Week Twelve. Linus Yamane. Time Inconsistency of Optimal Policy

Transcription

1 Week Twelve Linus Yamane Time Inconsistency of Optimal Policy A government s preferences at one point in time can be inconsistent with its preferences at a later point in time. People understand the government s incentive to renege on their original policy. This affects the people s behavior. We may be better off by taking away government discretion. Since credibility is the problem, we may need institutional reform to prevent discretionary policy. 1

2 Time Inconsistency of Optimal Policy Public policy prohibits negotiating with terrorists Once hostages are taken, incentive to negotiate Government promises to deport all illegal immigrants Once illegal immigrants are here, incentive to grant amnesty Government promises to vigorously prosecute all tax evaders Once taxes are evaded, incentive for tax amnesty Time Inconsistency of Optimal Policy Government promises a monopoly to anyone who discovers a cure for cancer Once cure is found, incentive to renege on patent Government announces it won t tax capital Once capital is in place, incentive to tax it Federal Reserve announces zero inflation Once people set 0, incentive to increase output 2

3 Chapter 16 Household and Firm Behavior A. Wages, taxes, and labor supply B. Interest rates, savings, and consumption C. Inventories and the accelerator model Wages and labor supply We choose between work and leisure Income effect: as your income goes up, you want to consume more leisure (leisure is a normal good) and work less hours Substitution effect: as your wage goes up, the opportunity cost of leisure goes up, and you work more hours Backward bending labor supply curve 3

4 Backward bending labor supply curve MEN WOMEN Backward bending labor supply curve 4

5 Income Taxes You are paid $10 per hour Let the marginal tax rate be 30% Your after tax wage is $7 per hour How many hours do you want to work? Now we cut the marginal tax rate by 33% A 33% tax cut is HUGE! Reagan (1981) tax cut was 25% Your after tax wage increases to $8 per hour Now how many hours do you want to work? Interest rates, savings, and consumption When interest rates rise, what do you do? Consume more, and save less? Consume less, and save more? Consume the same, save the same? When interest rates rise, what do you think most people do? Consume more, and save less? Consume less, and save more? Consume the same, save the same? 5

6 Interest rates, savings, and consumption We have net savers and net borrowers On average, households are net savers When interest rates rise, net savers may consume more or consume less Higher interest rates make them wealthier, so they want to consume more But higher interest rates make current consumption more expensive relative to future consumption, so they consume less The net effect is ambiguous Interest rates, savings, and consumption Target savers: People who save today in order to make a specific purchase (large screen TV, vacation) in the future. When interest rates rise, they save less. Net borrowers decrease consumption when interest rates rise (and save more) When interest rates rise, they become less wealthy, and consume less When interest rates rise, current consumption becomes more expensive relative to future consumption, and so they consume less 6

7 Interest rates, savings, and consumption So consumption and savings depend many things Current disposable income Wealth Expected future income Age Consumption and savings may depend on interest rates, but the effect is theoretically ambiguous Some empirical evidence that savings increase with interest rates Household Net Savings Rates 2013 Country Percent Denmark 1.1 Japan 0.8 Poland 1.0 Italy 4.3 United States 4.5 Korea 4.8 Canada 5.0 Spain 7.0 Australia 11.1 Switzerland 13.4 Luxembourg 14.3 Why do savings rates differ? Borrowing constraints? Do not change lifetime income, and do not change lifetime consumption, so should not change aggregate savings. 7

8 Inventory Investment Change in private inventories $106.1 billion in 2013 Most volatile part of gross domestic investment Reasons for holding inventories Production smoothing in face of volatile demand Stock out avoidance Factor of production Work in process (pipeline inventory) Shift production to times when costs are relatively low Take advantage of economies of scale Month Accelerator Model Monthly Sales Stock of Capital Gross Investment Net Investment January February March April May June July Changes in output become magnified into larger changes in investment Sales must continue to keep increasing at the same speed in order for net investment to stand still As soon as growth slows down, the accelerator principle takes over 8

9 Accelerator Model Rate of investment is proportional to the change in the economy s output Level of investment depends on how quickly the economy is growing Leotieff Production Function min, Economy operates at Accelerator Model and β Level of investment depends on 9

10 Enter the Multiplier Accelerator Multiplier Together they lead to a business cycle with booms followed by busts Samuelson Multiplier Accelerator Model (1939) Increase in I leads to an increase in Y Increase in Y leads to an increase in I But Y can not go much beyond potential output, so Y must slow down When Y slows down, I will fall When I falls, Y will fall But gross investment can t be negative This explains the business cycle 10

11 Paul Samuelson ( ) Foremost academic economist of the 20th century New York Times Foundations of Economic Analysis, 1947 Wrote Economics, An Introductory Analysis, first published in 1948, and eventually sold over 4 million copies Nobel Prize, 1970 U.S. Long Run Growth Year Real GDP (bill ) Real GDP per capita Population (thousand) 1900 $466 $6,121 76, ,391 47, , ,802 53, ,373 Period Real GDP growth Real GDP PC growth Population growth % 2.07% 1.32% % 0.87% 0.88% 11

12 Long Run Growth Rates How long have we been growing at these rates? If real GDP per capita grows at 2.07% a year, real GDP PC grows by a multiple of 7.6 every 100 years. Year GDP PC 2000 $47, , ? Industrial Revolution Extensive Growth Most growth before the Industrial Revolution Linear replication of the economy Increasing the scale of the economy Intensive Growth Most growth after the Industrial Revolution Technological change Improvements in efficiency or productivity through innovation and economies of scale 12

13 Thomas Malthus ( ) Malthus (1798) An Essay on the Principle of Population Food grows arithme cally Popula on grows geometrically Society is caught in a Malthusian trap Population (if unchecked) doubles every 25 years Since land is fixed, food production will not keep up with population Population growth is slowed by pestilence, famine and war Economics becomes known as the dismal science Malthus was wrong! Spectacular changes in technology After 1780s the development of cotton mills and the factory system in England Industrial revolution moves to European continent and the U.S. in the 1800s Demographic transition After 1870 population growth slowed as living standards and real wages grew Shift from quantity to quality of children 13

14 Production Function GDP is a function of labor, capital, land, raw materials, and technology,, Y = GDP A: level of technology (research and development, inventions and innovations, learning by doing) Labor: skill level, education, population Capital : plant and equipment, residential structures, inventories Land : natural resources GDP Growth GDP increases over time because Growth in employment Increase in capital stock Increase in human capital Technological change Per Capita GDP increases over time because Growth in employment relative to the population Increase in capital stock Increase in human capital Technological change 14

15 GDP Growth Growth in employment Increase supply Income tax rate reduction (?) Earned income tax credit Increase demand Subsidize employment Increase skills of the work force (education, training) NOTE: Increasing employment will increase GDP, but not necessarily the standard of living (GDP per capita) GDP Growth Increase in Capital Stock Increases labor productivity and living standards Gross investment = net investment + depreciation Business Provide specific investment incentives Households Increase incentives to save Government Reduce budget deficit NOTE: Should increase government expenditures on public capital (schools, roads, communication lines, bridges, dams, etc) 15

16 GDP Growth Increase Human Capital Knowledge, skills, training of workers Provide incentives to invest in human capital Public education, job training programs Technological Change Research and development (R&D) spending Direct government spending or tax incentives Patent protection Economic Growth Accounting Robert Solow (1924 present) Nobel Prize 1987 Technical Change and the Aggregate Production Function, Review of Economics and Statistics, 1957 Assume the following Aggregate production function with constant returns to scale (double inputs double outputs) Labor and capital are competitively priced Full employment of labor and capital 16

17 Economic Growth Accounting = growth rate of real GDP = growth rate of technology = growth rate of capital stock = growth rate of labor Share of income that goes to capital Share of income that goes to labor We can measure everything except Solve for = growth rate of technology Economic Growth Accounting Using data from Most growth in per capita GDP is accounted for by technological change! 17

18 Bigger Share vs Bigger Pie Rent Seeking vs Entrepreneurship Rent Seeking Behavior to increase one s share of existing wealth rather than creating new wealth Entrepreneurship Process of identifying and starting a business venture, sourcing and organizing the required resources Murphy, Shleifer and Vishny, The Allocation of Talent: Implications for Growth, Quarterly Journal of Economics, 1991 Country Lawyers U.S. 1/356 Germany 1/1,256 Japan 1/8,569 Lawyers are indeed bad, and engineers are good, for growth. European Economic Review No responsibility is assumed by the publisher for any injury and/or damage to persons or property from any use or operation of any methods, products, instructions, or ideas contained in the material herein. 18

19 Population Growth and Technological Change People come up with good ideas If you have more people, you get more good ideas Larger population spurs technological change Michael Kremer, Population Growth and Technological Change: One Million BC to 1990, Quarterly Journal of Economics, 1993 The Growth of World Population For thousands of years, population grew slowly. From A.D. 1 until the mid 1600s, population grew at about.04 percent per year. Since the Industrial Revolution, population growth has occurred at an unprecedented rate. 19

20 Real GDP Growth Per Capita Country Growth Rate Country Growth Rate China 6.65% (4.4%) Brazil 2.43% Indonesia 3.65% United States 2.04% Japan 3.31% Mexico 1.90% India 3.11% Bangladesh 1.69% Pakistan 2.59% Nigeria 1.42% Highest Growth Rate China 6.65% (4.4%) Botswana 6.00% Singapore 5.55% South Korea 5.49% Oman 5.11% Lowest Growth Rate Central African Rep 0.84% Madagascar 1.08% Niger 1.14% Liberia 1.54% Dem Rep of Congo 2.15% Why do growth rates differ? Growth rates tend to be higher with Lower per capita GDP Lower population growth rates Higher savings rates More international trade Differences in GDP per capita Population growth and savings rates explain 60% of variance in per capita income Population growth, savings rates, and human capital explain 80% of cross country differences Mankiw, Romer, & Weil QJE

21 History matters The other 20%? Japan and China Indonesia, Nigeria, Pakistan Latin America Politics matter Governments must be stable Governments must seek and promote development Culture matters Must create a sufficient number of entrepreneurs Schools of Thought Why are there business cycles? What should we do about them? Classical View (Adam Smith) Prices and wages are perfectly flexible All markets clear Economy is always at potential output No business cycles 21

22 Keynesian View Wages are rigid (labor markets do not clear) Investment depends on animal spirits and is very volatile When investment falls, GDP falls through the multiplier In recessions, the price level falls Nominal wages are sticky due to labor contracts Real wages rise, causing unemployment Use expansionary fiscal policy to move the AD curve out and stimulate the economy Monetarist View Private sector is inherently stable Money is all that matters Friedman Monetary policy has long and variable lags Follow monetary growth rule Time inconsistency of optimal policy Unstable money growth leads to business cycles Excessive money growth leads to inflation 22

23 Supply Side View Shift the AS curve out to get higher GDP without inflation Cut income taxes to spur labor supply As more people work, GDP rises As GDP increases, tax revenue increases Laffer Curve 23

24 Reality Check The real rate of return on investment (S&P500) is about 6% If we invest 8% of GDP, the return will be 6% of 8% or approximately 0.48% Gross investment is about 16% of GDP We need to increase gross investment by 50% (this is a lot!) in order to get 0.48% of growth New Classical Macroeconomics Rational Expectations School All prices and wages are flexible all markets clear People have rational expectations Use all available information in forming expectations about the future Do not make systematic mistakes in their expectations Why are there business cycles? People make mistakes 24

25 Rational Expectations School Lucas Supply Curve (Short run AS curve) Output increases when prices are higher than expected (ie. there is a price surprise) Policy Ineffectiveness Theorem Predictable (systematic, anticipated) macroeconomic policies have no effect on real output or unemployment If people are surprised by policy, it will have an effect on output But you can t fool all the people all the time New Classical Macroeconomics Real Business Cycle Models (RBC) All prices and wages are flexible All markets clear Fluctuations in employment are fully voluntary and socially optimal Why are there business cycles? Exogenous technological disturbances (productivity shocks) cause business cycles Potential output (long run AS curve) moves up and down 25