Road-Map to this Lecture

Transcription

1 Allocation 1

2 Road-Map to this Lecture 1. Consumption 2. Investment 3. Government Expenditures 4. Equilibrium: equilibrium in financial markets 5. Fiscal Policy I slide 1 2

3 Demand for goods & services Components of aggregate demand: C = consumer demand for g & s I = demand for investment goods G = government demand for g & s NX = net exports (Exports Imports) of goods and services Y = C + I + G + NX slide 2 3

4 Consumption, C def: disposable income is total income minus total taxes: Y T Consumption function: C = C (Y T ) Shows that (Y T ) C The marginal propensity to consume is the increase in C caused by a one-unit increase in disposable income. slide 3 4

5 C The consumption function C (Y T ) 1 MPC The slope of the consumption function is the MPC. Y T slide 4 5

6 The Marginal Propensity to Consume MPC = if I get $1 in extra income, how much of that will I consume (and hence, how much will I save?)? Mathematically: MPS = 1 MPC slide 5 6

7 Consumption as a Function of Y d Total Consumption as a function of Disposable Income Monthly Data 1959: : Total real Consumption Expenditures Real Disposable Income slide 6 7

8 Consumption Ratio Ratio of Personal Consumption Expenditures to GDP (1947:1 to 2005:4) Percent Jan-47 Jan-52 Jan-57 Jan-62 Jan-67 Jan-72 Jan-77 Jan-82 Jan-87 Jan-92 Jan-97 Jan-02 slide 7 8

9 Private Saving Ratio Gross Private Saving to GDP Ratio (1947:1-2005:4) Percent Jan-47 Jan-52 Jan-57 Jan-62 Jan-67 Jan-72 Jan-77 Jan-82 Jan-87 Jan-92 Jan-97 Jan-02 slide 8 9

10 Investment Def: purchase of capital goods by firms and households (home purchases mostly) Determinants of investment: Cost of project return on the project Cost = B(1+r) n Return = B(1 + d 1 ) (1 + d n ) - δ Let D = (1 + d 1 ) (1 + d n ), then we want slide 9 10

11 Investment, I The investment function is I = I (r ), where r denotes the real interest rate, the nominal interest rate corrected for inflation. The real interest rate is the cost of borrowing the opportunity cost of using one s own funds to finance investment spending. So, r I slide 10 11

12 The investment function r Spending on investment goods is a downwardsloping function of the real interest rate I (r ) I slide 11 12

13 Investment to GDP ratio Fixed Private Investment to GDP Ratio 20 Percent Jan-47 Jan-52 Jan-57 Jan-62 Jan-67 Jan-72 Jan-77 Jan-82 Jan-87 Jan-92 Jan-97 Jan-02 slide 12 13

14 Government spending, G G includes government spending on goods and services. G excludes transfer payments Initially, we will assume government spending and total taxes are exogenous.: G = G and T = T slide 13 14

15 Deficit versus Debt Deficit: T G also referred as public saving. It refers to the fiscal year it is a flow. Debt: is the accumulation of past deficits that we have not yet paid off it is a stock slide 14 15

16 digression: Budget surpluses and deficits When T > G, budget surplus = (T G ) = public saving When T < G, budget deficit = (G T ) and public saving is negative. When T = G, budget is balanced and public saving = 0. slide 15 16

17 The U.S. Federal Government Budget 5% percent of GDP 0% -5% -10% (T-G) as as a percent of of GDP -15% slide 16 17

18 The U.S. Federal Government Debt percent of GDP 120% 100% 80% 60% Fact: In In the the early early 1990s, about cents of of every tax tax dollar went went to to pay pay interest on on the the debt. (Today it s it s about 9 cents.) 40% 20% slide 17 18

19 The market for goods & services Agg. demand: CY ( T) + I( r) + G Agg. supply: Y = F ( K, L) Equilibrium: Y = CY ( T) + I( r) + G The real interest rate adjusts to to equate demand with supply. slide 18 19

20 Equilibrium in the Financial Market A simple supply-demand model of the financial system. One asset: loanable funds demand for funds: investment supply of funds:saving (private + public) price of funds: real interest rate slide 19 20

21 Demand for funds: Investment The demand for loanable funds comes from investment: Firms borrow to finance spending on plant & equipment, new office buildings, etc. Consumers borrow to buy new houses. depends negatively on r, the price of loanable funds (the cost of borrowing). slide 20 21

22 Loanable funds demand curve r The investment curve is also the demand curve for loanable funds. I (r ) I slide 21 22

23 Supply of funds: Saving The supply of loanable funds comes from saving: Households use their saving to make bank deposits, purchase bonds and other assets. These funds become available to firms to borrow to finance investment spending. The government may also contribute to saving if it does not spend all of the tax revenue it receives. slide 22 23

24 Types of saving private saving = (Y T ) C public saving = T G national saving, S = private saving + public saving = (Y T ) C + T G = Y C G slide 23 24

25 Notation: = change in a variable For any variable X, X = the change in X is the Greek (uppercase) letter Delta Examples: If L = 1 and K = 0, then Y = MPL. Y More generally, if K = 0, then MPL =. L (Y T ) = Y T, so C = MPC ( Y T ) = MPC Y MPC T slide 24 25

26 EXERCISE: Calculate the change in saving Suppose MPC = 0.8 and MPL = 20. For each of the following, compute S : a. G = 100 b. T = 100 c. Y = 100 d. L = 10 slide 25 26

27 Answers S = Y C G = Y 0.8( Y T ) G a. S = 100 b. S = = 80 c. S = = 20 = 0.2 Y T G d. Y = MPL L = = 200, S = 0.2 Y = = 40. slide 26 27

28 Loanable funds supply curve r S = Y C( Y T ) G National saving does not depend on r, so the supply curve is vertical. S, I slide 27 28

29 Loanable funds market equilibrium r S = Y C( Y T ) G Equilibrium real interest rate I (r ) Equilibrium level of investment S, I slide 28 29

30 The special role of r r adjusts to to equilibrate the goods market and the loanable funds market simultaneously: If If L.F. market in in equilibrium, then Y C G = I Add (C (C +G ) to to both sides to to get Y = C + I + G (goods market eq m) Thus, Eq m in L.F. market Eq m in goods market slide 29 30

31 Digression: mastering models To learn a model well, be sure to know: 1. Which of its variables are endogenous and which are exogenous. 2. For each curve in the diagram, know a. definition b. intuition for slope c. all the things that can shift the curve 3. Use the model to analyze the effects of each item in 2c. slide 30 31

32 Mastering the loanable funds model 1. Things that shift the saving curve public saving fiscal policy: changes in G or T private saving preferences tax laws that affect saving 401(k) IRA replace income tax with consumption tax slide 31 32

33 Example: The Reagan Deficits Percent -1 Public Deficit as a Ratio of GDP During the Reagan Years 0 Jan-82 Jan-83 Jan-84 Jan-85 Jan-86 Jan-87 Jan-88 Jan-89 Jan slide 32 33

34 CASE STUDY The Reagan Deficits Reagan policies during early 1980s: increases in defense spending: G > 0 big tax cuts: T < 0 According to our model, both policies reduce national saving: S = Y C( Y T ) G G S T C S slide 33 34

35 1. The Reagan deficits,, cont. 1. The increase in the deficit reduces saving r S 2 S 1 2. which causes the real interest rate to rise r 2 r 1 3. which reduces the level of investment. I 2 I 1 I (r ) S, I slide 34 35

36 Are the data consistent with these results? variable 1970s 1980s T G S rr II T G, S, and I are expressed as a percent of GDP All figures are averages over the decade shown. slide 35 36

37 Mastering the loanable funds model 2. Things that shift the investment curve certain technological innovations to take advantage of the innovation, firms must buy new investment goods tax laws that affect investment investment tax credit slide 36 37

38 An increase in investment demand raises the interest rate. r r 2 S An increase in desired investment r 1 But the equilibrium level of investment cannot increase because the supply of loanable funds is fixed. I 1 I 2 S, I slide 37 38

39 Saving and the interest rate Why might saving depend on r? How would the results of an increase in investment demand be different? Would r rise as much? Would the equilibrium value of I change? slide 38 39

40 An increase in investment demand when saving depends on the interest rate Real interest rate, r S(r) raises the interest rate.. A B 1. An increase in desired investment... I and raises equilibrium investment and saving. I 1 Investment, Saving, I, S slide 39 40

41 Suppose: A Numerical Example Y = 5,000; G = 1,000; T = 1,000 C = (Y T) I = 1,000 5,000r Calculate the equilibrium level r * slide 40 41

42 Example Continued Exogenous Variables: Y, G, and T. Their values are given outside the problem Endogenous Variables: r, C, I. Their values are determined in the problem slide 41 42

43 Finding r * We know: Y = C + I + G Hence: 5,000 = [ (5,000-1,000)] + Therefore: [1,000 5,000r] + 1,000 r * = 0.05 = 5% I = 1,000 5,000(0.05) = 750 slide 42 43

44 What Happens if Public Expenditure Increases by 25%? Suppose: G = 250, i.e., G = 1,250 Using the same algebra: r * = 10%, i.e., r = 5% I = 500, i.e., I = -250 or -33% Notice that in the new equilibrium G = - I =250 slide 43 44

45 What Happens if Taxes Decrease by 25% Now: T = -250, hencet = 750 r * = 8.75%, i.e., r = 3.75% I = 562, i.e., I = or -25% Notice that in the new equilibrium G - I slide 44 45

46 Fiscal Policy - Summary Notice that G = - T = 250 both generate a budget deficit of 250. However G = T = 0 G = 250 T = ,250 5% 750 3,250 10% 500 3, % 562 slide 45 46