How do I work Problem Sets 6 and 7?

Transcription

1 Fist: Know the assumptions How do I wok Poblem ets 6 and 7? 1) The time peiod is long enough that the economy has enough time fo all of its makets to go to euilibium. The labo maket goes to euilibium. Likewise, the loanable funds maket (and financial makets in geneal) goes to euilibium (no shotages of supluses of cedit). In shot, we can ignoe booms and busts and assume the economy is always at Nat. 2) The time peiod, howeve, is not long enough fo the economy s natual GP to makedly change. Nat and the PPC do not change. In the long-un (but not the vey long-un) the main issue is cowding out. In this poblem set you will investigate how an incease in Govenment spending, without a matching incease in taxes (i.e. an incease in the govenment deficit) can cowd out pivate Investment. econd: Get Used to the Mechanics of the Expanded Cicula Flow The cicula flow diagam we saw way back in chapte 6 was petty simple (figue 6.2, shown at ight). It only had two agents: households and fims (o businesses). All households could do with thei income was spend it. To make the cicula flow model moe ealistic, we add othe things households can do with thei income. In paticula, households can also use thei income: 1) to pay taxes (as the law euies), and 2) as savings. ome of a households income goes to taxes. ome is used fo consumption. Whateve is left ove is, by definition, thei savings. This leaves us with an identity o fomula. Income = C + + T. ince we ae not distinguishing between Income and GP in this model, we can wite: GP = C + + T (figue 15.1, following page). Figue 6.2: The Basic Cicula Flow Model 1

2 Figue 15.1: The omestic Cicula Flow Model If this isn t in colo, you can t tell what s a leakage & what s an injection. The Leakages ae: & T The injections ae: I & G Households may hoad some of thei savings as cash in the shot un, say keeping it in the povebial mason ja. Nonetheless, in the long-un this cash ends up in banks, bonds, mutual funds, the stock maket, and othe pats of the financial system. In the long-un all savings ends up in financial makets (which I ll call the loanable funds maket ). What does the financial system do with this savings? Again in the shot-un, banks and othe pats of the financial system may simply hold some this cash. In fact, banks have been doing just that fo much of (late) 2008, 2009, and In the long-un, howeve, this money will get loaned out. If, fo example, banks have excessive amounts of cash, they will eventually educe inteest ates to get this money loaned out. Banks, afte all, make thei pofits by lending money at inteest, not by keeping it in thei vault. The money that is loaned out goes to finance new physical capital, i.e. physical investment. Put it all togethe and savings goes to fund Investment. Likewise, taxes go to fund Govenment spending. avings and Taxes, both of which take away fom spending tempoaily (i.e. ae leakages), in the long-un get channeled into new spending in the fom of Investment and Govenment. This leaves us with a second long-un fomula: GP = C + I + G (again, figue 15.1 at ight). In fact, if C + I + G (i.e. spending) is less than GP, fims will not be selling eveything they poduce. In the shot-un this can happen, but not in the long-un. Technically, a lage % of lending goes to fund consumption puchases. Instead of showing a money aow flowing fom financial makets back to households and consumption spending, we just net this boowing fo consumption out of household savings. The avings aow flowing fom households to the financial secto is actually Net avings by households. Nonetheless, economists usually get a bit lazy and just call it avings. o what happens (again, in the long-un) if the govenment doesn t have a balanced budget? Afte all, in any given yea, few govenments do have a balanced budget. If the govenment spends moe than it collects in tax evenue, it uns a deficit. Whee does govenment get the exta money (deficit) money? It boows it! Figue 15.3 (next page) shows this. In figue 15.3, the govenment is boowing 1 tillion fom financial makets (labeled as the loanable funds maket). This means, at any given inteest ate, 1 tillion moe boowing is demanded. The exta govenment boowing shifts the demand fo loanable funds to the ight by 1 tillion and dives up inteest ates. The highe inteest mean less pivate secto boowing. Fims ae less likely to boow fo new physical capital as the inteest ate ises. Put is all togethe, and the 1 tillion of govenment boowing has cowded out 1 tillion of pivate investment!! Note that the fomulas still hold in figue GP = C + + T and GP = C + I + G. We ve just eplace (lowe) investment fo (moe) spending. 2

3 Figue 13.9 (below) summaizes how both high govenment spending and high consumption can cowd out investment. If govenment spending o consumption wee to decease, the aows would be evesed. Figue 13.9: Cowding Out Via Inteest Rates I UA Figue 15.3: Cowding out by Govenment Boowing If the govenment spends less than it takes in taxes, it uns a suplus. What does a govenment do with the exta tax dollas when it uns a suplus? It almost always uses them to pay down existing debt (the only othe thing it could eally do is bun the money). By paying down its existing debt the govenment is supplying loanable funds to the financial makets. This is vey impotant, by the way. A govenment suplus means the govenment is supplying loanable funds! The inceased supply of loanable funds dives down inteest ates which means moe boowing by fims fo investment pojects. A tillion dolla govenment suplus would get channeled into 1 tillion moe investment spending. Figue 13.9 also addesses how does an incease in consumption spending affects the economy in the long-un. An incease in consumption spending means less savings. Lowe savings means that financial makets have fewe funds to loan out. This tempoay shotage of loanable funds dives up inteest ates and chokes off boowing fo investment. Convesely, a decease in consumption means moe savings. While this may put the economy into a ecession in the shot-un, in the long-un it means moe funds ae available fo businesses to boow. Inteest ates fall and investment inceases (again, in the long-un). Thid: Let s Wok ome Examples The loanable funds maket (o financial maket) ae key to cowding out and poblem sets 7 & 8. The loanable funds maket can be modeled like any othe maket using supply and demand. People who put thei money into financial makets ae the supplies. Usually households ae the supplies of loanable funds. Govenment can also be a supplie of loanable funds if (and only if) it uns a govenment suplus. Business, 3

4 boowing fo physical investment pojects, ae the main pat of the demand side. Govenment can be a demande of loanable funds if it uns a deficit (athe than a suplus o balanced budget). Again, govenment deficits mean the govenment is boowing money. Let s wok a couple of examples (below). In all of these examples, you ae giving a savings schedule fo households. This schedule shows up as columns 1 and 2 below. It indicates how much households save ( Piv ) at each inteest ate. At highe inteest ates (highe ates of etun fom putting thei money in financial makets) households incease thei savings. You ae also given a demand schedule fo fims wanting to boow fo pivate investment pojects. This schedule is the 1 st and 3 d columns below. It shows how much fims ae willing to boow ( Piv ) at each inteest ate. As inteest ates fall, fims ae willing to boow moe. Finally, you ae given data on govenment spending, taxes, and eal GP. Example 1: What you ae given Govenment spending = 2,500 Taxes = 2,500 (Real) GP = 7,500 U Pivate Loanable Funds Mkt U.. Govenment (2 nd ) U.. Loanable Funds Mkt (3 d ) piv = Piv + avings = I Gov Gov = Total Total 8.5% 1, % % 1, % % % % % % % % % % 600 1, % % 600 1, % 500 1, % % 500 1, % 400 1, % % 400 1, % 300 1, % % 300 1, % 200 1, % % 200 1,700 (1 st ) Govt. Budget Balance = Balanced Budget (4 th ) = 7.5% (5 th ) = 800 (5 th ) I = 800 (6 th & 7 th ) C = Let s figue example 1 out. ince the govenment is spending exactly what it takes in taxes, it is unning a balanced budget. Theefoe, it is neithe boowing (i.e. demanding) no supplying any loanable funds. This means that evey cell of the uantity supplied and uantity 4

5 demanded columns fo the U.. govenment table ae 0. Now, we need to combine all pats of the loanable funds maket. To do this, at each inteest ate, add the pivate level of savings ( Piv ) to the govenment s savings ( Gov ) to get the total amount of savings at that inteest ate ( Total ). ince thee is no govenment savings in this example, the total amount of savings ( Total ) is no diffeent fom pivate savings ( Piv ). In simila fashion, at each inteest ate, add the pivate boowing ( Piv ) and the govenment boowing ( Piv ) to get total boowing ( Total ). Petty simple, huh? Now, the euilibium fo the loanable funds makets. It s when the inteest ate is 7.5%. At inteest ates above 7.5% thee is a suplus of loanable funds and banks have incentives to lowe inteest ates. At inteest ates below 7.5%, thee is a shotage of loanable funds. Banks have incentive to aise inteest ates. Only when inteest ates ae 7.5% do banks want to leave it unchanged. They ae lending out the amount of money they ae taking in. Although you ae not asked to plot the loanable funds maket on you poblem sets, I show you what it looks like at ight. Yeah. I think it s beautiful too! Now that we know the inteest ate, we can figue out the amount of savings and investment. At 7.5%, avings is 800 and Investment is 800. Finally, we can figue out the amount of consumption (C). In example 1, you ae given the level of eal GP 7,500. ince this is the long-un, the economy will go to its natual level of output so this is eual to natual GP. On you poblem sets 7 and 8 I often get lazy and leave the eal out of all the othe values. My bad. One should always adjust fo inflation. Well, just emembe that all values on these poblem sets ae eal values. o, how do you figue out the level of consumption? Thee ae two ways. Fist, you can look at what households do with thei income. ince GP (Yikes! I m leaving out eal again!) is 7,500, households ae eceiving 7,500 in income. Because the govenment takes 2,500 of households income as taxes and households ae saving 800, they must be spending (o consuming) the emaining 4,200. It s just the fomula = C + + T. The second way to solve fo consumption is to look at the goods and sevices maket. The spending souces, C + I + G, will add to GP. In othe wods, = C + I + G. ince GP is 7,500, Investment is 800, and Govenment is 2,500, Consumption has to be 4,200. 5

6 Example 1: The olution Govenment spending = 2,500 Taxes = 2,500 (Real) GP = 7,500 U Pivate Loanable Funds Mkt U.. Govenment U.. Loanable Funds Mkt piv = Piv + avings = I gov gov = Total Total 8.5% 1, % % 1, % % % % % % e7.0% % % % 600 1, % % 600 1, % 500 1, % % 500 1, % 400 1, % % 400 1, % 300 1, % % 300 1, % 200 1, % % 200 1,700 = C + I + G Goods & evices Mkts Govt. Budget Balance = Balanced Budget euilibium Final Revenues = = 7,500 P Investment = 800 Govt = 2,500 Consumption = 4,200 Taxes = 2,500 Only money flows ae shown = 7.5% = 800 I = 800 C = 4,200 Investment = 800 avings = 800 = C + + T loanable funds wage etc. Resouce Mkts labo & othe esouces 6

7 Example 2: What you ae given Govenment spending = 2,500 3,000 Taxes = 2,500 (Real) GP = 7,500 U Pivate Loanable Funds Mkt U.. Govenment U.. Loanable Funds Mkt piv = Piv + avings = I Gov Gov = Total Total 8.5% 1, % % 1,000 1, % % % 900 1, % % % 800 1, % % % 700 1, % 600 1, % % 600 1, % 500 1, % % 500 1, % 400 1, % % 400 1, % 300 1, % % 300 2, % 200 1, % % 200 2,200 Govt. Budget Balance = 500 deficit = 8.5% = 1,000 I= 500 C = That was fun! Let s wok two moe examples. In example 2, I ll incease govenment spending to 3,000. This means a 500 deficit, i.e. 500 of govenment boowing. ince govenment boowing has nothing to do with the inteest ate, govenment boowing will be 500 at each and evey inteest ate. Thee is no govenment savings. The figue at ight shows this in tems of the supply and demand cuves. How does this look when you use the tables to solve you poblem set? ince thee is no govenment suplus, Gov is 0 all the way down. The govenment deficit of 500 means that Gov 500 all the way down (the govenment is boowing 500 egadless of the inteest ate). Put it all togethe and the exta boowing dives inteest the ate up to 8.5%. At the highe inteest ate, savings has inceased slightly to 1,000. The main effect, howeve, is that the highe inteest ate has deceased investment to 500. Talk about cowding out! 7

8 Example 2: The olution Govenment spending = 2,500 3,000 Taxes = 2,500 (Real) GP = 7,500 U Pivate Loanable Funds Mkt U.. Govenment U.. Loanable Funds Mkt piv = Piv = + avings = I gov gov Total 8.5% 1, % % 1,000 1, % % % 900 1, % % % 800 1, % % % 700 1, % 600 1, % % 600 1, % 500 1, % % 500 1, % 400 1, % % 400 1, % 300 1, % % 300 2, % 200 1, % % 200 2,200 = C + I + G Goods & evices Mkts Govt. Budget Balance = 500 deficit Total euilibium Old, sit. 1, euilibium Final Revenues = = 7,500 Investment = 500 P Investment = 500 Govt eficit = 500 Govt = 3,000 avings = 1,000 Consumption = 4,000 Taxes = 2,500 Only money flows ae shown = C + + T = 8.5% = 1,000 I = 500 C = 4,000 loanable funds wage etc. Resouce Mkts labo & othe esouces 8

9 Example 3: A Govenment uplus - The olution Govenment spending = 2,500 2,000 Taxes = 2,500 (Real) GP = 7,500 U Pivate Loanable Funds Mkt U.. Govenment U.. Loanable Funds Mkt piv = Piv + avings = I gov gov = Total Total 8.5% 1, % % 1, % % % 1, % % % 1, % % % 1, % 600 1, % % 1,100 1, % 500 1, % % 1,000 1, % 400 1, % % 900 1, % 300 1, % % 800 1, % 200 1, % % 700 1,700 euilibium = C + I + G Goods & evices Mkts Govt. Budget Balance = 500 suplus = 6.5% = 600 I = 1,100 C = 4,400 Final Revenues = = 7,500 P Investment = 1,100 Govt = 2,000 Consumption = 4,400 Taxes = 2,500 Only money flows ae shown Investment = 1,100 Govt uplus = 500 avings = 600 = C + + T loanable funds wage etc. Resouce Mkts labo & othe esouces 9

10 Finally, let s look at all this in the context of the PPC. Because the PPC only gives us two axes, we have to goup ou poduction into two categoies. Investment (physical investment) is the main thing that is getting cowded out and the main thing we woy about getting cowded out. Theefoe, let s put investment (I) on one axis. That leaves C + G fo the othe axis. If I is about building fo the futue, and C + G is about living fo today, we ae plotting how much we choose to live fo today vesus build fo the futue (although it s easy to ague that much of C and especially G build fo the futue). Whateve you intepetation, the PPC fo ou thee situations is shown below. Actually, I gave you two views of the same PPC depending on whethe you want a close-up view o not. As long as you PPC is neat and pecise, this is one time I don t cae if you tuncate one o moe of the axes. Yeah! I m done (and so ae you) with this poblem set guide!! 10

11 Example 3: What you ae given Govenment spending = 2,500 2,000 Taxes = 2,500 (Real) GP = 7,500 U Pivate Loanable Funds Mkt U.. Govenment U.. Loanable Funds Mkt piv = Piv + avings = I Gov Gov = Total Total 8.5% 1, % 8.5% 8.0% % 8.0% 7.5% % 7.5% 7.0% % 7.0% 6.5% 600 1, % 6.5% 6.0% 500 1, % 6.0% 5.5% 400 1, % 5.5% 5.0% 300 1, % 5.0% 4.5% 200 1, % 4.5% Govt. Budget Balance = = = I = C = 11