Lecture 7. Unemployment and Fiscal Policy

Transcription

1 Lecture 7 Unemployment and Fiscal Policy

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3 The Multiplier Model As we ve seen spending on investment projects tends to cluster. What are the two reasons for this? 1. Firms may adopt a new technology at the same time. 2. Firms may have similar beliefs about expected future demand. We need a tool to help us understand how decisions of firms (and households) to raise or reduce spending will affect the economy as a whole

4 The Multiplier Model We begin with a simple model with only two types of expenditure: 1. Consumption 2. Investment Aggregate consumption is assumed to have two parts: 1. A fixed amount 2. A variable amount

5 The Multiplier Mechanism We can write the aggregate consumption function in the form of an equation. aggregate consumption = autonomous consumption + consumption that depends on income C = c 0 + c 1 Y c 0 = fixed amount (i.e. autonomous consumption) Y = income c 1 = marginal propensity to consume

6 The Multiplier Mechanism Marginal propensity to consume : The change in consumption when disposable income changes by one unit. What do you think the marginal propensity to consume is for the rich and wealthy? How about for those living paycheck to paycheck? For now, let s assume the MPC is, on average, 0.6.

7 The Multiplier Mechanism

8 The Multiplier Mechanism Autonomous consumption : Consumption that is independent of current income. Expectations about future income will heavily influence autonomous consumption

9 The Multiplier Model Goods market equilibrium : The point at which output equals the aggregate demand for goods produced in the home economy. The economy will continue producing at this output level unless something changes spending behavior. For now, we re assuming that: the level of output depends on the level of aggregate demand firms are willing to supply any amount of goods demanded there is no government spending or trade investment does not depend on level of output

10 The Multiplier Model So in this model there are just two components of aggregate spending/demand: 1. Consumption 2. Investment The equation for aggregate demand is therefore: AD = C + I AD = c 0 + c 1 Y + I

11 The Multiplier Model So what happens when there is a drop in investment spending? Decreased Production Smaller drop in consumption Equivalent drop in income

12 The Multiplier Model What happens when there is an increase in autonomous consumption? Increased Production Smaller increase in consumption Equivalent rise in income

13 The Multiplier Model What happens when there is an increase in autonomous consumption? Increased Production Smaller increase in consumption Equivalent rise in income

14 The Multiplier Model If the change in GDP is equal to the initial change in spending: We say that the multiplier is equal to one. If the total change in GDP is greater than the initial change in spending: We say that the multiplier is greater than one. If the total change in GDP is less than the initial change in spending: We say that the multiplier is less than one.

15 The Multiplier Model We call this model the multiplier model. A summary: A fall in demand leads to a fall in production and an equivalent fall in income The multiplier is the sum of all these successive decreases in production Production adjusts to demand

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17 The Multiplier Mechanism

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19 The Multiplier Mechanism

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27 The Multiplier Model This model is making some important assumptions We re assuming there are underutilized resources and labor We re assuming that wages are not affected by changes in the level of output We re assuming that firms do not adjust prices If we relax these assumptions, will this make the multiplier bigger or smaller, all else being equal?

28 Autonomous Consumption Think about a family with a mortgage on its house. How might they react to a fall in housing prices? They are likely to increase their precautionary savings We assume that households try to maintain their target wealth as long as possible

29 Great Depression The shift from A to B: Some economists have estimated that the size of the multiplier at the time was about 1.8. Why did households, even those not affected by credit constraints, cut consumption so much?

30 Great Depression Research since the Great Depression provides a number of explanations for the fall in autonomous consumption in the US Uncertainty Pessimism and the desire to save more The banking crisis of 1930 and 1931 and the collapse of credit

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35 Great Depression Three simultaneous positive feedback mechanisms brought the American economy down in the 1930s: 1. Pessimism about the future 2. The banking crisis 3. Deflation

36 Debt-Deflation Cycle Indebted households cut spending Higher debt burden for households Firms reduce wages Lower income and deflation

37 Debt-Deflation Cycle For Farmers Price of produce falls Increase production Lower incomes and higher debt burdens

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41 Great Depression In 1933 Roosevelt began a program of changes to economic policy: 1. The New Deal 2. US left the gold standard 3. Banking reforms How do you think these changes affected the expectations of businesses and households? How do you think that in turn affected their behavior?

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44 Great Recession The great moderation masked three changes that would create the environment for the global financial crisis. 1. Rising debt 2. Increasing housing prices 3. Rising inequality

45 Great Recession How does an increase in house prices affect consumption? For the non-credit-constrained, should reduce precautionary savings and increase consumption. For the credit-constrained, the higher collateral enables you to borrow more. This is called the financial accelerator.

46 Great Recession Recent research has shown that much of the subprime borrowing was to those with generally good credit taking out mortgages for second or third or fourth properties.

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53 Great Recession High debt burdens amplify the destruction of net worth. This amplification is the leverage multiplier. If house prices fall by 30 percent, the decline in net worth for indebted home owners is much larger because of the leverage multiplier.

54 The decline in net worth during the Great Recession completely erased all the gains from 1992 to In 2011, 11 million properties 23 percent of all properties with a mortgage had negative equity. Debt is the anti-insurance. Instead of helping to share the risks associated with home ownership, it concentrates the risks on those least able to bear it. How do you think those whose net worth was destroyed changed their consumer spending?

55 Great Recession What kind of consumer spending took the biggest hit during these years? Furniture purchases in 2007 were down 1.4 percent from Spending on appliances was up 2 percent in 2007, but was lower than the 7 percent growth in 2005 and In 2008, auto spending was down 9 percent, furniture spending was down 8 percent, and homeimprovement expenditures were down 5 percent.

56 Great Recession The spending response is the MPC out of housing wealth. Research estimates an MPC out of housing wealth during the recession on the order of 5 to 7 cents per dollar. So if an individual s house price fell by $10,000, they cut spending on average about $500 to $700.

57 Great Recession Given the aggregate decline in home values of about $5.5 trillion, that implies that the decline in home values led to a $275 to $385 billion decline in retail spending Why do you think the bursting of the stock market bubble, which destroyed a similar amount of wealth, didn t lead to a similar economic decline?

58 Great Recession In the context of a deregulated financial system, banks increased their borrowing: to extend more loans for housing to extend more loans for consumer durables like cars and furnishings to buy more financial assets based on bundles of home loans This all made it very profitable for banks to increase their leverage

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60 Debt-Deflation Cycle

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65 Great Recession Why did the problems in the subprime market and other parts of the US housing market lead to a (global) financial crisis and the Great Recession? High levels of debt by both households and firms High bank leverage Interconnectedness of banks across the globe Lack of public information on exposure to risk fire sales

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67 Great Recession Hedge financing : firms rely on future cashflow to repay all borrowings Speculative : firms rely on cashflow to repay the interest on borrowings but must roll over their debt to repay the principal Ponzi : cashflow covers neither principal nor interest; firms are betting that the underlying asset will appreciate enough to cover their liabilities

68 INVESTMENT SPENDING How do firms make investment decisions? Think of the manager or owner of a firm with some accumulated revenues in excess of costs, deciding what to do with them. There are four choices: 1. Dividends 2. Consumption 3. Investment abroad 4. Investment at home How do they decide among the four options?

69 INVESTMENT SPENDING The owner will compare the interest rate (r) to the (expected) profit rate (p) If r > p: The decision will be to repay debt or purchase a financial asset. If p > r: The owner will invest (either at home or abroad). The interest rate, then, is the opportunity cost of purchases of capital goods

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72 INVESTMENT SPENDING The empirical evidence suggests that business spending is not very sensitive to the interest rate The interest rate primarily affects the economy through demand for housing and consumer durables

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74 MULTIPLIER MODEL Putting together all the components, we end up with: AD = c o + c 1 1 t Y + I + G + X my Total consumption is c o + c 1 1 t Y t = tax rate, so 1 t Y is our disposable income Would an increase in the tax rate increase or decrease the multiplier? The more households are able to smooth fluctuations in disposable income, the smaller is c 1 and the greater is c o. m = our marginal propensity to import Both taxes and imports reduce the size of the multiplier.

75 FISCAL POLICY There are three main ways that government spending and taxation can dampen fluctuations in the economy: 1. Size of government 2. Government provided unemployment benefits 3. Government can directly intervene

76 FISCAL POLICY Unemployment benefits are an automatic stabilizer Government can also use deliberate stabilization policies What are some downsides to deliberate stabilization policies?

77 FISCAL POLICY Why won t consumer and investment spending necessarily increase on their own during a recession? Governments can use automatic stabilizers to help absorb any sudden changes. Government can provide economic stimulus until business and consumer confidence return This will cause budget deficits to rise, but it avoids a deep recession. This basic point was one of Keynes biggest contributions to economics.

78 FISCAL POLICY Government can also amplify fluctuations For example, a government might override the automatic stabilizers because it is concerned about the effect of a recession on its budget balance. Budget in balance: G = T Budget deficit: G > T Budget surplus: G < T

79 FISCAL POLICY These kinds of polices are often called austerity policy. This doesn t mean that government deficits should never be a concern.

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84 FISCAL POLICY It s important to realize that there is no single multiplier that applies at all times. Do you think the multiplier is bigger in a recession or in an economy at full capacity utilization? If the economy is doing really well, a 1% increase in government spending might displace or crowd out some private spending in the economy

85 FISCAL POLICY Questions about the size of the multiplier became especially salient after the crisis of 2008 Two economists found that, for the US, a $1 increase in government spending in the US raises output by about $1.50 to $2.00 in a recession, but only by about $0.50 in an expansion. They also found similar results in other countries The size of the multiplier will also depend on the expectations of firms and businesses.

86 Different Multiplier Effects Tax Cuts Multiplier Nonrefundable Lump-Sum Tax Rebate 1.02 Refundable Lump-Sum Tax Rebate 1.26 Temporary Tax Cuts Payroll Tax Holiday 1.29 Across the Board Tax Cut 1.03 Accelerated Depreciation 0.27 Permanent Tax Cuts Extend Alternative Minimum Tax Patch 0.48 Make Bush Income Tax Cuts Permanent 0.29 Make Dividend and Capital Gains Tax Cuts 0.37 Permanent Cut Corporate Tax Rate 0.30 Spending Increases Extend Unemployment Insurance Benefits 1.64 Temporarily Increase Food Stamps 1.73 Issue General Aid to State Governments 1.36 Increase Infrastructure Spending 1.59 Source: M. Zandi, The Economic Impact of the American Recovery and Reinvestment Act, Moody s Economy.com, 2009.

87 GOVERNMENT FINANCES To better understand the politics and economics of fiscal policy, we turn to the government's revenue and its expenditure. Primary deficit : The government deficit (its revenue minus its expenditure) excluding interest payments on its debt. The primary deficit worsens in a downturn, and improves in an upturn

88 GOVERNMENT FINANCES When there is a budget deficit, the governments typically borrow to cover the gap between revenue and expenditure. The government borrows by selling bonds. Government Debt : The sum of all the bonds the government has sold over the years to finance its deficits, minus the ones that have matured.

89 GOVERNMENT FINANCES A sovereign debt crisis is a situation in which government bonds come to be considered risky. A large stock of debt relative to GDP can also be a problem because the government has to pay interest on its debt and it has to raise revenue to pay the interest. However, there is no point at which governments need to have paid off all their stock of debt

90 GOVERNMENT FINANCES The British government ran a primary budget surplus in every year except one from 1948 until But it may also fall even when there is a primary budget deficit, as long as the growth rate of the economy is higher than the interest rate. This has been true for the US for almost all of the last 125 years. Why does inflation help a country reduce its debt ratio?

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93 There is no true level of the federal debt. The debt is not an object out in the world. It is a way of talking about some set of the payment commitments by some set of economic units, sets whose boundaries are inherently arbitrary. - J.W. Mason

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98 LESSONS THUS FAR The lessons from our discussion of fiscal policy and government debt: Automatic stabilizers play a useful role If additional fiscal stimulus is used, this should usually be reversed later Financial crises and wars increase government debt. Inflation reduces the government debt burden An ever-increasing debt ratio is unsustainable. If the growth rate is below the interest rate, it is necessary to run primary government surpluses

99 FISCAL POLICY AND TRADE In modern economies, what happens in the rest of the world is a source of shocks China, for example, is very important for Australian exports 32% of Australian exports went to China in 2013, accounting for 6.5% of Australian aggregate demand. What do you think happened to the Australian economy when the Chinese economy slowed down from a growth rate of 10.4% in 2010 to 7.7% in 2013?

100 FISCAL POLICY AND TRADE Thus, trade with other countries constrains, at least to some extent, the ability of domestic fiscal policymakers to use stimulus policies in a recession. A particularly striking example of this comes from France in the 1980s. At the start of the 80s, the French economy remained weak following the oil shocks of the 1970s. In 1981, the socialist prime minister Pierre Mauroy implemented a program to stimulate aggregate demand through increased government spending and tax cuts