Even though the price level for goods decreased, consumption and investment demand did not grow, because people expected a further decrease in prices and postponed consumption and investment into the future. Production of firms simply adjusted to this lower demand. The result was a self-reinforcing deflation spiral : A further decrease of the demand for goods! The self-healing capacities of the neoclassical theory failed

3 The Keynesian Theory Under these historical circumstances John Maynard Keynes developed his new macroeconomic theory, which was intended to explain the consequences of the world economic crisis and to deliver economic policy recommendations appropriate to overcome such a crisis. This theory was published in a book with the title General Theory of Employment, Interest and Money (1936). In this book, Keynes contested two basic assumptions of the neoclassical theory by assuming that 1. in the short run, goods prices are fix, so that they cannot decrease in case of a reduction of goods demand. As a consequence, he assumed that instead of goods prices the supply of goods adjusts to changes in demand = Keynesian Price Rigidity. 2. household consumption is only a positive function of household income C( ) ; the negative impact of the interest rate C(i ) can be neglected = Keynesian Consumption Function. = C(i ) = Neoclassical Consumption Function Quelle: SVG (2003), eigene Berechnungen The Keynesian consumption function C( ) corresponds at first sight much better to empirical observations as the neoclassical consumption function C(i ). The empirical correlation between consumption and income is in deed much stronger than the empirical correlation between consumption and interest rates, as the following graphs demonstrate: The second basic difference between Keynesian and neoclassical theory is the so called Keynesian Price Rigidity : In neoclassical theory, an increase of production output causes an increase of marginal costs, so that firms increase their prices (and vice versa). Consequently, an increase of the demand for goods causes an increase of the prices of goods (and vice versa). In Keynesian theory, firms do not immediately adjust their prices to production output: An increase (decrease) of the demand for goods causes a corresponding increase (decrease) of the supply of goods. The prices of goods stay however constant. Who is right Keynes or the Neoclassics? An large-scale empirical study of the European Central Bank has led to the following result: Percentage Distribution of Firms According Their Frequency of Price Adjustments per ear = C( ) = Keynesian Consumption Function Survey Period ; Sample Size Firms; BE = Belgium, DE= Germany; FR=France, IT=Italy LU= Luxembourg, NL=Netherlands, AT=Austria, PT=Portugal Quelle: SVG (2003), eigene Berechnungen Prof. Quelle: Dr. Rainer Maurer The Pricing Behavior of Firms in the Euro Area, EZB (2005)

4 Athor Surveys for other countries display similar results: Sample Period Industry Sector Average Change per ear: Carlton (1986) US Manufacturing Firms 1,2 Cecchetti (1986) US Newspapers 0,2 Blinder (1991) US Firms 1 Kayshap (1995) US Mail-Order Companies 0,8 Dahlby (1992) Canadian Insurances 0,8 Bank of England (1996) UK Firms The costs per price change will typically be constant or slightly increasing, if the number of price changes per year grows. Costs per Price Change Number of Price Changes per ear 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6, From these and similar studies follows: Firms do not immediately adjust their prices to changes in costs. Instead, they keep their prices constant over a longer period of time just as assumed by Keynes. The costs per price change will typically be constant or slightly increasing, if the number of price changes per year grows. If firms try to maximize their profits, they should in principle change their prices when their costs change. Why then do firms not change their prices more often? 3 6 Costs per Price Change Number of Price Changes per ear ,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6, Why do prices not change more often? In reality, changing prices causes costs: Internal organizational costs: Information of staff members, distribution chains, sales agents External communication costs: Explication and justification of price changes to clients Technical costs: printing costs of pricelists, mailing expenses If the costs per price change are higher than the return of a price change, a continuous adjustment of prices is not profit maximizing, as the following diagram shows: The return of 1 price change every 2 years will normally be quite high, since it is very likely that significant changes of production costs and demand strength will occur within a time span of 2 years. The return per price change will typically decrease, if the number of price changes per year grows. The return of 4 price changes per year will normally be lower, since it is not so likely that significant changes of production costs and demand strength will Return occur per every quarter Price Change Number of Price Changes per ear 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0-24 -

5 Return of an additional price change higher than costs Costs per Price Change Profit at 2 adjustments of prices per year => Profit maximizing number of price changes per year = 2 Costs per Price Change More often price changes profitable Return per Price Change Number of Price Changes per ear Return per Price Change Number of Price Changes per ear 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6, ,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0 => The higher the costs per price adjustment, the lower the number of profit maximizing price adjustments per year! Return of an additional price change lower than costs Costs per Price Change Return per Less often price Price Change change profitable Number of Price Changes per ear Costs per Price Change 2 Costs per Price Change 1 Return per Price Change Number of Price Changes per ear 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6, ,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0 Alternative explanation based on total cost and total return functions: => Profit maximizing number of price changes per year = 2 Costs per Price Change 9 Total Costs of Price Changes Return per Price Change Number of Price Changes per ear 6 3 Costs per Price Change Number of Price Changes per ear 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6, ,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0

6 Alternative explanation based on total cost and total return functions: Total Profit Maximum Total Costs Total Return of Price Changes Total Costs of Price Changes Anzahl der Preisanpassungen pro Jahr 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0 If we add now the Keynesian consumption function C() we receive the following relationship: = C() + I + G Obviously, this is a circular relationship: GDP depends on consumption C() and consumption C() depends on GDP and so on As the following analysis will show, this circular relationship can boost the effects of economic policy (but complicates a bit the graphical analysis ) As the diagrams show: It is possible to explain, why firms on average do not change their prices more often than one time per year with the standard microeconomic profit-maximization behavior: An optimal adjustment of prices according to the current demand and supply situation causes an additional return. But this return has to be compared to the additional costs caused by the price adjustment. Only if the additional return is larger than the additional costs, a price adjustment is actually profitable. Depending on the relation between the costs and return of a price change it can be profit-maximizing to hold prices on average constant for a time span of a year or even longer. Macroeconomics Rigid price setting and profit maximization are compatible! The Keynesian theory assumes therefore that in the shortrun (= within a time span of one year) firms keep their prices constant: P = constant within one year If the demand for goods changes in the short-run, firms do simply adjust their production instead of prices to the demand for goods. Consequently, in the short-run firms' production of goods is always equal to the sum of households consumption demand C plus firms demand for investment goods I plus government consumption demand G: = C + I + G Consequently, in the short-run demand for goods determines supply of goods! Since prices are constant and supply always adjust to demand the following equation always holds in the Keynesian model: For simplicity we will first assume that I and G are constant. What exactly means C()? Example: Let the consumption rate be: c = 50% and = 100 :

7 Solving the equation for reveals that under these assumptions GDP depends on investment and government consumption only: This means Everything that increases demand increases GDP : Restriction: This government consumption multiplier is only valid, if government consumption is financed with credits. As can be mathematically proven, financing government consumption with taxes yields a multiplier of exactly 1 under Keynesian assumptions This means Everything that increases demand increases GDP : An increase in investment by1, increases GDP by 1/(1-c) c = 50% An increase in investment by1, increases GDP by 1/(1-0,5)= Quelle: Kapitalismus für Anfänger Sachcomic, rororo The investment multiplier at work This means Everything that increases demand increases GDP : Graphical exposition of these considerations: G C()= 0,5 * An increase in government consumption by1, increases GDP by 1/(1-c) c = 50% An increase in government consumption by1, increases GDP by 1/(1-0,5)= Supply of = Production of = Income =

8 Consumption (C) dependent on GDP () C()= 0,5 * At what level of income () does the total demand for goods equal income? D = 0,5*+G+I C() + G = 0,5*+G C() = 0,5 * At what level does income generate a demand for goods, which is again equal to the level of income? = Where does the equation 0,5*+G+I = hold? Supply of = Production of = Income = Supply of = Production of = Income = Government Consumption = G = 5 C() + G = 0,5*+G C()= 0,5 * Every point on this 45 -line implies: = Supply of Supply of = Production of = Income = = I = 5 D = 0,5*+G+I C() + G = 0,5*+G C()= 0,5 * Supply of = Production of = Income = The 45 -line reveals the solution: D = 0,5*+G+I C() + G = 0,5*+G C()= 0,5 * Supply of = Production of = Income = Supply of = Production of = Income =

9 Digression: Stability Properties of the Market for D = 0,5*+G+I = 5 Gov. Consumption = 5 D = 0,5*+G+I C() + G = 0,5*+G C()= 0,5 * Consumption = 0,5 * (20) = 10 = 25 Supply of = 30 Excess Supply = 5 Since supply (GDP) adjusts to demand, supply falls to the lower demand level =25 Supply of = Production of = Income = Supply of = Income = Digression: What happens, if supply of goods is larger than the 3. Das keynesianische Modell der Volkswirtschaft equilibrium value = if there is excess supply? 3.1. Die Struktur des keynesianischen Modells The following digression shows that in this case an adjustment process takes place. Digression: Stability Properties of the Market for D = 0,5*+G+I Since supply of goods under Keynesian assumptions always adjusts to demand for goods, supply falls until it equals demand: Excess Supply = 5 = 25 Supply of Since supply (GDP) adjusts to demand, supply falls to the lower demand level =25 F49-F Supply of = Income = Digression: Stability Properties of the Market for D = 0,5*+G+I Digression: Stability Properties of the Market for D = 0,5*+G+I Excess Supply = 5 Supply of = 30 What happens, if supply of goods is larger than the equilibrium value =20? = 25 New Supply of = 25 Since supply (GDP) adjusts to demand, supply falls to the lower demand level =25 Supply of = Income = Supply of = Income =

10 Digression: Stability Properties of the Market for D = 0,5*+G+I Digression: Stability Properties of the Market for D = 0,5*+G+I = 22,5 Supply of = 25 Excess Supply = 2,5 Since supply (GDP) adjusts to demand, supply falls to the lower demand level =25 Supply of = 30 We observe this kind of adjustment process if supply is larger than demand Supply of = Income = Supply of = Income = Digression: Stability Properties of the Market for D = 0,5*+G+I Digression: Stability Properties of the Market for D = 0,5*+G+I = 22,5 New Supply of = 22,5 Excess Supply = 2,5 Since supply (GDP) adjusts to demand, supply falls to the lower demand level =22,5 = 20 Supply of = 20 We observe this kind of adjustment process if supply is larger than the equilibrium value of =20 Supply of = Income = Supply of = Income = Digression: Stability Properties of the Market for D = 0,5*+G+I Digression: What happens, if supply of goods is smaller than the 3. Das keynesianische Modell der Volkswirtschaft equilibrium value = if there is excess demand? 3.1. Die Struktur des keynesianischen Modells The following digression shows that in this case an adjustment process takes place. = 21,25 Supply of 22,5 Excess Supply = 2,5 and so on until = 20 is reached! Since supply of goods under Keynesian assumptions always adjusts to demand for goods, supply grows until it equals demand: Supply of = Income =

11 Digression: Stability Properties of the Market for D = 0,5*+G+I Digression: Stability Properties of the Market for D = 0,5*+G+I What happens, if supply of goods is smaller than the equilibrium value =20? In this case, we observe the opposite adjustment process Supply of = 10 Supply of = Income = Supply of = Income = Digression: Stability Properties of the Market for D = 0,5*+G+I Digression: Stability Properties of the Market for D = 0,5*+G+I = 15 Supply of = 10 Excess = 5 Since supply (GDP) adjusts to demand, supply grows to the higher demand level =15 To sum up: No matter whether supply is larger or smaller than demand, an adjustment process results such that supply finally equals demand. Supply of = Income = Supply of = Income = Digression: Stability Properties of the Market for D = 0,5*+G+I Digression: Stability Properties of the Market for D = 0,5*+G+I = 20 Supply of = 20 In this case, we observe the opposite adjustment process This means: The equilibrium point =20 is stable! Supply of = Income = Supply of = Income =

12 What happens now, if the equilibrium on the market for goods is disturbed by a sudden increase in investment demand? Increase in by 5 D = 0,5*+G+I+ΔI D = 0,5*+G+I C() + G = 0,5*+G C()= 0,5 * Increase in GDP by 10 = 5 * (1/(1-0,5)) Supply of = Income = D = 0,5*+G+I C() + G = 0,5*+G C()= 0,5 * How strong is GDP-growth, if investment grows by 5? Increase in investment by 5 Consumption = 0,5*20 = 10 D = 0,5*+G+I+ΔI D = 0,5*+G+I C() = + 10 G = 0,5*+G C()= 0,5 * Gov. Consumption = 5 Growth of Consumption = 5 Consumption = 0,5 * 30 = 15 Supply of = Income = Supply of = Income = Increase in by 5 D = 0,5*+G+I+ΔI D = 0,5*+G+I C() + G = 0,5*+G C()= 0,5 * How strong is GDP-growth, if investment grows by 5? Increase in by 5 D = 0,5*+G+I+ΔI D = 0,5*+G+I C() + G = 0,5*+G As implied C()= by the 0,5 investment * multiplier 1/(1-c), a consumption ratio of c = 50% together with an increase in investment by 5 causes GDP to grow by 10 = 5 * (1/(1-0,5)) = 5 * 2. Supply of = Income = Supply of = Income =

13 The following diagram graphically illustrates the multiplier effect: D = 0,5*+G+I+ΔI D = 0,5*+G+I 3rd: Increase in Consumption by c*δ = 0,5 * 5 = 2,5 C() + G = 0,5*+G Increase in by 5 C()= 0,5 * What causes the multiplier effect? Supply of = Income = D = 0,5*+G+I+ΔI D = 0,5*+G+I D = 0,5*+G+I+ΔI D = 0,5*+G+I Increase in by 5 1st: Increase in C() + G = 0,5*+G by 5 C()= 0,5 * What causes the multiplier effect? Increase in by 5 4th: Increase C()= C(-T) in Income 0,5*+G + by G Δ = 2,5 C()= 0,5 * What causes the multiplier effect? Supply of = Income = Supply of = Income = Increase in by 5 D = 0,5*+G+I+ΔI D = 0,5*+G+I C() + G = 0,5*+G 2nd: Increase in Income C()= 0,5 * by 5 = Δ What causes the multiplier effect? Increase in by 5 D = 0,5*+G+I+ΔI 5th: Increase D = 0,5*+G+I in Consumption by c*δ = 0,5 * 2,5 = 1,25 C() + G = 0,5*+G C()= 0,5 * What causes the multiplier effect? Supply of = Income = Supply of = Income =

14 D = 0,5*+G+I+ΔI D = 0,5*+G+I etc... C() + G = 0,5*+G Increase in by 5 C()= 0,5 * => The primary increase in investment demand by 5 is multiplied by the additional increase in consumption demand by factor 2 = 1/ (1-0,5). Supply of = Income = How would Keynes argue? Verbal Description of the Multiplier Process: An increase in investment demand by 5 causes an increase in total supply (which does always adjust to total demand) by 5. This causes an increase in household income by 5. This increase in income by 5 and a consumption ratio of 50 % causes an increase in consumption by 0,5 * 5 = 2,5. This increase in consumption demand by 2,5 causes an increase in total supply by 2,5. This causes an increase in household income by 2,5. This increase in income by 2,5 and a consumption ratio of 50 % causes an increase in consumption by 0,5 * 2,5 = 1,25. This increase in consumption demand by 1,25 causes in increase in total supply by 1,25. This causes an increase in household income by 1,25. This increase in income by 1,25 and a consumption ratio of 50 % causes an increase in consumption by 0,5 * 1,25 = 0,625, and so on This example shows: If it is possible to increase investment, GDP will grow as a result by a magnitude that is 1/(1-c) as high as the increase in investment. The same holds, if government consumption grows: If government consumption (financed by credits) grows, GDP will grow as a result by a magnitude that is 1/(1-c) as high as the increase in government consumption. Consequently, if the consumption ratio equals c = 0,89 (as for Germany), the multiplier equals 1/(1-0,89) = 9,09. Given the assumptions made, the government can arbitrarily increase GDP! Since the production of GDP needs labor input, the government is able to arbitrarily increase the demand for labor! However, this holds only as long as firms keep their prices constant and adjust their supply to demand, i.e. within a period of one year! Digression: Will GDP explode? The3. graphical Das keynesianische exposition seems to indicate Modell that der the Volkswirtschaft growth of GDP will go on forever, since 3.1. households Die Struktur increase des keynesianischen their consumption additionally Modellsafter every increase of GDP. However, it is possible to proof mathematically that this intuition is wrong. This follows from the calculation based on levels we have already made: Macroeconomics The Keynesian Model with Capital Market It is possible to show the same based on first differences:

15 The Keynesian Model with Capital Market The Keynesian Model with Capital Market The "Keynesian Cross" reveals the basic features of the Keynesian Theory. It suffers, however, from the shortcoming of constant investment. Keynes assumed that firms' investment depends on two factors: 1. the capital market interest rate (i), which represents the costs of investment, and 2. the expected return on investment E(r), where the function E(r) symbolizes the expectation value of the return on investment r. Like the Neoclassics, Keynes assumed that a higher (lower) interest rate reduces (increases) firm investment, since it increases (lowers) investment costs. Following Keynes, an increase (decrease) of the expected return on investment, increases (decreases) firm investment, since more investment projects become profitable at a higher return The Keynesian Model with Capital Market E(r 1 ) < E(r 2 ) I(i, E(r 2 )) demand of firms I(i) positively depends on expected return E(r): If the expected return increases, investment demand increases too Digression: The Difference between the Keynesian and the Neoclassic Function 1. The Keynesian Function: I(i, E(r)) depends negatively on the interest rate, because an increase in the capital market interest rate increases the costs of investment. depends positively on expected investment return, because an increase in expected investment return (at a given interest rate) makes more investment projects profitable. Contrary to the neoclassical model, the investment return is uncertain, since it depends on the demand for goods, which is uncertain under Keynesian assumption. Hence, it is the uncertainty of demand for goods that causes the uncertainty of investment return E(r). 2. The Neoclassical Function: I(i, L) For the same reasons as in Keynesian theory, investment depends negatively on the interest rate. depends furthermore positively on labor input L, since productivity of capital goods is higher, when more worker are available to work with these machines. Since under neoclassical assumptions demand for goods does always equal supply of goods (Say s Theorem), there is no uncertainty on investment return. Therefore investment return is constant, so that it does not appear in the neoclassical investment function The Keynesian Model with Capital Market E(r 1 ) > E(r 2 ) I(i, E(r 2 )) demand of firms I(i) positively depends on expected return E(r): If the expected return decreases, investment demand decreases too The Keynesian Model with Capital Market The Keynesian Model with Capital Market S() = 0,5* C()+ C()= 0,5* demand I(i) negatively depends on the interest rate i Consequently, savings like consumption do not depend on the interest rate! S= 15 = 0,5*30 = 30 Income = Since household consumption depends on household income C(), household savings, which equal household income minus household consumption, depends on income too: C() = S(). If for example household income is = 30 and the consumption ratio is c = 50% household savings equal S() = C() = 30 0,5*30 = 15

16 The Keynesian Model with Capital Market i 1 I 1 = 15 S() = 0,5* I = 15 C()+ C()= 0,5* Income = As the capital market diagram now shows, at the resulting interest rate i 1 the demand for investment goods equals I 1 = 15 too, so that the resulting equilibrium income is indeed equal to =30. This somewhat astonishing result is not due to chance but a consequence of a mathematical law called Walras Law Reduction of the Propensity to Consume Since under Keynesian assumptions, the supply of goods does always adjust to the demand for goods, a reduction of demand causes immediately a reduction of GDP: If households expect a deterioration of the economic development, so that they fear unemployment and increase their savings to have a financial safety cushion in the case they become unemployed, they reduce their consumption demand. Consequently, what they have expected, a deterioration of the economic development, does actually occur. Such a phenomenon is called self-fulfilling expectations : What is expected does actually happen, because it is expected Digression: Walras Law Walras Law was discovered by the French economist Léon Walras and 1874 published in his book Éléments d èconomie politique pure. Is says: If the number of all markets in an economy is equal to N and N-1 markets are in equilibrium (i.e. demand equals supply on N-1 markets) and all households keep their budgets (i.e. spend not more and not less money for consumption and savings than equals their income), then the Nth market will automatically be in equilibrium too (i.e. demand equals supply on the Nth market too). In the above version of a Keynesian model only two markets exist: The goods market and the capital market. Hence N=2. Consequently, if the goods market is in equilibrium such that = C() + I(i, E(r)) and the household keeps its budget constraint such that = C() + S() then, the capital market must necessarily be in equilibrium too, i.e. savings supply S() must be equal to investment demand I(i, E(r)) such that S()= I(i, E(r)) It is easy to see that this is actually true, if one subtracts the budget constraint from the goods market equilibrium equation: [] = C() + I(i, E(r)) [C() + S()] <=> 0 = I(i, E(r)) S() <=> S() = I(i, E(r)) Reduction of the Propensity to Consume Source: Bondt, G. J. de (2009), Euro area money demand: empirical evidence on the role of equity and labour markets, ECB Working Paper Macroeconomics The Keynesian Model with Capital Market side Shocks Reduction of the Propensity to Consume Reduction of the Propensity to Consume i 1 S() = 0,5* I 1 =15 C() + 15 C()= 0,5* S 1 = 15 1 Income = What happens, if households expect a deterioration of economic development and do therefore increase their savings ratio from (1-c) = 50% to (1-c) = 75%?

17 Reduction of the Propensity to Consume Reduction of the Propensity to Consume S() = 0,5* C() + 15 S() = 0,75* i 1 i 1 0,25* + 15 C()= 0,5* I 1 =15 I 1 =15 C()= 0,25* S 1 = 15 1 Income = What happens, if households expect a deterioration of economic development and do therefore increase their savings ratio from (1-c) = 50% to (1-c) = 75%? The consumption ratio decreases from c = 50% to c = 25% ) All variables change simultaneously. Therefore savings must not be calculated based on starting income (=30). The resulting income of a period is not given before the end of a period, which equals 20 in the given example S 2 = 15 Income = Savings and investment remain unchanged, since the increase in the savings ratio 0,75 = (1-0,25) does exactly compensate for the decrease in GDP to a level of 20: 1) S( 1 ) = (1-0,5) * 30 = 0,5 * 30 = 15 = S( 2 )= (1-0,25) * 20 = 0,75 * Reduction of the Propensity to Consume i 1 S 1 = 15 S() = 0,5* I 1 =15 1 0,5* ,25* + 15 C()= 0,5* C()= 0,25* Income = What happens, if households expect a deterioration of economic development and do therefore increase their savings ratio from (1-c) = 50% to (1-c) = 75%? The consumption ratio decreases from c = 50% to c = 25% Reduction of the Propensity to Consume To sum up: A deterioration of household expectations on the economic development increases the savings ratio and decreases the consumption ratio respectively. This reduction of consumption demand (C() ) causes a reduction of the supply of goods and hence a reduction of GDP ( ), which equals household income ( ). This initiates a negative multiplier process: Household consumption shrinks further, because of lower household income: C( ). Consequently, consumption demand contracts even further, so that total supply of goods contracts again and consequently household income decreases, so that consumption demand contracts once again and so on Reduction of the Propensity to Consume Reduction of the Propensity to Consume S() = 0,75* i 1 0,25* + 15 I 1 =15 C()= 0,25* S 2 = 15 2 Income = The consumption ratio decreases from c = 50% to c = 25% => GDP decreases from 1 =15 * (1/(1-0,5) = 30 to 2 = 15 * (1/(1-0,25) = 20 This negative multiplier process keeps on, until the decreased consumption demand plus the (unchanged!) investment goods demand equals again income and GDP respectively: C() + I(i, E(r)) = As displayed by the above graphs, the reduction of the consumption ratio to 25% causes via the negative multiplier process a reduction of GDP to 15 * (1/(1-0,25) = 15 * 1,33 = 20. Question: What would be the effect on GDP of a rise of the consumption ratio to 75%?

18 Macroeconomics The Keynesian Model with Capital Market side Shocks Reduction of the Propensity to Consume Reduction of the Propensity to Invest Reduction of the Propensity to Invest i 1 S() = 0,5* I(i, E(r 2 )) I 2 =5 C() + 15 C() + 5 S 1 = 15 1 Income = The demand for investment goods and the demand for credits to finance these investment goods decrease. 1) 1) All variables change simultaneously. Therefore, both demand curves must be shifted simultaneously. (If only the credit demand curve were shifted, the decreasing interest rate would increase investment demand to its starting level.) Reduction of the Propensity to Invest Since under Keynesian assumptions, supply of goods does always adjust to demand for goods, a reduction of demand causes immediately a reduction of GDP: If firms expect a deterioration of economic development, so that they fear a decrease in investment return, they reduce their demand for investment goods so that their expectations actually realize. Consequently, what they have expected, a deterioration of the economic development, does actually occur. Consequently, firms too can cause self-fulfilling expectations : What is expected does actually happen, because it is expected Reduction of the Propensity to Invest i 1 S() = 0,5* S 2 = 5 I(i, E(r 2 )) I 2 =5 C() + 15 C() + 5 Income = If investment equals 5 and the consumption ratio is 50%, the resulting GDP equals = 5 * ( 1/(1-0,5) ) = 5 * 2 = 10 For an consumption ratio for c = 50% the savings ratio will equal (1-c) = 50%, so that at a GDP of 10, savings equal S() = 0.5 * 10 = Reduction of the Propensity to Invest Reduction of the Propensity to Invest S() = 0,5* C() + 15 S() = 0,5* i 1 i 1 C() + 5 I 1 =15 I(i, E(r 2 )) I 2 =5 S 1 = 15 1 Income = S 2 = 5 2 Income = What happens, if firms expect a lower investment return r 2 < r 1, because of a deterioration of the economic development and lower their investment from 15 to 5? If investment equals 5 and the consumption ratio is 50%, the resulting GDP equals = 5 * ( 1/(1-0,5) ) = 5 * 2 = 10 For a consumption ratio of c = 50% the savings ratio will equal (1-c) = 50%, so that at a GDP of 10 savings equal S() = 0.5 * 10 =

19 Reduction of the Propensity to Invest To sum up: A deterioration of the expectations of firms on the economic development causes a reduction of the investment demand of firms. This reduction of investment demand (I(i, E(r) ) ) causes a reduction of the supply of goods and hence a reduction of GDP ( ), which equals household income ( ). This initiates a negative multiplier process: Household consumption shrinks further, because of lower household income: C( ). Consequently, consumption demand contracts even further, so that total supply of goods contracts again too and consequently household income decreases, so that consumption demand contracts once again and so on Reduction of the Propensity to Invest Potential Explanations: At first sight, this seems to indicate that primarily expectations of changing investment returns of firms cause business cycle fluctuations. However, it might as well be that these expectations depend on household consumption demand: A reduction of consumption growth could cause a deterioration of business expectations so that firms reduce their investment. A rise of consumption growth could cause a amelioration of business expectations so that firms rise their investment. Under such conditions, a relatively small change of household consumption demand could cause big changes of investment demand. Such an effect is called Accelerator Effect Reduction of the Propensity to Consume This negative multiplier process keeps on, until the decreased consumption demand plus the investment goods demand equals again income and GDP respectively: C() + I(i, E(r)) = As displayed by the above graphs, the reduction of investment demand by 10 causes via the negative multiplier process a reduction of GDP to 10 * (1/(1-0,5) = 20. Macroeconomics The Keynesian Model with Capital Market side Shocks Reduction of the Propensity to Invest Reduction of the Propensity to Consume Consequences for the Labor Market Question: What would be the effect on GDP of a rise of the investment demand by 10? Reduction of the Propensity to Invest To sum up: Equipment investment (=gross investment./. change of inventories./. real estate investment = investment in machines ) fluctuates significantly pro-cyclically: During an upswing, equipment investment grows faster than GDP. During an downswing, equipment investment grows slower than GDP. To the contrary, private consumption displays a significantly weaker correlation with the business cycle. During a downswing, only a slight weakening of consumption growth becomes apparent. The consumption ratio, however, is not unambiguously positively correlated with the business cycle. These stylized facts are not singular for Germany: Since the beginning of the 50ties, they show up for all industrialized countries Consequences for the Labor Market As the preceding chapter has revealed, a deterioration of consumer and/or investor expectations concerning the economic development can actually cause a recession a reduction of GDP. A reduction of GDP means however that firms also reduce their demand for production factors - notably their demand for labor: If wages are not flexible, but fixed by collective labor agreements, labor supply stays unchanged. If labor demand slumps while labor supply stays constant, unemployment will emerge. This kind of unemployment is ultimately caused by a reduction in the demand for goods. It is called Keynesian unemployment

20 (L D1,K 1 ) w_ 1 P 1 "Normal Capacity GDP" or "Full Employment GDP" Labor of the Neoclassical Model (L,K 1 ) Equilibrium Labor Input L D1 (w 1 /P 1,K 1 ) L L S (w/p) L D (w/p,k 1 ) The Effect of the on the Labor Market Under the assumptions of the neoclassical model (s. chapter 2.1.) the supply of goods depends on the equilibrium labor input L D (w 1 /P 1,K 1 ) and the given capital stock K 1. The resulting level of GDP is called "Normal Capacity GDP or (since there is no unemployment) "Full Employment GDP. D,1 D,2 Decrease of Keynesian Labor in a Recession w_ 1 P 1 Decrease of GDP below its Full Employment Level in a Recession L D ( D,2 ) L 1 L D ( D,1 ) Keynesian Unemployment (L,K 1 ) L L S (w/p) The Effect of the on the Labor Market If the demand for goods falls (for one of the reasons discussed in section 3.2.) below the full employment GDP, i.e. D < (L D1,K 1 ), Keynesian labor demand will be lower than the equilibrium labor input of the neoclassical model: L D ( D ) < L D (w 1 /P 1,K 1 ). If the real wage is downward fixed by a collective bargaining contract to the long-run market equilibrium level of w 1 /P 1, the resulting unemployment is called Keynesian unemployment L D1 (w 1 /P 1,K 1 ) L LME ECB L 1 L (L D1,K 1 ) w_ 1 P 1 "Normal Capacity GDP" or "Full Employment GDP" Labor of the Neoclassical Model L D1 (w 1 /P 1,K 1 ) L D1 (w 1 /P 1,K 1 ) (L,K 1 ) Equilibrium Labor Input L L S (w/p) L D (w/p,k 1 ) L The Effect of the on the Labor Market Under the assumption of the Keynesian model, firms adjust in the short run their production of goods to the demand for goods. Therefore they will also adjust their labor demand to the demand for goods in the short run! Consequently, in the short run, the labor demand of firms is, under Keynesian assumptions, not determined by the real wage w/p and the given capital stock K 1, i.e. by L D (w/p,k 1 ), but by the demand for goods D. The "short-run" demand for labor therefore equals L D ( D ) D,2 D,1 Increase in Short-run Labor in a Boom w_ 2 P 1 w_ 1 P 1 Increase in GDP above its Full Employment Level in a Boom L 1 L 1 (L,K 1 ) L L D ( D,1 ) L D ( D,2 ) L S (w/p) Keynesian Overemployment L The Effect of the on the Labor Market We know from section 3.2. that also the opposite can happen: The demand for goods can grow above full employment GDP, i.e. D > (L D1,K 1 ). Then Keynesian labor demand will be higher than the equilibrium labor input of the neoclassical model: L D ( D ) > L D (w 1 /P 1,K 1 ). Since collective bargaining contracts typically allow an increase of wages, wages will grow (also due to overtime premiums). The result is called Keynesian overemployment D,1 "Normal Capacity GDP" or "Full Employment GDP" (L,K 1 ) Keynesian Labor L D ( D,1 ) L L S (w/p) The Effect of the on the Labor Market If the demand for goods equals the full employment GDP, i.e. D = (L D1,K 1 ), Keynesian labor demand will equal the equilibrium labor input of the neoclassical model: L D ( D ) = L D (w 1 /P 1,K 1 ). w_ 1 P 1 L D (w/p,k 1 ) Classification of Business Cycles: Actual GDP Growth > Growth Trend =Upswing Actual GDP Growth < Growth Trend =Downswing L D1 (w 1 /P 1,K 1 ) L Prof. Source: Dr. Rainer Maurer EU-Ameco Database

21 Macroeconomics Classification of Business Cycles: Actual GDP Growth > Growth Trend =Upswing Actual GDP Growth < Growth Trend =Downswing The Keynesian Model with Capital Market side Shocks Reduction of the Propensity to Invest Reduction of the Propensity to Consume Consequences for the Labor Market 4.3. Fiscal and Monetary Policy in the Keynesian Model Fiscal Policy Source: EU-Ameco Database Fiscal Policy Source: EU-AMECO Data Base As we have already seen, there are two types of fiscal policy depending on their way of financing: Debt Financed Fiscal Policy Tax Financed Fiscal Policy If the government finances its consumption (G) by taxes (T) and by debt (D G ) the following budget constraint results: G = T + D G To simplify the following analysis we will analyze only debt financed fiscal policy: G = D G Debt Financed Fiscal Policy Under Keynesian assumptions, tax financed fiscal policy has the same results, yet the strength of the effect is somewhat weaker, since it lacks a multiplier effect (Haavelmo-Theorem) Consequences for the Labor Market To sum up: Keynesian theory and empirical evidence shows recessions typically come along with an increase in unemployment. This leads to the question, whether the government should intervene in a recession to prevent the emergence of Keynesian unemployment. As the neoclassical model (AU 2.2) has revealed, fiscal as well as monetary policy is without effect under the assumptions of the neoclassical model. In the following, we will analyze whether this result also holds under the assumptions of the Keynesian model Fiscal Policy i I S() = 0,5* I(i, E(r )) I I,S D C() + I C() Full Employment GDP Starting point is a situation, where a demand-side recession has caused GDP to fall to a level of D below its full employment level # D, so that Keynesian unemployment has emerged. What happens then, if the government rises its consumption from G=0 to G=5 and finances this expenditure with new debt of D G =G=5 via the credit market? # D

22 Fiscal Policy i S() = 0,5* C() + I + G C() + I C() Fiscal Policy i S() = 0,5* I(i, E(r )) + D G C() + I + G C() + I C() I(i, E(r )) I I,S I(i, E(r )) I I,S I D # D I D # D The rise of government consumption from G=0 to G=5 raises total demand for goods by 5. The rise of GDP to its full employment level # D, increases the demand for labor to its full employment level L D ( # D)=L D (w 1 /P 1,K 1 ), so that the Keynesian unemployment disappears Fiscal Policy i S() = 0,5* I(i, E(r )) + D G I(i, E(r )) I I,S I D # D C() + I + G C() + I C() The multiplier effect then causes total demand to grow by additional 5 units, so that total GDP grows by 10. To finance this additional government consumption, the credit demand grows by the government demand for credits equal to G=D G =5. # D D w_ 1 P 1 L D ( D ) L 1 L D ( # D) (L,K 1 ) L L S (w/p) L S (w/p) Keynesian Unemployment Fiscal Policy The increase of GDP from D to # D caused by the increase of government consumption causes an increase of the short-run demand for labor from L D ( D ) to L D ( # D). Consequently, the Keynesian Unemployment caused by the recession completely disappears. If the increase of government consumption were lower that G=5, Keynesian unemployment would not completely disappear. If the increase of government consumption were stronger than G=5, GDP would grow stronger than # D. This would cause an "overheating" of the economy L 1 L Fiscal Policy i S() = 0,5* I(i, E(r )) + D G I(i, E(r )) I I,S I D C() + I + G C() + I C() Since the increase in income by 10, increases, for a given savings ratio of 50%, the credit supply of households by 5, credit supply of households grows by the same amount as government consumption. # D # D D w_ 1 P 1 L D ( D ) L 1 L 1 (L,K 1 ) L L D ( # D) L S (w/p) Disappearance L S of (w/p) Keynesian Unemployment L Fiscal Policy The increase of GDP from D to # D caused by the increase of government consumption causes an increase of the short-run demand for labor from L D ( D ) to L D ( # D). Consequently, the Keynesian Unemployment caused by the recession completely disappears. If the increase of government consumption were lower that G=5, Keynesian unemployment would not completely disappear. If the increase of government consumption were stronger than G=5, GDP would grow stronger than # D. This would cause an "overheating" of the economy

23 Fiscal Policy To sum up: What happens, if the government rises government consumption from G=0 to G=5 and finances these additional expenditures with new debt via the credit market G=5=D G? The increase in the demand for goods by government consumption G=5 causes a positive multiplier process (see section 3.1.1). Therefore, GDP grows by G*(1/(1-c)) = 5*(1/(1-0,5)) = 10 from 20 to 30. At a GDP (=income!) of 30, total savings of households equals *(1-c) = 30*(1-0,5) = 15. The increase in GDP causes an increase in savings to a level large enough to finance the government demand for additional credits of D G =5, without causing the interest rate to rise! Consequently, contrary to the neoclassical theory, no Crowding- Out of private consumption or investment takes place! Fiscal Policy Why is fiscal policy able to cause an economic recovery under Keynesian assumptions, but not under the assumptions of the neoclassical model? Under the assumptions of the Keynesian model, the supply of goods adjusts to the demand for goods, so that GDP and hence household income grows. The increase in government debt, causes an increase in the demand for credits. The increase in GDP causes at the same time an increase in household savings, so that credit supply grows. The increase in household credit supply is sufficient to compensate the effect of additional government credit demand on the interest rate. Therefore, an increase in the interest rate does not take place! Therefore, investment demand for firms does not decrease. As a consequence, a debt-financed expansion of government consumption does not result in a Crowding-Out of private demand! Tax financed fiscal policy? Fiscal Policy The rise of government consumption finances itself via its expansionary effect on GDP! To produce a higher GDP, firms need more labor input. Consequently, the demand for labor grows. Consequently, Keynesian unemployment caused by a deterioration of future expectations of firms and/or households is reduced by the additional government consumption. Caution: In the above graphical example, an increase in government consumption by G = 5 is just enough to completely eliminate initial unemployment. This must not necessarily be the case! If government consumption grows to a higher (lower) level than G=5, the increase in labor demand will be higher (lower) than necessary to establish full employment. Macroeconomics The Keynesian Model with Capital Market side Shocks Reduction of the Propensity to Consume Reduction of the Propensity to Invest Consequences for the Labor Market 4.3. Fiscal and Monetary Policy in the Keynesian Model Fiscal Policy Fiscal Policy Why is fiscal policy able to cause an economic recovery under Keynesian assumptions, but not under the assumptions of the neoclassical model? Under the assumption of the neoclassical model, the supply of goods is fix. An increase in the demand for goods cannot cause an increase in the supply of goods: The increase in government debt, causes an increase in the demand for credits. Since the supply of credits does, however, not grow, the resulting increase in the interest rate causes a reduction of investment (I(i ) ) and a reduction of household consumption (C(i ) ). This is the reason for the complete Crowding-Out under neoclassical assumptions. In the above analysis of fiscal policy the existence of money supply and demand was neglected by assuming implicitly a pure barter economy. Under the existence of money, the effect of fiscal policy would be somewhat dampened, because an increase in GDP increases the demand for money and consequently the interest rate, so that investment demand shrinks somewhat and the net increase in GDP is correspondingly smaller. Nevertheless, the net effect of fiscal policy on GDP is significantly positive, even in a Keynesian model with money. In this sense, the neglect of money is harmless. Of course, in the following analysis of monetary policy, we cannot neglect the existence of money

24 The Determinants of Money Supply: Just like in the neoclassical model, the central bank determines money supply: M S As the discussion of monetary policy in Chapter 6 will show, most central banks offer in various ways their money as a credit on the capital market. Therefore, we can simply add money supply of the central bank to credit supply of households. Consequently, total real credit supply equals the sum of real savings of households plus the real value of money supply by the central banks ( =nominal money supply (M S ) divided by the price level P: Total Real Credit Supply = S() + M S / P Determinants of Money : Just like in the neoclassical model, firms demand money to pay their production factors labor and capital. Consequently, the real demand for money depends on the sum of real wage and real interest payments, which equal real GDP:. Additionally, the original Keynesian model accounts for the fact, that households and firms care for the opportunity costs of holding money (= interest costs = interest rate = i) and do therefore demand less money if the interest rate is high and vice versa. For simplicity we will neglect the dependency of money demand on the interest rate in the following exposition, since it has no significant effects on the results The Credit Market without Money Supply and : S() Determinants of Money : Consequently, real money demand depends like in the neoclassical model positively on GDP () : Real Money = R D () I(i, E(r )) Total real credit demand equals then credit demand for the purchase of investment goods I(i, E(r)) plus money demand: Total Real Credit = I(i, E(r)) + R D () I The Credit Market with Money Supply: S() S() + M S / P The Credit Market without Money Supply and : S() M S /P I(i, E(r )) I(i, E(r )) I I + R D I

25 The Credit Market with Money Supply: S() S() + M S / P The capital market with money supply and demand can now be inserted into the Keynesian model: M S /P I(i, E(r )) I I + R D The Credit Market with Money Supply and Money : S() S() + M S / P R D () i i S( ) S( )+M/P I I +R D I(i)+R D ( ) I(i) I I,S D # D C()+I C() Full Employment GDP I M S /P I + R D I(i, E(r )) + R D () I(i, E(r )) Starting point is a situation, where a demand-side recession has caused GDP to fall to a level of D below its full employment level # D, so that Keynesian unemployment has emerged. Ex. 25, sl The Credit Market with Money Supply and Money : S() S() + M S / P R D () If money supply (M S /P) equals money demand (R D ()), the interest rate equals the natural interest rate, i.e. the interest rate that would result without money. i i I I +R D S( )+M/P+5 I(i)+R D ( ) I(i) I I,S D # D C()+I C() I M S /P I + R D I(i, E(r ))+ R D () I(i, E(r )) What happens now, if the central bank rises money supply and hence total credit supply by ΔM /P= 5?

26 i i S( )+M/P+5 I I # I # +R D I(i)+R D ( ) I(i) I I,S D # D C()+I C() i S( )+M/P+5 S( # )+M/P+5 I # I # +R D I(i)+R D ( ) I(i) I # I,S D # D C()+I # C()+I C() The raise of money supply causes a reduction of the interest rate from i to. This rises investment from I to I #. Since GDP grows by 10, household savings grow by 10 times the savings ratio: 10*(1-c) = 10*0,5 = 5. This causes credit supply to shift to the right by 5 units i i S( )+M/P+5 I I # I # +R D I(i)+R D ( ) I(i) I # I,S D # D C()+I # C()+I C() i I # S( # )+M/P I # +R D I(i)+R D ( # ) I(i) I # I,S D # D C()+I # C()+I C() The rise of investment by 5 increases the demand for goods by 5. The multiplier process causes a final increase in GDP by 10 units. This would cause a further decrease in the interest rate. However the increase in GDP causes also an increase in money demand, so that the R D ()-curve shifts to the right too i i S( )+M/P+5 I I # I # +R D I(i)+R D ( ) I(i) I # I,S D # D C()+I # C()+I C() i S( # ) I # S( # )+M/P I # +R D # I(i)+R D ( # ) I(i) I # I,S D # D C()+I # C() The growth of GDP causes a higher demand for labor, so that labor demand grows and Keynesian unemployment disappears. To simplify the analysis, we make the assumption that money demand R D () shifts to the right by the same amount as the savings supply, so that the interest rate stays constant at the level caused by monetary policy. In this case the adjustment process comes to an end. If the shift of money demand were smaller, a further decrease of the interest rate would cause a further growth of GDP

27 To sum up: the Effects of Monetary Policy An increase in money supply by the central bank of ΔM /P= 5 causes real credit supply to increase by the same amount. This lowers the interest rate, so that investment demand grows by 5: I(i ) This causes an increase in the demand for goods (= consumption demand + investment demand) by 5. The multiplier process finally yields an increase in GDP by 5 * (1/(1-c)) = 5 * (1/(1-0,5)) = 5 * 2 = 10. It is as well possible that the increase in money demand is too small (strong), to absorb the higher savings of households. In this case, the interest rate would further decrease (increase). Consequently, investment would further grow (shrink), until GDP-growth (GDP-decrease) would cause a money demand, which adds up with investment demand to total credit supply For the production of a higher GDP more labor input is needed, so that labor demand grows from L to L #. In the above graphical example the increase in money supply is chosen so that the resulting GDP # D is large enough to cause an increase in labor demand that completely eliminates unemployment. This is not necessarily the case: If the increase in money supply by the central bank is not large enough, unemployment will not disappear completely. If the increase in money supply by the central bank is too large, employment may rise above its long run equilibrium level and an "overheating" of the economy might result Beside the increase in labor demand, GDP growth has two further effects: 1. Household savings grow by the increase in GDP times the savings ratio: Δ * (1-c) = 10 * (1-0,5) = Money demand grows, since the transaction of a higher GDP needs more money: R D ( # ) > R D ( ). In the above graphical example, the assumption was made that the increase in savings exactly meets the higher demand for money. This too must not necessarily be the case Why is monetary policy able to cause an economic recovery under Keynesian assumptions, but not under the assumptions of the neoclassical model? Under the assumptions of the neoclassical model, the supply of goods is fixed by the given capital stock and the equilibrium labor input. An increase in the demand for goods cannot cause an increase in the supply of goods: If the central bank increases money supply, so that households demand more goods, this causes excess demand for goods, which causes the price level to increase Why is monetary policy able to cause an economic recovery under Keynesian assumptions, but not under the assumptions of the neoclassical model? In the Keynesian model, goods supply always adjusts to goods demand, An increase in money supply, which causes an increase in demand for goods can therefore cause an increase of total production

28 Macroeconomics Digression: Why does price adjustment in a recession or boom increase profits? Firms, which operate in markets with perfect competition, maximize their profits by adjusting their prices to their marginal costs. In a boom situation, they increase their production quantities. Consequently, their marginal costs grow. When they adjust their prices in the long-run, they will therefore raise their prices. In a recession, they reduce their production quantities. Consequently, their marginal costs fall. When they adjust their prices in the long-run, they will therefore lower their prices. In reality many firms operate in markets with monopolistic competition. Consequently, they can practice mark-up pricing, i.e. their prices are always somewhat higher than their marginal costs. In a boom situation, demand grows stronger such that these firms can in the long-run increase their profits by raising their mark-up. In a recession, demand becomes weaker such that these firms can in the long-run increase their profits by reducing their mark-up to stabilize demand Macroeconomics The Keynesian Model with Capital Market side Shocks Reduction of the Propensity to Consume Reduction of the Propensity to Invest Consequences for the Labor Market 4.3. Fiscal and Monetary Policy in the Keynesian Model Fiscal Policy 4.4. The Long-run Implications of the Keynesian Model The Long-run Implications of the Keynesian Model A change of the price level will affect the economy in the same way as in the neoclassical model (s. Chapter 2.2.1): Via the capital market: Starting point is an equilibrium in the capital market: S() + M / P = I(i, E(r)) + R D () If there is an recession, firms will decrease their prices from P to P # < P. This will cause an increase of the real value of money from M / P # > M / P. As a result their will be excess supply of credits: S() + (M / P # ) > I(i, E(r)) + R D () Excess supply will decrease the interest rate from < i, so that investment demand will grow from I(i, E(r)) to I(, E(r)) until a new equilibrium is reached: S() + (M / P # ) >= I(i, E(r)) + R D () Higher investment in turn will increase the demand for goods The Long-run Implications of the Keynesian Model As section 3.1 has shown that in reality it takes one year until firms start to adjust their prices. When firms adjust their prices, they will do so according to the current degree of their capacity utilization: When a rise in the demand for goods has caused a boom so that production lies above full employment GDP, firms will notice that an increase in prices will help to increase their profits. When a decline in the demand for goods has caused a recession so that production lies below full employment GDP, firms will notice that a decrease in prices will help to increase their profits. In the following, we will therefore analyze what happens, if the economy is in a recession (production below the full employment level) and firms start to reduce their prices The Long-run Implications of the Keynesian Model i S( )+M/P S( )+M/P # I I +R D I(i) P > P # I(i)+R D ( ) I,S I P C()+I C() Full Employment GDP The resulting lower interest rate triggers the same adjustment process as discussed in section! When the price level of goods prices decreases from P to P #, the real value of the money offered by the central bank increases: (M D /P ) This causes an increase in credit supply from S( )+M D /P to S( )+M D /P # #

29 4.4. The Long-run Implications of the Keynesian Model i I S( )+M/P # I # I # +R D I(i)+R D ( ) I(i) I,S I # C()+I C() 4.4. The Long-run Implications of the Keynesian Model C()+I # S( # )+M/P # i I(i)+R D ( # ) C() I(i) I # I,S I # I # +R # D # This increase in credit supply causes the interest rate to decrease from i to. The lower interest rate causes a rise of investment from I to I #. Consequently, the decrease in prices by firms causes a decrease in the interest rate, which causes an increase in investment. This increase in investment causes an increase in the demand for goods, which leads ultimately to an increase in the demand for labor. (->Exercise 27) The Long-run Implications of the Keynesian Model S( )+M/P # C()+I # C()+I i I(i)+R D ( ) C() I I # I # +R D I(i) I,S This increase in investment increases the demand for goods from D to # D. Since the supply of goods adjusts to the demand for goods, the demand for labor grows to the full-employment level. I # # 4.4. The Long-run Implications of the Keynesian Model Tu sum up: Starting point of the analysis was a recession, i.e. a situation where firms had adjusted their supply of goods to a reduction in the demand for goods, while they kept their prices constant. This reduction in the supply of goods caused a reduction of GDP production below the full employment level. Therefore, the variable production costs of firms fall below the price of goods. Therefore, profit maximizing firms can increase their profits by lowering their prices. Consequently, when firms start with the adjustment of prices, they will lower their prices so that the price level of all goods decreases The Long-run Implications of the Keynesian Model S( )+M/P # C()+I # S( # )+M D /P # I # I # +R D # I(i)+R D ( # ) I(i)+R D ( ) I,S I # # C() The resulting rise of GDP from D to # D increases household savings from S( ) to S( # ) and money demand from R D ( ) to R D ( # ). Under the assumption that savings supply and money demand grow by the same margin the interest rate stays constant The Long-run Implications of the Keynesian Model 1 ) In a nominal formulation of the credit market, the fall of goods prices causes the nominal demand for credits to decrease stronger than the nominal supply of credits, so that the resulting excess supply of nominal credits lowers the interest rate. Consequently, both ways of representing the credit market (the nominal and the real) yields the same result. The real representation is used here, because it facilitates the graphical analysis. (for a more detailed description see the digression in AU 2, slides 90-91) This reduction of goods prices (P ) causes an increase in the real value of the money offered by the central bank as a credit (M): 1) (M / P ) Since money is offered as a credit to the credit market, this means that the real supply of credits increases. This increase in the real credit supply lowers the interest rate so that investment of firms increases. This rise of investment causes an increase in the demand for investment goods, so that the total demand for goods increases.

30 4.4. The Long-run Implications of the Keynesian Model Since firms adjust their supply of goods always to the demand for goods, they raise their production of goods. Since a higher production of goods needs more labor input, firms demand more labor on the labor market. Consequently, Keynesian unemployment shrinks and households receive more income. A higher household income causes households to consume more C( ), so that a multiplier effect results (see section above) Consequently, the production of goods grows even more and simultaneously the demand for labor. When the production of goods has reached its normal level of capacity utilization, a further reduction of prices does not increase profits anymore so that firms stop lowering their prices Macroeconomics The Keynesian Model with Capital Market side Shocks Reduction of the Propensity to Consume Reduction of the Propensity to Invest Consequences for the Labor Market 4.3. Fiscal and Monetary Policy in the Keynesian Model Fiscal Policy 4.4. The Long-run Implications of the Keynesian Model 4.5. Policy Conclusions The Long-run Implications of the Keynesian Model Finally, two secondary effects must be taken into account: On one hand, the increase in GDP causes an increase in household savings by ΔS = Δ * (1-c). On the other hand, the increase in GDP causes an increase in the transaction demand for money : R D ( ) This means that on the capital market, credit supply grows (caused by the increase in household savings) and credit demand grows (caused by the increase in money demand). If this increase in credit demand exactly equals the increase in credit supply, the interest rate stays constant As the above analysis has shown, in the long run (=when prices start to adjust) the economy is able to find its way out of recession without any help by the government. In other words, in the long run the self-healing capacities of the market work even under the assumptions of the Keynesian model. This however means, that the Keynesian theory does not imply the necessity of government anti-cyclical policy. The Keynesian theory implies however that government business cycle policy makes sense, if it allows to accelerate the process of economic recovery. Such an acceleration of economic recovery is, however, only possible if the government (or the central bank) is able to react in face of a recession before firms start lowering their prices (and cause a recovery in this way) The Long-run Implications of the Keynesian Model If the increase in credit supply were stronger than the increase in credit demand, a further decrease in the interest rate would evolve, which would cause a further increase in investment demand. This process would hold on, until the increase in money demand is sufficient to absorb the increase in credit supply. After this adjustment process has taken place, the economy is in a new equilibrium without unemployment. Consequently, the time-frame for government business cycle policy corresponds to the span of time until firms start adjusting their prices (about 1 year). Only if the government (and/or the central bank) is able to increase the demand for goods before firms start adjusting their prices, it is possible to shorten the duration of the autonomous adjustment process of the economy. If fiscal and monetary policy come to late, i.e. when firms have already reduced their prices, this may cause an excess demand for goods that can lead to an overheating of the economy: The following graphs illustrate this problem:

31 Fiscal Policy becomes effective: G Start of Recession: D Ideal Case: No Implementation Lag => No Danger of Overheating: Implementation Lag of Fiscal Policy = 0 ear => Increase in for : D 0,5 ear => Overcoming of Recession before 1 year is over! 1 ear 1,5 ear No reason for price adjustment, since the recession is already overcome! Start of Price Adjustment by Firms = 1 ear No Overheating, since no price adjustment takes place! As a consequence, the resulting excess demand for goods causes in the long run (when firms start to adjust their prices again) an increase in prices, which will finally cause a recession (exercise 27). In this case, fiscal or monetary policy would not dampen but boost business cycle fluctuations. These dangers lead to the question, whether the government (or the central bank) is able to react fast enough to reduce the duration of the recovery process and avoid an overheating of the economy. This question will be discussed in the following Start of Recession: D Realistic Case: Implementation Lag => Danger of Overheating: Implementation Lag of Fiscal Policy = 1 ear 0,5 ear Fiscal Policy becomes effective: G 1 ear 1,5 ear Firms Increase in decrease Prices: P => i =>I(i) => for : D Start of Price Adjustment by Firms = 1 ear => Increase in for : D Twofold Effect : D + D => Overheating of the Economy Practical experience with anti-cyclical fiscal policy has shown that there are several reasons for lags in the implementation of such policies. These lags can be classified according to the following scheme: Inside Lag Time between a shock to the economy and the policy action responding to that shock. Total Implementation Lag Outside Lag Time between the policy action and its influence on the economy Overheating by fiscal policy (see also exercise 27) : In this case, the increase in the demand for goods caused by the reduction of prices by firms will be boosted by the additional demand for goods from the government. As a consequence the demand for goods grows so strong that total demand for goods exceeds the full employment level. Overheating can of course also be caused by monetary policy: In this case, the reduction of the interest rate caused by the reduction of prices will be boosted by the increase in credit supply of monetary policy. As a consequence the demand for investment goods grows so strong that total demand for goods exceeds the full employment level The inside lag of fiscal policy has two sources: 1. The government needs time to analyze the causes of a recession ( diagnosis lag ): Only in case of a reduction of the demand for goods caused by a deterioration of the expectations of firms and households (= demand side shock) Keynesian government spending policies will work. If the recession is caused e.g. by a shock in the prices of raw materials (= supply side shock), Keynesian spending policies will not work. 2. The government needs time to change its budgeting: On the expenditure side laws must be changed in order to increase government spending for goods and services. On the revenue side laws must be changed in order to finance the additional government spending: Taxes and/or borrowing must be increased. Changing laws takes time (weeks if not months) in a parliamentary system ( reaction lag )

32 The outside lag of fiscal policy: Once the fiscal policy measures of the government are implemented, some time is needed until they unfold their full influence on the economy: In our textbook version of the Keynesian model a primary increase in the demand for goods immediately causes an increase in income and the increase in income causes immediately an additional increase in household consumption demand via the multiplier effect. In reality, a couple of time is needed until households realize the increase in their income (and/or lower risk of getting unemployed) and react on this with a rise of their demand for goods. Therefore, in reality the multiplier effect needs much more time to get started than in the simple Keynesian textbook model Quelle: Mankiw, Gregory; Macroeconomics, Worth Publishers, S. 384 Blue lines: Forecasts of the US-unemployment rate (average value of 20 US forecast institutes) Red Line: Actual USunemployment rate Taken together, the implementation lags of fiscal policy may delay its effect on the real economy for a span of time, which is likely between half a year and one year. Hence the implementation lag comes close to the one-year lag with which firms adjust their prices! Inside Lag Time between a shock to the economy and the policy action responding to that shock. Total Implementation Lag Outside Lag Time between the policy action and its influence on the economy The Policy Problem: Critics of the concept of anti-cyclical fiscal policy argue that governments are not altruistic and benevolent agents committed to the public welfare only, but strive like households or firms to maximize their individual welfare. If this hypothesis were right, it would be unlikely that governments actually try to reduce business cycle fluctuations. Instead they would use their economic policy instruments to increase the probability of being reelected The Forecast Problem: In principle, business cycle forecasts could be one way to circumvent the problem of implementation lags. Such forecasts could help to start the implementation of fiscal policy measures in advance, so that the effects of fiscal policy already start working at the beginning of a recession. However this approach works only, if the forecasts are sufficiently reliable. Experience has however shown, that forecasts of economic developments are exposed to a high degree of uncertainty. Forecasts of economic phenomena are forecasts of a complex system and are as difficult as forecast of meteorological or ecological phenomena. The following graph gives an example how difficult economic forecasting can be Therefore, these critics of fiscal policy argue that if governments were given access to a lot of fiscal policy instruments, they would not stabilize the economy but destabilize it with a political business cycle of the following kind: A couple of time before an election, the government increases government consumption, in order to rise the growth of income and reduce unemployment. This resulting improvement of economic conditions induces the electors to vote for the government. Once the government has won the elections, it will immediately reduce government consumption, in order the keep the government deficit in check and be able to rise again government consumption before the next elections. This reduction of government consumption will cause a recession after the election

33 The Empirical Effect of Monetary Policy (USA, 1965:3-1995:3) To sum up: The practical implementation of fiscal policy is subject to a couple of problems that do not appear in the Keynesian textbook model: 1. The Implementation Lag 2. The Forecast Problem 3. The Policy Problem Source: Christiano/Eichenbaum/Evans (2006), Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy, % % Quarters % % Quarters % % Quarters Quarters Quarters Quarters Anti-cyclical monetary policy too can be subject to implementation lags: The inside lag of economic policy is, however, typically much shorter than the inside lag of fiscal policy, since the central bank can change its money supply immediately without changes of laws that must be approved by the parliament (see chapter 6 Monetary Theory and Policy ). Nevertheless the outside lag of monetary policy can be quite important: Even though the effect of a change of monetary policy on interest rates is quite direct and fast in reality (see the next diagram), a decrease in interest rates does not immediately cause an increase in firms demand for investment goods. This is the case, because investment plans of firms are made in advance and it takes up to six months until firms actually demand more investment goods and hence increase economic demand The forecast problem is of course the same for monetary and fiscal policy. However, for an independent central bank, the policy problem of monetary policy is of less importance as for fiscal policy. Since the inside implementation lag and policy problem is of less importance, monetary anti-cyclical policy has much more proponents than fiscal policy Macroeconomics 1) Private Haushalte; Laufzeit 1-5 Jahre; Zinsfixierung; Neugeschäft 2) Unternehmen außerhalb des Finanzsektors; Laufzeit 1-5 Jahre; Zinsfixierung; Neugeschäft Quelle: ECB The Keynesian Model with Capital Market side Shocks Reduction of the Propensity to Consume Reduction of the Propensity to Inves Consequences for the Labor Markett 4.3. Fiscal and Monetary Policy in the Keynesian Model Fiscal Policy 4.4. The Long-run Implications of the Keynesian Model 4.5. Policy Conclusions Case Study: Fiscal Policy in Germany

34 Case Study: Fiscal Policy in Germany The concept of anti-cyclical fiscal policy implies: Case Study: Fiscal Policy in Germany The policy instruments of the Law for Stability and Growth: Increase of credit financed government consumption in recessions and, consequently, government budget deficits in recessions: T-G < 0 Dampening of economic activity in booms by a reduction of government demand and, consequently, government budget surpluses in booms : T-G > 0 If periods of budget deficits and budget surpluses set off each other, the total amount of accumulated government debt should stay constant. This idea is displayed by the following graph: Authorization (but no obligation) of the federal government to immediately change government consumption in the face of an economic imbalance on the goods market : In a period of economic boom, the reduction of government consumption should be used to amortize government debt. In a recession, the increase in government consumption should be financed with debt up to a volume of 5 Bn.. Consequently, in a boom, we should observe a surplus in the government budget and in a recession, we should observe a deficit in the government budget GDP-Level The Theory of Anti-Cyclical Fiscal Policy UPSWING DOWN- SWING UPSWING GDP with perfect anti-cyclical fiscal policy Actual GDP without anti-cyclical fiscal policy UMTS-Auction Time Budget Surplus fig + 0 Budget Surplus = T-G > 0 Budget Deficit = T-G < Source: SVR (2004) Acceptance of the Treuhand- Debt by the Government Case Study: Fiscal Policy in Germany Based on the concept of anti-cyclical fiscal policy, the Law for Stability and Growth (Stabilitäts- und Wachstumsgesetz) was implemented by the minister of economic affairs Karl Schiller in This law was considerably influenced by the experience of having successfully managed the first large recession of the post-war period ( ) with the help of Keynesian inspired fiscal policy. One important purpose of this law was the reduction of the inside implementation lag in the execution of Keynesian business cycles policies Case Study: Fiscal Policy in Germany As these charts show, there is no strong evidence that German governments since 1970 have followed the theory of anti-cyclical fiscal policy. If we add up the yearly budget deficits of the last chart (= D G,t ) over the past, we receive the level of accumulated government debt: LAD G,t = D G,t + D G,t-1 + D G,t-2 + D G,t-3 + If we divide the level of accumulated government debt up to a certain year t by the GDP level of this year, we receive the debt-gdp ratio: LAD G,t / GDP t If the growth rate of accumulated government debt is stronger than the growth rate of GDP, the debt-gdp ratio is growing. After the acceptance of the Treuhand-Debt by the government in 1996 the debt-gdp ratio reached for the first time the 60% limit according to the definition of the Maastricht Treaty

35 Case Study: Fiscal Policy in Germany Source: SVR (2004) To fight the steadily increase of public debt, the German parliament has implemented a so called debt brake in the German constitution (Article 115) by May According to this debt brake, the federal government must run a balanced government budget, i.e. G = T, starting with the year the federal states must run a balanced government budget starting with the year There are however exceptions: In a recession, debt financed government expenditure is allowed, if the debts are reduced again in an upswing = anticyclical fiscal policy is allowed. In case of natural disasters or extraordinary emergencies debt financed government expenditures are allowed, if it is ensured that the resulting debt is paid back afterwards. What will the long-run consequences of the debt brake be? Does this make sense? Digression: Causes for the increase in the dept-to-gdp ratio in Germany Expansion of welfare state services at the beginning of the seventies by the government under chancellor Willy Brand (extension of retirement entitlements, increase in investments in social housing, increase in housing allowances, increase in government subsidies for the acquisition of personal assets). Decrease in GDP-Growth and government revenues in the course of the oil crisis of Strong upward trend of unemployment since the beginning of the seventies and the resulting increase in government unemployment allowances and other social transfers. Extension of active employment policies by the government of chancellor Schmidt and the financial aftermaths of the social policy initiatives of the government of chancellor Brandt. Decrease in GDP-growth and government revenues during the oil crises at the beginning of the eighties. Nullification of the consolidation records of the government under chancellor Helmut Kohl by the economic design of the German unification by the same government. This shows, government budget policy is mainly determined by political developments there seems to be no room to take care for economic concepts like the theory of anti-cyclical business cycle policy Macroeconomics The Keynesian Model with Capital Market side Shocks Reduction of the Propensity to Consume Reduction of the Propensity to Inves Consequences for the Labor Markett 4.3. Fiscal and Monetary Policy in the Keynesian Model Fiscal Policy 4.4. The Long-run Implications of the Keynesian Model 4.5. Policy Conclusions Case Study: Fiscal Policy in Germany Limits of Government Debt Case Study: Fiscal Policy in Germany Limits of Government Debt Is there an economic limit for government debt? Arithmetically the upper limit is the present value of maximal tax payments, which depend on the politically maximal possible tax rate and GDP (τ max * t ): This equation shows that the debt-to-gdp ratio LAD t / t is a reasonable Present value of future interest payments Present value of future tax payments empirical measure for sustainability of government debt. If the present value of all future interest payments on government debt becomes larger than the present value of the maximal possible future tax payments, the government is not able to serve its debt and has to declare bankruptcy

36 Limits of Government Debt Is there an economic limit for government debt? Of course, governments will try to reduce their debt repayments before this upper limit is reached they will restructure their debt: debt restructuring = partial bankruptcy Since this is a risk for the creditors of government debts, financial markets will typically react long before the upper limit is reached and demand a risk premium (= higher interest rate). In reality, the reputation of governments seems to play an important role for the level of such risk premiums, as the following diagrams show: Limits of Government Debt Why does the Japanese debt-to-gdp ratio not lead to higher risk premiums? The creditors of Japanese government debt expect that the japanese government is able and willing to serve its debt in the future. The expectations of financial markets play a crucial role in respect to the upper limit of government debt. It is even possible that the phenomenon of self-fulfilling expectations appears, as the following scheme displays: Limits of Government Debt Self-fulfilling expectations of government bankruptcy: Doubts come up concerning the ability of a government to repay all debt. Sales lead to fall in market prices of government bonds Fall in market price = Increase of effective interest rate Prof. Dr. Rainer Maure Ability of government to repay debt falls. Higher interest rates increase costs of revolving government debt

37 Nominal GDP must grow faster as the debt level! Limits of Government Debt Important: There are historical examples showing that governments had been able to reduce a debt burden of more than 200% of GDP, without bankruptcy or restructuring of debt: Limits of Government Debt Is there an economic limit for government debt? However, keeping the total debt growth rate below the GDP growth rate can be politically difficult if the interest rate is larger than the GDP growth rate: To keep the debt-to-gdp ratio constant the following relationship must hold: This formula is quite intuitive. In means: If the debt-to-gdp ratio shall stay constant, the change of the debt-level (=deficit) in percent of GDP must equal the growth rate of GDP (=the change of GDP in percent of GDP) It is possible to reduce the debtto-gdp ratio without reducing the debt level Limits of Government Debt Is there an economic limit for government debt? Multiplying both sides of the equation with the interest rate i t yields: This means that, since in normal times the interest rate i t is larger than GDP growth t / t such that i t / ( t / t ) >1, interest payments are larger that the possible new deficit. In other words: Interest payments cannot be financed with new credits in the longrun, if the debt-to-gdp ratio shall stay constant! In other words: To keep the debt-to-gdp ratio constant, a part of tax-income must be used to finance interest payments! <=> Taxes cannot be completely spent for government consumption! <=> Debt cannot be completely financed with new debt!

38 Limits of Government Debt Case Study: Economic Policy in the Great Recession Is there an economic limit for government debt? As a consequence: If debt is completely financed with new debt, the debt-to-gdp ratio will grow! Limits of Government Debt Case Study: Economic Policy in the Great Recession Is there a moral limit for government debt? 1. Not future generations, but future tax payers pay for today debt: Interest for government debt accumulated by current generations, will not be paid by future generations, but by future tax payers to future owners of government bonds. Therefore, the money stays within the generation. 2. Every generation does not only inherit debt, but also net wealth like infrastructure, physical capital (machines, buildings ), technical knowledge, institutions, human capital The yearly monetary and non-monetary return, of this net wealth, is opposed to the interest payments, which have to be paid to the owners of government bonds. Is this return equal to the costs of interest payments, future tax payers suffer no net loss! The Keynesian Model with Capital Market side Shocks Reduction of the Propensity to Consume Reduction of the Propensity to Invest Consequences for the Labor Market 4.3. Fiscal and Monetary Policy in the Keynesian Model Fiscal Policy 4.4. The Long-run Implications of the Keynesian Model 4.5. Policy Conclusions Case Study: Fiscal Policy in Germany Limits of Government Debt Case Study: Economic Policy in the Great Recession Macroeconomics Case Study: Economic Policy in the Great Recession Private Consumption in Current Prices, Billion Euro Quelle: Statistisches Bundesamt

39 Case Study: Economic Policy in the Great Recession Gross in Current Prices, Billion Euro Case Study: Economic Policy in the Great Recession Production in Manufacturing, 2005 = 100 As postulated by the Keynesian model firms adjust their production in the short-run to the demand for goods. Quelle: Statistisches Bundesamt Quelle: Statistisches Bundesamt Case Study: Economic Policy in the Great Recession Case Study: Economic Policy in the Great Recession The expenditure account of GDP show the components of the demand for domestic goods: = C + I + G + EX IM <=> BIP = Consumption + Gross + Government Consumption + Exports Net Exports - Imports As the data reveal, the current recession was mainly caused by a reduction of investment and export demand. The reason for the reduction of investment and export demand was the bursting of a speculative bubble on the US real estate market. The causal chain behind the development is relatively complex, as the following chart shows: Case Study: Economic Policy in the Great Recession Exports./. Imports in Current Prices, Billion Euro Case Study: Economic Policy in the Great Recession USA Germany Decrease in Real Estate Prices Loss of Credit Receivables of US Banks Loss of Credit Receivables of Germ. Banks Quelle: Statistisches Bundesamt Net Wealth Loss of Households Reduction in Consumption Reduction in Credit Supply by US Banks Reduction in Reduction in Consumption and from Germany German Consumption Relatively Stable Reduction in Reduction of Export Reduction in Credit Supply by Ger. Banks Reduction of Production in Germany

40 Case Study: Economic Policy in the Great Recession Fiscal Policy Measures in Germany: Konjunkturpaket I of November 2008 with a total volume of about 100 Bn. : Case Study: Economic Policy in the Great Recession Geldpolitische Maßnahmen: Subsidization of building investment: energy saving investments Subsidization of investment in equipment: extension of write-off possibilities Extension of child allowances and other family support benefits Increase of credit supply for midsize companies: Sonderprogramm KfW Bank Case Study: Economic Policy in the Great Recession Fiscal Policy Measures in Germany: Konjunkturpaket II of January 2009 with a total volume of about 50 Bn. : Reduction of income tax Reduction of health insurance allowances Additional Extension of child allowances Subsidization of private demand for cars ( Cash for clunkers ) Municipal investment program: Improvement of infrastructure Case Study: Economic Policy in the Great Recession Monetary Policy Measures: Case Study: Economic Policy in the Great Recession Case Study: Economic Policy in the Great Recession