ECO LECTURE 30 1 OKAY. TODAY WHAT WE WANT TO DO IS FINISH UP THE MATERIAL TALKING ABOUT FISCAL POLICY AND THEN WE'LL BE READY FOR AN EXAM TO

Transcription

1 ECO LECTURE 30 1 OKAY. TODAY WHAT WE WANT TO DO IS FINISH UP THE MATERIAL TALKING ABOUT FISCAL POLICY AND THEN WE'LL BE READY FOR AN EXAM TO COVER THIS KEYNESIAN ECONOMIC MODEL AND FISCAL POLICY. WHAT WE WERE DOING LAST TIME -- LET ME SORT OF GO BACK AND SET THE SCENE SO THAT IT'S ALL FAMILIAR TO YOU. THE KEYNESIAN MODEL OF THE ECONOMY HAS GOT A TOTAL PRODUCTION CURVE WHICH IS -- THIS IS THE FORTY-FIVE DEGREE LINE. THERE'S A TOTAL EXPENDITURE CURVE WHICH, YOU'LL REMEMBER, TOTAL EXPENDITURES EQUALS CONSUMPTION PLUS INVESTMENT PLUS GOVERNMENT SPENDING PLUS NET EXPORTS. THIS IS AUTONOMOUS SPENDING. I'LL CALL THAT A1. WE'RE VERY INTERESTED IN THAT AUTONOMOUS SPENDING BECAUSE IT'S THROUGH THIS AMOUNT, AUTONOMOUS CONSUMPTION PLUS INVESTMENT PLUS GOVERNMENT SPENDING PLUS NET EXPORTS MINUS MPC TIMES TAXES -- THESE ARE PERSONAL TAXES THAT WE'RE TALKING ABOUT -- THAT'S WHAT THAT A1 IS. ON TEST DAY WHAT I'LL DO IS I'LL GIVE YOU VALUES FOR THESE. WHY DON'T I GIVE YOU A FEW VALUES RIGHT NOW AND THEN WE'LL JUST DO A QUICK CALCULATION FOR FUN. LET'S SAY THE SLOPE OF THIS CURVE, WHICH IS EQUAL TO THE MPC, IS EQUAL TO -- OH, I CAN'T REMEMBER WHAT I'VE USED BEFORE. LET'S USE POINT NINE. I DON'T THINK I'VE USED THAT BEFORE. WE'LL ASSUME CONSUMPTION IS FIFTY, INVESTMENT TWENTY, GOVERNMENT SPENDING THIRTY, NET EXPORTS MINUS TEN. THE MPC, I JUST SAID, IS POINT NINE AND LET'S SAY TAXES ARE --UMM, WHAT WOULD BE A

2 ECO LECTURE 30 2 GOOD AMOUNT -- TWENTY. SO WHAT DO WE HAVE? SEVENTY, A HUNDRED, NINETY -- WE'RE UP TO NINETY HERE, AND THEN THIS IS MINUS EIGHTEEN WHICH IS SEVENTY-TWO. MY MATH RIGHT? YEAH, I THINK IT IS. OKAY. SO WHAT WE HAVE HERE IS SEVENTY-TWO DOLLARS THAT'S AUTONOMOUS CONSUMPTION SPENDING. EQUILIBRIUM INCOME, QE EQUALS AUTONOMOUS CONSUMPTION SPENDING TIMES ONE OVER ONE MINUS THE MPC, WHICH THIS THING IN PARENTHESES IS OUR MULTIPLIER. THIS IS EQUAL TO SEVENTY-TWO DOLLARS TIMES TEN, ONE OVER ONE MINUS POINT NINE IS EQUAL TO ONE OVER POINT ONE WHICH IS EQUAL TO TEN, EQUALS SEVEN TWENTY. NOW, WHAT I'M SAYING TO YOU IS THIS AMOUNT RIGHT HERE, SEVEN TWENTY, THAT'S THE EQUILIBRIUM LEVEL OF GDP. OKAY. WE CAN CARRY OUT VARIOUS SORT OF GOVERNMENT POLICIES, FISCAL POLICIES. IF WE ADD TEN TO GOVERNMENT EXPENDITURES -- LET ME GET A LITTLE BIT DIFFERENT COLOR HERE TO MARK THIS OFF. IF WE ADD TEN TO GOVERNMENT EXPENDITURES, THIS CURVE SHIFTS UP. THE TOTAL EXPENDITURES CURVE SHIFTS UPWARD BY TEN DOLLARS TO EIGHTY-TWO. EQUILIBRIUM INCOME IS HOW MUCH? YOU OUGHT TO BE ABLE TO DO IT IN YOUR HEAD. HERE'S A SHIFT IN AUTONOMOUS SPENDING IS TEN DOLLARS. WE'VE GOT A MULTIPLIER OF TEN, SO THIS IS EIGHT TWENTY. EQUILIBRIUM GDP WENT UP BY TEN TIMES THE CHANGE IN GOVERNMENT SPENDING. OR WE COULD MULTIPLY EIGHTY-TWO TIMES TEN AND GET EIGHT HUNDRED AND TWENTY. OKAY. SUPPOSE INSTEAD -- LET'S TRY SOMETHING A LITTLE BIT DIFFERENT.

3 ECO LECTURE 30 3 SUPPOSE INSTEAD OF INCREASE IN GOVERNMENT SPENDING, WHAT WE DID IS WE INCREASED TAXES. LET'S INCREASE TAXES TEN DOLLARS. OKAY. INCREASE TAXES TEN DOLLARS, THEN THIS WOULD GO FROM TWENTY TO THIRTY. POINT NINE TIMES THIRTY IS TWENTY-SEVEN. OH, BOY. I DON'T KNOW WHAT'S THE EASIEST WAY TO DEMONSTRATE THIS. IT WAS -- WELL, IT'S GONE UP BY NINE -- I'M SORRY -- YEAH, IT HAS. WE WERE AT EIGHTEEN DOLLARS. BOY, THERE IS SO MUCH ON THE BOARD HERE. HERE'S WHAT WE DID HAVE. THIS TAX COMPONENT WAS THE MARGINAL PROPENSITY TO CONSUME, NINETY PERCENT OF PREVIOUSLY TWENTY. SO THIS WAS AN EIGHTEEN DOLLAR WHICH WAS NEGATIVE. IT WAS TAKING AWAY FROM SPENDING. WHEN YOU TAX PEOPLE THEY HAVE LESS MONEY AND THEY SPEND LESS. SO ANYWAY, THIS WAS A NEGATIVE EIGHTEEN TO BEGIN WITH AND NOW IT'S POINT NINE TIMES THIRTY WITH A NEGATIVE, SO THIS IS NEGATIVE TWENTY-SEVEN. WAS NEGATIVE EIGHTEEN, NOW IT'S NEGATIVE TWENTY-SEVEN. THAT IS TO SAY THE TAX COMPONENT IS NOW SHIFTING DOWNWARD. WE'VE GONE -- WE WERE HAVING TAXES DEPRESS SPENDING BY EIGHTEEN DOLLARS; NOW THEY'RE DEPRESSING SPENDING BY TWENTY-SEVEN. SO THE NET AMOUNT IS TAXES ARE GONNA DEPRESS SPENDING BY NINE DOLLARS, MINUS NINE. AUTONOMOUS SPENDING IS GONNA GO BACK DOWN, FROM EIGHTY-TWO DOWN TO -- WHAT'S NINE LESS THAN THAT -- SEVENTY-THREE. I DON'T KNOW IF IT WAS EASIER TO SHOW THIS SOME OTHER WAY OR NOT, BUT -- 'CAUSE I'VE REALLY GOT TWO POLICIES IN HERE. I INCREASED

4 ECO LECTURE 30 4 GOVERNMENT SPENDING BY TEN DOLLARS, G INCREASED TEN. I INCREASED TAXES BY TEN DOLLARS. BY THE WAY, THIS IS CALLED A BALANCED BUDGET FISCAL POLICY. INCREASED G BY TEN, INCREASED T BY TEN. I DON'T MEAN TO SAY WE HAVE A BALANCED BUDGET. I MEAN THERE'S NEW POLICIES THAT I'M TALKING ABOUT WHERE WE'RE CHANGING GOVERNMENT SPENDING AND CHANGING TAXES AT THE SAME TIME. SAME AMOUNT, SAME DIRECTION. IN TERMS OF WHATEVER THE BUDGET WAS TO BEGIN WITH, IT HAS NOT CHANGED. IF THE BUDGET WAS PREVIOUSLY BALANCED, IT STILL IS BALANCED. IF THE BUDGET WAS PREVIOUSLY IN DEFICIT BY TWENTY DOLLARS, IT'S STILL IS IN DEFICIT TWENTY DOLLARS BECAUSE TAXES AND GOVERNMENT SPENDING HAVE CHANGED BY AN EQUAL AMOUNT. HERE'S WHAT WE'VE SEEN. WHEN GOVERNMENT SPENDING WENT UP BY TEN DOLLARS, THE AUTONOMOUS SPENDING CURVE SHIFTED UP. HERE'S THE AUTONOMOUS SPENDING FROM SEVENTY-TWO UP TO EIGHTY-TWO. THAT'S THE TEN DOLLARS. BUT WHAT WE'VE ALSO SEEN IS WHEN TAXES WENT UP BY TEN DOLLARS, AUTONOMOUS SPENDING WENT DOWN BY NINE. WHY IS THAT A SMALLER AMOUNT? WELL, THE ANSWER IS THIS: WHEN WE CAME ALONG AND SPENT -- NOT "WE" BUT THE GOVERNMENT. WHEN THE GOVERNMENT CAME ALONG AND SPENT TEN DOLLARS TO BEGIN WITH, THAT TEN DOLLARS WENT DIRECTLY INTO TOTAL SPENDING. THAT'S THE END OF THE STORY. TEN DOLLARS MORE OF TOTAL SPENDING. BUT WHEN THE GOVERNMENT CAME ALONG WITH ITS TAX INCREASE AND SAID, "WE'RE GONNA TAX YOU ANOTHER TEN DOLLARS," THAT DIDN'T

5 ECO LECTURE 30 5 COME OUT -- THAT WASN'T A TEN DOLLAR DEDUCTION IN SPENDING AND HERE'S WHY. WHEN THEY CAME TO ME AND THEY SAY, "HEY, TOM. IT'S TIME FOR YOU TO PAY AN EXTRA TEN DOLLARS IN TAXES," I SAY, "OKAY." WELL, MY MPC IS NINETY PERCENT SO MY DISPOSABLE INCOME IS NOW GONE DOWN BY TEN DOLLARS. AND WHEN MY DISPOSABLE INCOME DOES DOWN BY TEN DOLLARS TO PAY THE TAXES, I'M GONNA REDUCE MY CONSUMPTION SPENDING BY NINETY PERCENT OF THE TEN DOLLARS, BY NINE DOLLARS. SO THERE'S A REDUCTION IN AUTONOMOUS SPENDING BY NINE DOLLARS. WHERE'S THAT OTHER ONE DOLLAR COME FROM? THAT IS TO SAY, IF MY TAX BILL WENT UP BY TEN DOLLARS AND I'LL REDUCE MY SPENDING BY NINE, WHICH IS WHAT WE'RE TALKING ABOUT HERE, WHERE DO I GET THE OTHER DOLLAR TO PAY MY TAXES? AND THE ANSWER IS: IT COMES OUT OF MY SAVINGS. AND SO IF THE -- THE FACT THAT I TAKE SOME OF THAT MONEY OUT OF SAVINGS, THAT MEANS THAT -- REALLY WHAT IT MEANS IS THAT THE GOVERNMENT SPENDING INCREASE IS MORE POWERFUL -- IT SHIFTS THE CURVE BY TEN DOLLARS -- MORE POWERFUL THAN THE TAX INCREASE. IT ONLY SHIFTS THE CURVE BY NINE. WE CAN SEE THAT RIGHT HERE. THAT'S WHAT THIS MPC IS HERE FOR, IS TO TELL US THE TAX CHANGE IS ONLY PARTLY -- IN THIS CASE, NINETY PERCENT -- A REDUCTION IN SPENDING, BUT TEN PERCENT OF IT IS A REDUCTION IN SAVING. AND THAT WASN'T GONNA BE MONEY SPENT ANYWAY AND, THAT BEING THE CASE, IT DIDN'T TAKE AWAY FROM AGGREGATE DEMAND. OR TOTAL EXPENDITURES, I SHOULD SAY.

6 ECO LECTURE 30 6 ANYWAY, LET ME GO OVER HERE AND SEE IF I CAN WRITE SOMETHING DOWN THAT MAKES SENSE OUT OF ALL OF THIS. WE HAVE A BALANCED BUDGET THEOREM. OH, DID I EVER WORK OUT THE FINAL EQUILIBRIUM? I DON'T THINK I DID. SEVEN HUNDRED AND THIRTY DOLLARS. THERE WE GO. BALANCED BUDGET THEOREM SAYS THIS: IF G AND T INCREASE BY EQUAL AMOUNTS -- FOR EXAMPLE, TEN DOLLARS -- REAL GDP WILL INCREASE BY THE SAME AMOUNT. THAT IS TO SAY, TEN DOLLARS. AND THEN WE COULD GO IN THERE AND PUT THE WORD "DECREASE" WHERE IT SAYS "INCREASE" RIGHT NOW. IF G AND T DECREASE BY -- OH, EXCUSE ME -- EQUAL AMOUNTS, THEN GDP WILL DECREASE BY THAT SAME AMOUNT. THAT IS TO SAY, THERE'S A BALANCED BUDGET MULTIPLIER OF ONE. MULTIPLIER -- OR I'LL SAY BB MULTIPLIER EQUALS ONE. AND AGAIN, THE THINKING BEHIND THAT -- LET ME SEE IF I CAN REPRESENT THIS. CHANGE IN Q IS EQUAL TO CHANGE IN G, GOVERNMENT SPENDING -- PURCHASES; I SHOULD SAY GOVERNMENT PURCHASES -- TIMES ONE OVER ONE MINUS THE MPC. WITH RESPECT TO TAXES, CHANGING Q, EQUALS CHANGE IN TAXES TIMES THE MPC TIMES ONE OVER ONE MINUS THE MPC. AND IT'S THIS THING RIGHT IN HERE, THIS MP -- OH, I'M SORRY. THERE SHOULD BE A NEGATIVE SIGN HERE. IT'S THAT MPC IN THERE THAT CAUSES - - OH, LET'S SEE IF WE CAN'T COME UP WITH A TAX MULTIPLIER AND A GOVERNMENT SPENDING MULTIPLIER. HERE'S THE GOVERNMENT SPENDING MULTIPLIER. AND I THINK I'VE SAID IT BEFORE, BUT I'LL JUST REMIND YOU. WE COULD'VE ALSO WRITTEN THIS AS ONE OVER THE MARGINAL

7 ECO LECTURE 30 7 PROPENSITY THE SAME SINCE ONE MINUS THE MPC IS THE MARGINAL PROPENSITY. HERE'S THE TAX MULTIPLIER. AHH, HOW DO I WANT TO WRITE THIS DOWN? LET ME SHIFT MY NEGATIVE SIGN OVER HERE. SO HERE'S MY GOVERNMENT SPENDING MULTIPLIER, ONE OVER THE MARGINAL PROPENSITY TO SAVE. HERE IT IS FOR MY TAX MULTIPLIER. IT'S THE MPC OVER THE MPS WITH A NEGATIVE SIGN OUT IN FRONT OF IT. AND THE GOVERNMENT SPENDING MULTIPLIER IS SIMPLY BIGGER THAN THE TAX MULTIPLIER. AND WHY IS THAT? AGAIN, THE REASON IS JUST WHAT I MENTIONED A MOMENT AGO. IF MY TAXES GO UP BY TEN DOLLARS, I SEE THAT AS A REDUCTION IN DISPOSABLE INCOME SO I LOWER MY CONSUMPTION SPENDING BY THE MPC TIMES TEN DOLLARS. HERE IT'S NINE DOLLARS. AND SO THERE'S NINE DOLLARS TAKEN OUT OF AUTONOMOUS SPENDING BUT NOT THE SAME AMOUNT AS WENT IN TO AUTONOMOUS SPENDING WHEN THE GOVERNMENT INCREASED SPENDING BY TEN BUCKS. SO ANYWAY, BALANCED BUDGET MULTIPLIER EQUAL TO ONE. YOU DON'T HAVE TO BE ABLE TO WRITE A WHOLE DISSERTATION ABOUT THIS OR DO ALL THE FORMULAS, BUT IT'D BE GOOD IF YOU WOULD BE FAMILIAR WITH THIS. BY THE WAY, HERE'S KIND OF A NEAT RELATIONSHIP THAT MAY HELP YOU REMEMBER THIS. WE'VE GOT TWO MULTIPLIERS. HERE'S THE -- LET ME PUT AN M FOR THE MULTIPLIER WITH A G. HERE'S THE GOVERNMENT SPENDING MULTIPLIER. HERE'S THE TAX MULTIPLIER. OKAY. HERE'S HOW I CAN REMEMBER THESE PRETTY EASILY. IF THE GOVERNMENT SPENDING

8 ECO LECTURE 30 8 MULTIPLIER IS IN THIS CASE TEN -- WE HAD AN MPC OF POINT NINE, WHATEVER THAT WAS -- THEN THE TAX MULTIPLIER IS GONNA BE ONE SMALLER THAN TEN WHICH IS NINE. ALWAYS ONE SMALLER WITH A NEGATIVE SIGN OUT FRONT. ONE SMALLER AND ONE OVER MPS. AND SO LET ME GIVE YOU ANOTHER EXAMPLE. SEE IF YOU CAN'T JUST DO THIS ONE IN YOUR HEAD. LET'S SAY I TELL YOU THE MPC IS EQUAL TO POINT SEVEN FIVE. HERE'S WHAT YOU SHOULD SAY. THE GOVERNMENT SPENDING MULTIPLIER IS EQUAL TO FOUR AND THE TAX MULTIPLIER IS EQUAL TO -- HERE'S OUR NEGATIVE SIGN. IT'S ALWAYS GONNA BE THERE FOR A TAX MULTIPLIER. BUT IT'S GONNA BE ONE UNIT SMALLER THAN FOUR WHICH IS THREE. ANOTHER ONE -- LET'S SAY THE MPC IS POINT EIGHT. THE GOVERNMENT SPENDING MULTIPLIER IS GONNA BE FIVE. THE TAX MULTIPLIER IS GONNA BE -- PUT A NEGATIVE SIGN OUT THERE BUT THEN JUST REDUCE FIVE BY ONE. FOUR. I HAD TO STOP THERE FOR A SECOND. I THINK I WAS GONNA GET THAT WRONG. ANY QUESTIONS ABOUT THIS? HERE'S WHAT YOU WANT TO DO BEFORE TEST DAY. YOU WANT TO WORK A FEW OF THESE PROBLEMS AND THAT'S WHY I'VE TRIED TO, THE LAST FEW CLASS PERIODS, COME IN AND START OFF WORKING A PROBLEM. YOU WANT TO BE COMFORTABLE WITH THIS BECAUSE ON TEST DAY YOU'RE FOR SURE GONNA HAVE TO DO SOME OF THESE CALCULATIONS. AND YOU DON'T WANT TO STOP RIGHT THEN AND SAY, "OH, THAT'S IN MY NOTES SOMEPLACE." JUST HAVE IT AUTOMATIC AND -- LIKE THIS THING I'M DOING

9 ECO LECTURE 30 9 RIGHT HERE, BY JUST REDUCING THE GOVERNMENT SPENDING MULTIPLIER BY ONE AND THEN PUTTING A NEGATIVE SIGN UP. IT DOESN'T TAKE YOU FOREVER. AND, GEE. BALANCED BUDGET MULTIPLIER? WELL, LOOK AT THIS. WE'VE GOT A GOVERNMENT SPENDING MULTIPLIER, FIVE; A TAX MULTIPLIER OF MINUS FOUR; THE DIFFERENCE BETWEEN THOSE IS ONE. THERE'S OUR BALANCED BUDGET MULTIPLIER: ONE. OKAY. ANY QUESTIONS ABOUT THAT. THAT'S THE TYPE OF PROBLEMS THEN THAT WE WILL BE CALCULATING FOR EXAM DAY, FOR TEST DAY. OKAY. WHAT WE WANT TO DO -- AND, BY THE WAY, YOU UNDERSTAND THE IDEA -- I PUT IT UP LAST TIME, BUT THE IDEA IS THIS: IF THE EQUILIBRIUM LEVEL OF GDP IS LOW -- LET'S SAY IT'S RIGHT HERE AT SEVEN TWENTY -- AND FULL EMPLOYMENT IS OVER HERE AT NINE HUNDRED, THEN THE IDEA OF THE KEYNESIAN MODEL IS HOW'RE WE GONNA GET EQUILIBRIUM AND GDP UP TO NINE HUNDRED? AND THE ANSWER IS: SOMEHOW OR ANOTHER WE HAVE TO SHIFT THIS TOTAL EXPENDITURES CURVE UP SO THAT IT PASSES THROUGH THE TOTAL PRODUCTION CURVE AT NINE HUNDRED. WONDER WHAT THIS WOULD HAVE TO BE RIGHT HERE? WHAT WOULD AUTONOMOUS SPENDING HAVE TO BE IN ORDER TO GET EQUILIBRIUM GDP AT NINE HUNDRED? ANYBODY? EXACTLY. NINETY. OKAY. SO ANYWAY -- AND THAT WOULD BE, THEN, WHAT? FROM OUR ORIGINAL POSITION, WHAT'D WE HAVE? SEVENTY-TWO DOLLARS. THAT WOULD BE AN EIGHTEEN DOLLAR INCREASE IN AUTONOMOUS SPENDING. AND HOW DO WE GET AUTONOMOUS SPENDING TO GO UP EIGHTEEN

10 ECO LECTURE DOLLARS? ONE WAY WOULD BE TO INCREASE GOVERNMENT SPENDING BY EIGHTEEN DOLLARS. SO ANYWAY, LET'S GO ON. WE'VE KIND OF GOT THE POSITIVE SIDE OF THIS WHOLE KEYNESIAN MODEL. WHAT'S THE NEGATIVE SIDE? AND THE NEGATIVE SIDE IS THIS: IT'S NOT ALWAYS AS EFFECTIVE AS IT'S SUPPOSED TO BE. THIS WAS REAL EASY JUST TO COME OVER HERE AND GO, "OH, YEAH. ALL WE HAVE TO DO IS INCREASE AUTONOMOUS SPENDING FROM SEVENTY- TWO TO NINETY, AND THEN WE HAVE EQUILIBRIUM GDP AT FULL EMPLOYMENT AND THE WORLD'S A BETTER PLACE TO LIVE IN." THAT'S KIND OF AN EASY THING TO SAY, BUT IT'S NOT SO EASY TO DO IN REALITY BECAUSE THERE ARE CERTAIN THINGS THAT MAKES FISCAL POLICY LESS POWERFUL, LESS EFFECTIVE, THAN THE KEYNESIAN MODEL, THE SIMPLE KEYNESIAN MODEL, MAKES IT OUT TO BEE. HERE'S THE FIRST THING. LIMITATIONS, LET'S CALL IT, ON KEYNESIAN FISCAL POLICY. ONE, THE AGGREGATE SUPPLY CURVE -- LET'S SAY SHORT- RUN AGGREGATE SUPPLY CURVE HAS A POSITIVE SLOPE. I'LL JUST STICK WITH THESE NUMBERS THAT WE WERE WORKING WITH A MOMENT AGO HERE AND JUST SAY, OKAY. SUPPOSE REAL GDP -- NATURAL REAL GDP IS NINE HUNDRED DOLLARS. THAT'S WHEN WE HAVE FULL EMPLOYMENT. WE SHIFT AUTONOMOUS SPENDING NOW FROM SEVENTY-TWO TO NINETY DOLLARS. THE EQUILIBRIUM GDP GOES FROM SEVEN TWENTY TO NINE HUNDRED. THAT'S EXACTLY WHAT WE WANT: SUCCESS. SO WE COME OVER HERE, WE DRAW OUR AGGREGATE DEMAND

11 ECO LECTURE CURVE. IT SHIFTED TO THE RIGHT BY A HUNDRED AND EIGHTY DOLLARS. EQUILIBRIUM GDP IS AT NINE HUNDRED, THE WORLD IS A BETTER PLACE. WELL, JUST A SECOND. WHAT IF THE AGGREGATE SUPPLY CURVE LOOKS LIKE THIS, UPWARD SLOPING? THEN WE GET THE AGGREGATE DEMAND CURVE SHIFT BUT WE DON'T ACTUALLY MOVE ALL THE WAY OUT TO NATURAL REAL GDP BECAUSE SOME OF THAT INCREASE IN SPENDING -- AND THAT'S WHAT WE'RE TALKING ABOUT HERE, AGGREGATE DEMAND. SOME OF THAT INCREASE IN SPENDING DIDN'T WORK ITS WAY INTO CREATING MORE JOBS AND MORE REAL PRODUCTION. SOME OF THAT INCREASE IN SPENDING JUST CAUSED THE PRICE LEVEL TO GO UP. WE HIT INFLATION. KEYNES DIDN'T COUNT ON INFLATION 'CAUSE HE WAS WRITING DURING A DEPRESSION PERIOD. OKAY. BUT ANYWAY, THE POINT IS IS THAT ONE LIMITATION OF THIS FISCAL POLICY, WHY DOESN'T IT WORK AS WELL AS IT DOES ON THE BLACKBOARD, AND THE ANSWER IS: THERE'S OTHER STUFF GOING ON OTHER THAN STABLE PRICES. A SECOND THING THAT CAUSES THIS KEYNESIAN FISCAL POLICY TO BE LESS EFFECTIVE THAN IT MIGHT OTHERWISE BE IS SOMETHING CALLED CROWDING OUT. YOU'VE HEARD OF CROWDING INTO LINE; THIS IS CROWDING OUT. HERE'S THE IDEA OF CROWDING OUT. IT SAYS BASICALLY THIS: INCREASE GOVERNMENT SPENDING -- AND THAT'S WHAT WE WERE TALKING ABOUT JUST A MOMENT AGO WAS TO GET TOTAL EXPENDITURES UP AND INCREASE GDP. INCREASE GOVERNMENT SPENDING, ACCORDING TO THIS CROWDING OUT ANALYSIS. INCREASE GOVERNMENT SPENDING

12 ECO LECTURE CAUSES PRIVATE SPENDING TO GO DOWN. THE GOVERNMENT SPENDS MORE, PRIVATE INDIVIDUALS SPEND LESS. AND SO THE CURVE SHIFTS UPWARD. THE GOVERNMENT COMES ALONG AND SPENDS EIGHTEEN DOLLARS. THE TOTAL EXPENDITURES CURVE SHIFTS UPWARD BY EIGHTEEN DOLLARS. AND THEN PRIVATE SPENDING, LIKE CONSUMPTION AND INVESTMENT, THAT STARTS GOING DOWN AND SO THE CURVE SHIFTS DOWNWARD AND WE DON'T GET THAT FULL IMPACT ON AGGREGATE DEMAND OR ON TOTAL EXPENDITURES. OR MAYBE DO IT THIS WAY: INCREASE IN G, DECREASE IN C, AND DECREASE IN I. THAT'S WHAT WE MEAN BY CROWDING OUT. WHAT CAUSES THAT? WELL, THERE'S DIFFERENT KINDS OF CROWDING OUT. THERE'S WHAT YOU COULD CALL A DIRECT CROWDING OUT, CO CROWDING OUT. HERE'S A DIRECT CROWDING OUT. IT'S SOMETHING LIKE THIS: IF THE GOVERNMENT BUILDS A LIBRARY AND LENDS BOOKS OUT FOR FREE, THEN PEOPLE SAY, "HEY, NOW I DON'T HAVE TO BUY BOOKS. I'LL GO TO THE LIBRARY AND GET 'EM FOR FREE." AND SO BOOK PURCHASES OUT AT THE BARNES & NOBLE OR, YOU KNOW, WHATEVER THE BOOK STORE, BOOK PURCHASES GO DOWN. AMAZON.COM. IF THE GOVERNMENT BUILDS A HIGHWAY, THEN THE PRIVATE SECTOR DOESN'T BUILD A TURNPIKE. INCREASE IN GOVERNMENT SPENDING FOR HIGHWAYS, DECREASE IN PRIVATE SPENDING FOR TURNPIKES. YOU GET THE IDEA. THERE ARE A NUMBER OF THESE THINGS -- HEALTHCARE SERVICES. IF THE GOVERNMENT COMES AROUND AND GIVES YOU A SHOT -- YOU KNOW,

13 ECO LECTURE IMMUNIZES YOU AGAINST THE FLU OR WHATEVER -- THEN YOU'RE LESS LIKELY TO GO OUT AND PAY A DOCTOR TO GIVE YOU THE SAME KIND OF SHOT. WHEN THE GOVERNMENT SPENDS THE MONEY, THEN WE INDIVIDUALS SAY WE DON'T NEED TO AS MUCH. OKAY. HOW ABOUT ANOTHER KIND OF CROWDING OUT WHICH IS REALLY INDIRECT: CO, CROWDING OUT, AND THAT IS CAUSED THROUGH CHANGES IN INTEREST RATES. AND THIS OCCURS WITH DEFICIT SPENDING. HERE'S THE STORY ON THIS ONE. LET ME -- I'D BETTER GET UP HERE AND SORT OF MAKE SOME SYMBOLS TO MAKE THIS CLEAR. INCREASE IN G AND NO CHANGE IN T, THAT RESULTS IN AN INCREASE IN THE GOVERNMENT'S DEFICIT. SO IF THE GOVERNMENT SPENDS MONEY AND DOESN'T RAISE TAXES IN ORDER TO PAY FOR THAT SPENDING, THERE'S AN INCREASE IN THE DEFICIT. WHEN THERE'S AN INCREASE IN THE DEFICIT, THE GOVERNMENT NEEDS TO BORROW MONEY. INCREASE IN THE DEMAND FOR CREDIT. THE GOVERNMENT NEEDS TO BORROW SO NOW IT'S DEMANDING CREDIT. ALL THIS DEMAND FOR CREDIT DRIVES UP THE PRICE OF CREDIT WHICH IS THE INTEREST RATE. I'LL JUST PUT THAT I THERE. I'VE ALREADY SORT OF SPELLED OUT -- WHERE'D I DO IT -- CHANGES IN INTEREST RATES. SO THE GOVERNMENT'S BORROWING MORE IN ORDER TO FINANCE ITS SPENDING AND DRIVING UP INTEREST RATES. AND WHEN THE GOVERNMENT DRIVES UP INTEREST RATES, THEN BUSINESSES SAY, "GOSH, WE CAN'T AFFORD TO INVEST AS MUCH IN NEW PLANT AND EQUIPMENT. INTEREST COSTS ARE PART OF THE EXPENSES THAT WE INCUR IF WE INVEST. AND NOW WITH

14 ECO LECTURE THESE HIGHER INTEREST RATES, WE CAN'T AFFORD TO INVEST AS MUCH ANYMORE." AND, BY THE WAY, THE SAME THING HAPPENS FOR INDIVIDUALS. LET ME DO THIS HERE. DECREASE CONSUMPTION SPENDING. MAYBE YOU WERE THINKING ABOUT BUYING A NEW CAR OR BUYING A HOUSE AND THE INTEREST RATE WAS PRETTY LOW. IT WAS SIX PERCENT OR WHATEVER. AND THEN ALL OF A SUDDEN THE GOVERNMENT'S BORROWING MORE, DRIVING UP INTEREST RATES, AND ALL OF A SUDDEN THE INTEREST RATE IS SEVEN PERCENT. AND THEN YOU GO DOWN AND YOU SAY, "OKAY. I'M READY TO BORROW THE MONEY TO BUY THAT HOME," AND THEY SAY, "OH, BY THE WAY. SINCE, YOU KNOW, LAST WEEK WHEN WE FIRST TALKED, INTEREST RATES HAVE GONE UP FROM SIX TO SEVEN PERCENT." AND YOU SAY, "GOSH, I CAN'T AFFORD THOSE HOUSE PAYMENTS NOW. I JUST WON'T BUILD A HOME." OR, "I'LL BUILD A SMALLER HOME." WHETHER YOU BUILD A SMALLER HOME OR NO HOME, YOUR CONSUMPTION SPENDING HAS GONE DOWN. AND SO AGAIN WHAT'S HAPPENED IS: THE GOVERNMENT'S SPENT MORE. IT'S SHIFTED THE TOTAL EXPENDITURES CURVE UP OR INCREASED AGGREGATE DEMAND, BUT THE NEXT STEP ALONG THE WAY IS INTEREST RATES ARE DRIVEN UP, INVESTMENT SPENDING DOWN, CONSUMPTION SPENDING DOWN, AND IT COULD BE THAT WE GO ALL THE WAY BACK TO WHERE WE BEGAN WITH RESPECTIVE TOTAL EXPENDITURES. HOW ABOUT THIS ONE? THIS IS JUST A LITTLE BIT MORE COMPLICATED BUT IT'S BASED ON THE SAME IDEA. ANOTHER INDIRECT CROWDING OUT. IT

15 ECO LECTURE OPERATES THROUGH EXCHANGE RATES. WE START OFF THE SAME WAY: INCREASE IN GOVERNMENT SPENDING WITH NO CHANGES IN TAXES, INCREASE THE DEFICIT WHICH INCREASES THE GOVERNMENT'S DEMAND FOR CREDIT -- THIS IS A LONG ONE -- WHICH INCREASES INTEREST RATES. WE'RE ONLY PARTWAY THERE. INTEREST RATES ARE HIGHER. LET ME JUST KIND OF BRING THIS ONE ON BACK AROUND. INTEREST RATES ARE HIGHER, SO NOW FOREIGNERS BUY U.S. BONDS AND DEPOSIT MONEY IN U.S. BANKS. WHY? WELL, 'CAUSE WE HAVE THESE HIGHER INTEREST RATES NOW. OUR GOVERNMENT'S BORROWING MONEY AND DRIVING UP INTEREST RATES, SO FOREIGNERS WANT TO PUT THERE MONEY HERE. AND WHEN FOREIGNERS DO THAT -- YOU KNOW, LIKE IF YOU'RE LIVING IN JAPAN OR YOU'RE LIVING IN MEXICO OR LIVING IN LONDON AND YOU WANT TO PUT MONEY IN THE UNITED STATES, YOU DON'T JUST SEND YOUR OWN, LIKE, PESOS OR POUNDS. YOU HAVE TO SEND DOLLARS. SO WHEN FOREIGNERS WANT TO PUT THEIR MONEY IN UNITED STATES BANKS, THAT INCREASES THE DEMAND FOR THE DOLLAR, FOREIGN DEMAND FOR THE DOLLAR, WHICH INCREASES THE EXCHANGE RATE. INCREASE VALUE OF DOLLAR. BOY, ECONOMISTS HAVE TO GO A LONG WAY IN ORDER TO GET TO AN ANSWER, DON'T THEY? WE'RE NOT THERE YET. SO NOW THE VALUE OF THE DOLLAR HAS GONE UP. OUR GOVERNMENT'S BORROWING, INTEREST RATES ARE UP, FOREIGNERS START SENDING THEIR MONEY HERE. AND TO SEND MONEY THEY HAVE TO BUY DOLLARS FIRST, SO THEY'VE DRIVEN UP THE VALUE OF THE DOLLAR. THE

16 ECO LECTURE EXCHANGE RATE IS UP, THE DOLLAR IS STRENGTHENED, AND SO NOW THERE'S A DECREASE IN XN, NET EXPORTS, TO THE REST OF THE WORLD. WHEN OUR DOLLAR BECOMES MORE VALUABLE, THAT MEANS OUR GOODS BECOME MORE COSTLY TO FOREIGNERS. IT MEANS THEIR GOODS BECOME CHEAPER TO US. SO WE DON'T SELL SO MANY GOODS TO THEM, WE BUY MORE FROM THEM, AND OUR NET EXPORTS GO DOWN. SO WE'RE BACK TO THIS STORY. THE GOVERNMENT SPENDS MORE, TOTAL EXPENDITURES ARE UP. BUT NOW, BECAUSE OF THIS CROWDING OUT EFFECT -- AND I'M SAYING IN THE FOREIGN SECTOR -- NET EXPORTS ARE GOING BACK DOWN, THIS ENTRY RIGHT HERE. AND ONE FINAL WAY -- I'M GONNA HAVE TO -- I GUESS I'LL -- AHH, I'D BETTER DO IT OVER HERE. ONE FINAL INDIRECT FORM OF CROWDING OUT WORKS LIKE THIS: INCREASE IN G WITH NO CHANGE IN T. SO, BY THE WAY, THAT'S WHAT WE'VE ASSUMED HERE THE LAST THREE TIMES, IS THAT IT'S NOT ONLY GOVERNMENT SPENDING MORE BUT IT'S RUNNING A DEFICIT. IF THE GOVERNMENT INCREASES ITS SPENDING WITH NO INCREASE IN TAXES, THEN THAT INCREASES THE NATIONAL DEBT. OF COURSE, THERE IS A BIGGER DEFICIT BUT THAT ADDS TO THE NATIONAL DEBT. AND HERE'S WHAT PEOPLE START THINKING; THIS IS U.S. CITIZENS: INCREASE IN NATIONAL DEBT, THERE'LL BE AN INCREASE IN FUTURE TAXES. PEOPLE START SAYING, "WELL, THE GOVERNMENT'S GOT A BIGGER DEBT AND THEY'RE GONNA HAVE TO TAX US MORE IN THE FUTURE IN ORDER TO PAY THAT DEBT." AND SO THEN PEOPLE START SAYING, "MAN, IF MY FUTURE

17 ECO LECTURE TAXES ARE GONNA GO UP, I'D BETTER START SAVING MONEY." INCREASE SAVING TO PAY TAXES. "I'D BETTER BE SAVING SOME MORE IN ORDER TO PAY MY FUTURE TAX BILL." BUT, YOU KNOW, WHEN PEOPLE SAVE MORE, THAT ALSO MEANS DECREASE IN CONSUMPTION SPENDING. THOSE ARE THE SAME THING. THAT IS TO SAY, THE GOVERNMENT SPENDS MORE, THEY RUN UP THE NATIONAL DEBT, WE START THINKING, "OH-OH, YOU KNOW WHAT THAT MEANS. THEY CAN ONLY SPEND THIS MONEY FOR SO LONG. FINALLY THEY'RE GONNA COME BACK AND START TAXING US TO PAY THE INTEREST AND PRINCIPLE ON THE NATIONAL DEBT. SO MY TAX BILL NEXT YEAR AND TEN YEARS FROM NOW, FIFTY YEARS FROM NOW, WILL BE HIGHER AND SO I'D BETTER GET READY FOR HIGHER TAXES. SO I'LL SAVE A LITTLE BIT MORE, I'LL SPEND A LITTLE BIT LESS." A LOW OF CROWDING OUT, HUH? SO ANYWAY, WHAT WE'RE SAYING HERE -- AND NOW WE'RE REALLY JUST TO THE SECOND. THERE'LL BE ONE MORE ITEM HERE. BUT WHAT WE'RE SAYING IS THAT GOVERNMENT SPENDING GOES UP AND NOW OUR ONE, TWO, THREE, FOUR DIFFERENT FORMS OF CROWDING OUT THAT SAYS ONCE GOVERNMENT SPENDING WENT UP AND NOW THERE'S A LITTLE BIT OF REDUCTION IN CONSUMPTION SPENDING, INVESTMENT SPENDING, AND NET EXPORTS. AND SO WHAT WE CAN TALK ABOUT IS WHETHER CROWDING OUT IS COMPLETE OR INCOMPLETE. IS IT COMPLETE OR IS IT INCOMPLETE? IF CROWDING OUT IS COMPLETE, HERE'S WHAT HAPPENS: GOVERNMENT SPENDING GOES UP BY

18 ECO LECTURE WHATEVER WE SAID HERE, EIGHTEEN DOLLARS, THEN PRIVATE SPENDING GOES DOWN BY EIGHTEEN DOLLARS. AND IF CROWDING OUT IS COMPLETE, THE MULTIPLIER EQUALS ZERO. IF CROWDING OUT IS COMPLETE, EVERY TIME THE GOVERNMENT PUTS ANOTHER DOLLAR INTO THE ECONOMY, THEN THE PRIVATE SECTOR TAKES IT OUT -- I'M SAYING IN TERMS OF SPENDING. THE PRIVATE SECTOR TAKES IT OUT, AND SO WE GET NO IMPACT ON THE ECONOMY. IF IT'S INCOMPLETE CROWDING OUT, THEN THE MULTIPLIER IS LESS THAN ONE OVER ONE MINUS THE MPC BUT IT'S STILL GREATER THAN ZERO. I DON'T KNOW IF I'M SUPPOSED TO BE MAKING THOSE SYMBOLS GO THAT WAY. THE MULTIPLIER IS STILL GREATER THAN ZERO, BUT IT IS LESS THAN -- HOW CAN I DO THIS? I THINK I'M SUPPOSED TO DO IT THIS WAY. THERE WE GO. I KNEW SOMETHING LOOKED WRONG THERE. THE MULTIPLIER -- IF WE HAVE INCOMPLETE CROWDING OUT, I'M SAYING -- THEN OUR MULTIPLIER, OUR REAL MULTIPLIER, IS GONNA BE LESS THAN ITS THEORETICAL VALUE AND YET STILL POSITIVE. AND THAT'S PROBABLY THE CASE, THIS INCOMPLETE CROWDING OUT. WE COULD HAVE ZERO CROWDING OUT WHERE ALL THESE THINGS ARE JUST NOTHING, BUT I'M REALLY NOT GONNA BE TELLING YOU THAT STORY. OKAY. ONE FINAL THING THAT REDUCES THE EFFECTIVENESS OF FISCAL POLICY IS LAGS. LAGS. LAG: IT TAKES TIME FOR THINGS TO HAPPEN. AND THERE ARE FIVE LAGS. LET ME JUST KIND OF TICK THESE OFF FOR YOU. WE DON'T HAVE TO GO THROUGH AND TALK ABOUT 'EM IN GREAT

19 ECO LECTURE DETAIL. YOU CAN READ ABOUT 'EM IN YOUR TEXTBOOK. BUT THERE'S A DATA LAG. THE DATA LAG IS -- GOSH, IF WE WENT INTO A RECESSION, WE DON'T KNOW IT OVERNIGHT. IT'S NOT LIKE SOMEBODY RINGS A BELL AND SAYS, "HEY, A RECESSION JUST STARTED." WE HAVE TO FIND THAT OUT BY LOOKING AT THE DATA AND THE DATA IS SLOW TO COME IN -- OR ARE SLOW TO COME IN. AND SO SOMETIMES WE DON'T FIND OUT ABOUT A RECESSION OR THE END OF A RECESSION FOR SEVERAL MONTHS. LET ME REMIND YOU OF SOMETHING THAT HAPPENED BACK IN GEORGE BUSH WAS PRESIDENT AND HE WAS RUNNING FOR RE-ELECTION. BILL CLINTON WAS RUNNING AGAINST HIM. HE SAYS, "HEY, THE" -- CLINTON SAYS, "THE ECONOMY'S IN A RECESSION, BEEN IN A RECESSION A LONG TIME. WE NEED TO DO SOMETHING TO CHANGE THIS." GEORGE BUSH SAYS, "OH, NO. THE ECONOMY'S DOING BETTER THAN EVERYBODY THINKS." THAT WAS IN HERE'S WHAT HAPPENED. GEORGE BUSH LOST THE ELECTION, OF COURSE, BUT IN DECEMBER OF 1992, A COMMITTEE THAT PUTS THE DATA ON RECESSIONS, A COMMITTEE CAME OUT AND SAID, "THE RECESSION OF ENDED BACK IN MARCH OF 1991." AND SO LET ME SORT OF TELL YOU. HERE WE ARE IN DECEMBER OF '92 AND WE'RE SAYING THAT RECESSION ENDED BACK IN MARCH -- MARCH WAS THE LAST YEAR OF RECESSION. APRIL WAS THE FIRST YEAR OF RECOVERY OF THAT WAS MORE THAN A YEAR AND A HALF AGO. SO IT TOOK FROM MARCH OR APRIL OF '91 TO DECEMBER OF '92 TO FIGURE OUT THERE WAS NO RECESSION. WELL, IF IT TAKES YOU THAT LONG IN ORDER TO GET THE DATA TO SAY

20 ECO LECTURE THERE'S NO RECESSION, THAT MEANS THAT FOR THAT NEXT YEAR AND HOWEVER MANY MONTHS IT WOULD BE, EIGHT MONTHS, THE FEDERAL RESERVE AND THE TREASURY AND CONGRESS, THEY WOULD ALL BE FIGHTING A RECESSION THAT DIDN'T EVEN EXIST. SO THERE'S A LONG LAG JUST TO GET THE DATA. A SECOND LAG, THERE'S A WAIT AND SEE LAG. YOU KNOW, JUST THE FIRST TIME YOU GET A NUMBER THAT SAYS RECESSION COULD'VE STARTED, YOU DON'T SAY, "OKAY. LET'S CHANGE POLICY." WHAT YOU SAY IS, "I WONDER IF THAT'S JUST LIKE A STATISTICAL, YOU KNOW, SAMPLING PROBLEM. I WONDER IF THERE'S ANYTHING REAL THERE. YOU KNOW, WE'D BETTER WAIT A FEW MONTHS AND SEE IF ANYTHING NEW DEVELOPS. IF IT LOOKS LIKE THERE'S SOMETHING REALLY SOLID HERE, WE'LL TAKE ACTION. BUT WE DON'T WANT TO TAKE ACTION -- ALL THESE NUMBERS THAT WE TALKED ABOUT BEFORE, GDP AND SO FORTH, THEY COME THROUGH SAMPLING TECHNIQUES AND SO THERE COULD BE SAMPLING ERROR. OR IT COULD BE THAT WE JUST PICKED A FEW SECTORS TO LOOK AT MOST CLOSELY AND THEY'RE HAVING TEMPORARY DOWNTURNS, A LITTLE BIT OF BAD WEATHER, OR A STRIKE, OR SOMETHING LIKE THAT. AND SO SINCE A LITTLE BAD WEATHER OR A STRIKE IS GONNA PASS, IT'S PROBABLY NOT A REAL PROBLEM. WE'LL WAIT AND SEE WHAT THE DATA SAYS IN A MONTH OR TWO OR THREE OR FOUR." SO THERE'S A DATA PROBLEM OF -- IT JUST TAKES TIME TO GET DATA. AND THERE'S THE I-DON'T-TRUST-THE-DATA PROBLEM. IT'S THE WAIT

21 ECO LECTURE AND SEE. I WANT TO SEE SOME MORE RESULTS BEFORE I JUMP TO CONCLUSIONS. THERE'S THE LEGISLATIVE LAG. YOU GO TO THE CONGRESS AND YOU SAY, "OKAY, CONGRESS. I'VE STUDIED THIS. THE DATA IS IN. WE LOOKED AT IT MONTH AFTER MONTH AND THERE IS A TRUE PROBLEM. WHAT WE NEED TO DO IS INCREASE GOVERNMENT SPENDING IN ORDER TO FIGHT A RECESSION." AND THE CONGRESS SAYS, "OKAY. WE'LL DO SOMETHING." AND WHAT THEY MEAN BY "DO SOMETHING" IS "WE'LL TALK ABOUT IT. WE'LL FORM SOME COMMITTEES, WE'LL HAVE SOME MEETINGS, AND THEN WE'LL GET READY FOR THE NEXT ELECTION AND THEN WE'LL TALK ABOUT SOMETHING ELSE, AND THEN WE'LL COME BACK AND ACTUALLY ADDRESS THIS IN A YEAR OR TWO." SO THERE'S A LEGISLATIVE LAG. IF THE RECESSION STARTS TODAY AND YOU KNOW IT STARTS TODAY, YOU TELL THE CONGRESS AND THEY DON'T DO ANYTHING TODAY. THEY TALK ABOUT IT TODAY. THERE'S A TRANSMISSION LAG. AFTER THE CONGRESS SAYS, "OKAY. LET'S ACT. LET'S DO SOMETHING," THEN THEY START SPENDING THE MONEY. HERE'S WHAT HAPPENS. LET'S SAY THE CONGRESS SAYS, "WE'RE GONNA INCREASE GOVERNMENT PURCHASES OF GOODS AND SERVICES IN ORDER TO STIMULATE THE ECONOMY. LET'S BUILD A HIGHWAY." YOU KNOW WHAT THEY'D DO? THEY DON'T JUST START BUILDING A HIGHWAY THAT DAY. WHAT THEY SAY IS, "WE PASSED A LAW TODAY TO BUILD A HIGHWAY. NOW WHAT WE'RE GONNA DO IS WE'RE GONNA TELL THE TRANSPORTATION DEPARTMENT TO PUT OUT BIDS ON THIS. AND THESE BIDS -- ALL THESE

22 ECO LECTURE DIFFERENT CONTRACTORS CAN COME IN AND TELL US HOW MUCH THEY WOULD PAY -- OR CHARGE US IN ORDER TO BUILD THIS HIGHWAY." AND THEN AFTER THEY HAVE SUCCESSFULLY -- AND THIS TAKES SEVERAL MONTHS -- SUBMITTED A BID AND GOTTEN THE BID, THEN THEY GO OUT AND HIRE EMPLOYEES. THEY START GETTING THEIR SUPPLIES TOGETHER. THEY START SHOWING UP -- WELL, THERE'S A LITTLE BIT OF BAD WEATHER AND NOW THEY'LL SHOW UP NEXT MONTH, THE NEXT MONTH AFTER THEY HIRED THE EMPLOYEES AND GOT ALL THE SUPPLIES. AND MAYBE THERE'S ANOTHER SIX MONTHS OR A YEAR BURNED UP RIGHT THERE OF JUST THIS WHOLE TRANSMISSION LAG OF TRANSMITTING THIS CONGRESSIONAL LAW INTO ACTUAL DOLLARS GOING INTO SOMEBODY'S POCKET. AND THEN THERE'S AN EFFECTIVENESS LAG. ONCE THE MONEY'S COMING IN -- LET'S SAY I'M THE CONSTRUCTION WORKER THAT'S GONNA WORK ON THIS NEW HIGHWAY AND I START GETTING THE MONEY IN MY POCKET. THEN I'D GO OUT AND SPEND IT BUT, YOU KNOW, I DON'T SPEND IT ALL IN ONE DAY. I KIND OF WAIT AWHILE AND MAYBE I SAY, "GOSH, I COULD BE LAID OFF AT ANY TIME. MAYBE I'D BETTER SAVE A LOT OF THIS. WE'LL SEE IF THIS IS A PERMANENT JOB OR JUST TEMPORARY." AND THEN THAT MULTIPLIER EFFECT, THAT IF I DO SPEND THE MONEY THERE'S A MULTIPLIER EFFECT BUT NOT OVERNIGHT. IT TAKES A FEW WEEKS, A FEW MONTHS FOR THIS TO HAPPEN. MAYBE A YEAR OR TWO. SO WHAT I'M TELLING YOU IS, WITH THE LAGS YOU COULD HAVE A PROBLEM START ON JANUARY 1, 2000, AND IT MIGHT BE -- YOUR GUESS IS AS

23 ECO LECTURE GOOD AS MINE, TO TELL YOU THE TRUTH. IT MIGHT BE JANUARY 1, 2002, BEFORE SOMETHING HAPPENS. THERE COULD BE A LAG OF A YEAR OR TWO VERY EASILY. AND I'M NOT TRYING TO TELL YOU IT'S TWO YEARS. I'M TRYING TO TELL YOU THERE'S A LONG AND VARIABLE -- LET'S WRITE IT THAT WAY: LONG AND VARIABLE -- LAG BETWEEN THE ONSET OF A PROBLEM AND WHEN WE'RE ACTUALLY DOING SOMETHING ABOUT IT. SO WHAT DOES THAT MEAN? IT MEANS THIS: IT MEANS THAT THERE MAY NO LONGER BE A PROBLEM BY THE TIME YOU ACTUALLY TAKE ACTION. YOU MIGHT SAY -- IF YOU'RE AN ECONOMIST OR IF YOU'RE IN CONGRESS, YOU MIGHT SAY, "YOU KNOW WHAT WE OUGHT TO DO IS JUST IGNORE THIS THING. THIS RECESSION CAME ALONG. PROBABLY BY THE TIME WE CAN DO ANYTHING IT'LL BE GONE." THE LAST RECESSION THE UNITED STATES HAD -- I SHOULDN'T SAY THE LAST. LET'S SAY THE AVERAGE RECESSION IS ONLY GONNA BE LASTING ABOUT A YEAR, YEAR AND A HALF. THAT'S THE AVERAGE, YEAR AND A HALF. WELL, IF IT TAKES YOU TWO YEARS TO DO SOMETHING, IT'S KIND OF LATE, ISN'T IT? AND SO WHAT I'M TELLING YOU IS THIS IS A REAL ELEGANT THEORY ABOUT HOW THE GOVERNMENT CAN INCREASE SPENDING AND INCREASE REAL GDP AND SOLVE ALL THE WORLD'S PROBLEMS. BUT THERE ARE SOME REAL WORLD DIFFICULTIES OF MAKING THIS STUFF HAPPEN, AND LAGS ARE ONE OF THOSE DIFFICULTIES. HERE'S THE PROBLEM THAT WE HAVE: THERE'S -- LET ME WRITE THESE UP. THERE ARE TWO TERMS: ONE IS COUNTERCYCLICAL, ONE IS

24 ECO LECTURE PROCYCLICAL POLICY. AND LET ME JUST KIND OF GIVE YOU AN IDEA. HERE IS TIME AND REAL GDP. AND WHAT I'M SAYING IS THE ECONOMY GOES THROUGH THESE CYCLES. WE'VE ALREADY TALKED ABOUT THE BUSINESS CYCLE. IF THERE'S A COUNTERCYCLICAL POLICY -- AND THAT'S THE DESIRED ONE. THAT'S WHAT KEYNES WAS TALKING ABOUT. IF WE HAVE A COUNTERCYCLICAL POLICY, WE FIGHT THE BUSINESS CYCLE. WHEN THE ECONOMY IS STRONG, THE GOVERNMENT TAKES SPENDING OUT. WHEN THE ECONOMY IS WEAK, THE GOVERNMENT ADDS SPENDING IN. AND SO WHAT WE WANT TO DO IS, WE WANT TO MAKE THE PEAKS NOT SO HIGH AND WE WANT TO MAKE THE LOWS NOT SO LOW. AND THERE'S STILL A LITTLE BIT OF A CYCLE THERE BUT NOT AS MUCH OF A CYCLE. COUNTERCYCLICAL: WE'RE FIGHTING THE CYCLE. WHEN THE ECONOMY'S STRONG, WE WANT TO WEAKEN IT. WE WANT TO RAISE TAXES. WE WANT TO LOWER GOVERNMENT SPENDING. WHEN THE ECONOMY'S WEAK, WE WANT TO STIMULATE IT. WE WANT TO FIGHT THE CYCLE BY INCREASING GOVERNMENT SPENDING OR LOWERING TAXES. THAT'S THE KEYNESIAN POLICY. AND I'M SAYING DUE TO THESE LAGS, WE MAY HAVE A PROCYCLICAL POLICY. IT MAY JUST BE THE CASE THAT WHEN THE ECONOMY'S STRONG, WE'RE GIVING IT MORE MONEY; AND WHEN THE ECONOMY'S WEAK, WE'RE TAKING AWAY. WE'RE MAKING THE RECESSIONS DEEPER. WE'RE MAKING THE PEAKS HIGHER. THIS IS NOT A GOOD POLICY. IN PRACTICE THE GOVERNMENT'S RUN UP SO MUCH DEFICIT -- RUN UP SO MUCH DEBT, I SHOULD SAY, AND IN PRACTICE THESE LAGS ARE SO

25 ECO LECTURE SEVERE THAT ANY MORE IT'S VERY DIFFICULT FOR THE CONGRESS TO CONDUCT FISCAL POLICY. EVEN THOUGH WE'VE GOT THE KEYNESIAN MODEL OF HOW IT ALL WAS SUPPOSED TO WORK, I'M SAYING IT DIDN'T WORK PERFECTLY IN THE FIRST PLACE. WE'VE GOT THESE FIRST PROBLEMS I'VE MENTIONED. BUT THEN WITH THE LAGS AND THE DEEP FINANCIAL DIFFICULTIES THAT OUR GOVERNMENT'S IN, THEN BASICALLY THE CONGRESS DOESN'T DO MUCH OF THIS ANYMORE. LET'S TURN OUR ATTENTION TO ONE FINAL TOPIC AND THEN WE WILL BE DONE WITH THIS MATERIAL ON FISCAL POLICY, AND THE FINAL TOPIC WILL BE SUPPLY-SIDE FISCAL POLICY. SUPPLY-SIDE FISCAL POLICY. ALL OF THE FISCAL POLICY WE'VE BEEN TALKING ABOUT SO FAR HAS BEEN BASED ON THE IDEA OF STIMULATING -- WELL, I SHOULD SAY CHANGING AGGREGATE DEMAND. EVERYTHING WE'VE DONE UP TILL NOW, THE IDEA IS SHIFT THE AGGREGATE DEMAND CURVE. HOW DID WE DO THIS? HERE'S THE AGGREGATE SUPPLY CURVE THAT KEYNES ASSUMED AND ALL THIS STUFF IS SHIFTING TO AGGREGATE DEMAND, FROM AD1 TO AD2 AND SO FORTH. AND THEN INCREASING REAL GDP. YOU GET THE IDEA. WITH SUPPLY-SIDE FISCAL POLICY, THE IDEA IS CAN WE DO SOMETHING TO HELP THE ECONOMY ON THE SUPPLY SIDE OF THE ECONOMY? AND BY THAT I MEAN AGGREGATE SUPPLY. I'M GONNA DRAW THIS AGGREGATE SUPPLY CURVE SLOPING UPWARD, SHORT-RUN AGGREGATE SUPPLY. AGGREGATE DEMAND CURVE IS SLOPING DOWNWARD. AND I'M NOT GONNA CHANGE THAT AGGREGATE DEMAND

26 ECO LECTURE CURVE RIGHT NOW. I'LL JUST LEAVE IT ALONE. WITH SUPPLY-SIDE FISCAL POLICY WE WOULD SAY SOMETHING LIKE, "HEY, HERE'S THE EQUILIBRIUM REAL GDP. BUT FULL EMPLOYMENT IS OUT HERE AT SOME GREATER AMOUNT, QN." FULL EMPLOYMENT GDP, NATURAL REAL GDP. OKAY. SO WHAT CAN WE DO TO MAKE THAT HAPPEN? AND THE ANSWER IS: WELL, IF WE WANTED THIS REAL GDP AND WE'RE GONNA DO IT THROUGH THE SUPPLY SIDE OF THE ECONOMY, WE NEED THAT AGGREGATE SUPPLY CURVE TO SHIFT TO THE RIGHT, SRAS2. HOW CAN WE DO THAT? HOW ABOUT THIS: LOWER MARGINAL TAX RATES. THAT'S ONE WAY. AND ANOTHER WAY, DEREGULATE THE ECONOMY -- AND REALLY WE MEAN COMPANIES -- TO ALLOW THEM TO BECOME MORE EFFICIENT. IF YOU'LL REMEMBER, OUR AGGREGATE SUPPLY CURVE -- JUST LIKE OUR PRODUCTION POSSIBILITIES FRONTIER. IT'S BEEN AWHILE SINCE YOU'VE SEEN THAT ONE, PRODUCTION POSSIBILITIES FRONTIER. THIS PRODUCTION POSSIBILITIES FRONTIER, ITS POSITION IS BASED ON HOW MANY RESOURCES WE HAVE AVAILABLE. AND THE IDEA IS, IF WE WILL LOWER MARGINAL TAX RATES, THERE'LL BE MORE INVESTMENT SO THERE'D BE MORE CAPITAL RESOURCES. THERE'LL BE MORE PEOPLE WANTING TO WORK SO THERE'D BE MORE LABOR RESOURCES. AND SO BY LOWERING MARGINAL TAX RATES, WE CREATE INCENTIVES TO WORK AND INVEST. THAT SHIFTS THE AGGREGATE -- SHIFTS THE PRODUCTION POSSIBILITIES FRONTIER OUTWARD, BUT SHIFTS THE AGGREGATE SUPPLY CURVE TO THE RIGHT.

27 ECO LECTURE DO YOU REGULATE IN THE ECONOMY? BASICALLY, WHAT WE DO IS WE ALLOW RESOURCES TO BE USED MORE EFFECTIVELY. I THINK I TOLD YOU THE OTHER DAY HOW WE USED TO HAVE REGULATIONS THAT SAID THAT A TRUCK CAN DELIVER -- THIS IS A SEMI-TRUCK AND SO FORTH -- COULD DELIVER PRODUCTS -- THIS IS BACK IN THE '60S AND '70S -- COULD DELIVER PRODUCTS, BUT THEN HAD TO GO BACK EMPTY TO WHERE IT CAME FROM AND THEN PICK UP MORE GOODS TO DELIVER SOMEPLACE ELSE. WELL, ONCE WE DEREGULATED THAT SITUATION, TRUCKING, THEY'D DRIVE OUT WITH A LOAD OF MATERIALS AND THEN PICK UP SOME AND BRING 'EM BACK. OKAY. SO THOSE ARE SUPPLY-SIDE FISCAL POLICIES. WHAT WE HAD -- AND, BY THE WAY, AN INCREASE IN AGGREGATE -- LET ME KIND OF DRAW THIS UP HERE REAL QUICKLY JUST TO MAKE A POINT. HERE'S SHORT-RUN AGGREGATE SUPPLY. IF WE HAVE AN AGGREGATE DEMAND INCREASE FROM AD1 TO AD2, HERE'S WHAT WE SEE: YEAH, REAL GDP RISES, BUT WE GET INFLATION. THERE'S KIND OF A TRADEOFF. DO YOU WANT REAL GDP TO GO UP AND JOBS TO GO UP OR DO YOU WANT INFLATION? AND, BOY, WE DON'T LIKE THAT INFLATION SO IT'S KIND OF A TRADEOFF. BUT HERE'S THE GOOD NEWS. IF WE ARE STIMULATING THE ECONOMY, REAL GDP, BY STIMULATING AGGREGATE SUPPLY, THE PRICE LEVEL GOES DOWN. WE DON'T HAVE INFLATION. WE HAVE THE OPPOSITE OF INFLATION. SO THAT'S KIND OF GOOD NEWS IN MANY PEOPLE'S BOOKS. WE'RE FIGHTING INFLATION AT THE SAME TIME WE'RE STIMULATING THE ECONOMY. OKAY.

28 ECO LECTURE LET ME MENTION TO YOU THAT BACK IN THE 1920S, 1960S, 1980S, IN THOSE THREE DECADES IN THE TWENTIETH CENTURY, WHAT WE HAD WAS TAX RATE CUTS. DECREASE IN MARGINAL TAX RATES. AND, BY THE WAY, LET ME JUST TAKE ONE SECOND TO MENTION MARGINAL TAX RATES, THAT TERM. WHAT WE MEAN IS THE PERCENT OF ONE MORE DOLLAR OF INCOME THAT GOES TO TAXES. AND SO WHAT I MEAN IS -- WITH THE MARGINAL TAX RATE I MEAN THIS: IF MY INCOME WENT UP BY ONE MORE DOLLAR AND I PAID THIRTY-FIVE CENTS IN TAXES, THIRTY-FIVE CENTS ADDITIONAL TAXES -- THE MARGINAL MEANS INCREMENTAL OR ADDITIONAL -- THEN I'D BE IN THE THIRTY-FIVE PERCENT MARGINAL TAX BRACKET. OKAY. BUT ANYWAY, IN THE '20S AND THE '60S AND THE '80S, WE HAVE MARGINAL TAX RATES LOWERED SIGNIFICANTLY AND IN ALL THREE OF THOSE DECADES WE EXPERIENCED ECONOMIC BOOMS AND DECLINING INFLATION. WHICH IS EXACTLY WHAT THIS THING IS TELLING US SHOULD HAPPEN, THIS DIAGRAM. IF YOU CAN BELIEVE THIS, IN I CAN'T BELIEVE IT EVEN. IN 1961 WHEN JFK BECAME PRESIDENT, THE HIGHEST MARGINAL TAX RATE WAS NINETY-ONE PERCENT. CAN YOU BELIEVE THAT? YOU GO TO WORK, YOU EARN A HUNDRED DOLLARS -- YOU'RE AN INVESTOR AND YOU EARN A HUNDRED DOLLARS, YOU TURN NINETY-ONE OVER TO THE GOVERNMENT AND YOU KEEP NINE. THIS IS FOR PEOPLE AT THE VERY HIGHEST LEVEL OF INCOME. KENNEDY LOWERED THIS, I THINK, IN '64 -- IT WAS A KENNEDY PROPOSED TAX CUT -- LOWERED IT TO SEVENTY PERCENT. ` REAGAN CAME TO OFFICE IN 1981 AND THEN THROUGH '86 HE DID

29 ECO LECTURE SEVERAL THINGS, AND LOWERED THIS FROM FIFTY ALL THE WAY DOWN TO TWENTY-EIGHT PERCENT. LET ME DO ONE CALCULATION FOR YOU TO SHOW YOU THE IMPORTANCE OF THAT. LET'S SAY YOU'VE GOT ONE DOLLAR'S WORTH OF INCOME. IN THIS CASE, YOU GET TO KEEP NINE CENTS OUT OF THAT DOLLAR, MARGINAL DOLLAR'S WORTH OF INCOME. HERE IF YOU HAVE ANOTHER DOLLAR'S WORTH OF INCOME YOU GET TO KEEP SEVENTY-TWO CENTS. THE INCENTIVE IS EIGHT TIMES AS STRONG THEN UNDER THE REAGAN TAX POLICY AS IT HAD BEEN PRIOR TO PRESIDENT KENNEDY COMING TO OFFICE. BIG CHANGE IN INCENTIVES. ANYWAY, WE WILL HAVE AN EXAM NEXT TIME. IT WILL COVER THIS MATERIAL ON FISCAL POLICY. SO LONG. * * * * SUPPLEMENTAL MATERIAL WELL, HI. I THOUGHT WHAT WE'D DO FOR A MINUTE HERE AFTER CLASS IS TALK ABOUT ONE MORE CURVE, SOMETHING CALLED A LAFFER CURVE. IT'S NAMED AFTER A PERSON NAMED ARTHUR LAFFER. HE WAS AN ECONOMIST AT THE UNIVERSITY OF SOUTHERN CALIFORNIA. THE WAY THE STORY GOES IS BACK IN THE LATE 1970S WHILE ARTHUR LAFFER WAS WITH A FRIEND AT DINNER, SITTING IN A RESTAURANT, HE PULLED OUT A NAPKIN AND SKETCHED A CURVE ON IT. AND THIS CURVE BECAME PRETTY FAMOUS. IT'S NOT AS WELL-KNOWN TODAY AS IT WAS BACK TEN, FIFTEEN YEARS AGO, BUT NEVERTHELESS, THERE'S SOME POWERFUL IDEAS CONTAINED IN THIS CURVE THAT HE DREW. AND SO WHAT

30 ECO LECTURE WE'RE GONNA TALK ABOUT IS SOMETHING CALLED A LAFFER CURVE. LET ME SKETCH THE CURVE OUT AND THEN WE'LL TALK MORE ABOUT THE WHYS AND WHY NOTS, AND SO FORTH, OF IT. LET'S PUT ALONG THE HORIZONTAL AXIS HERE THE MARGINAL TAX RATE. ON THE VERTICAL AXIS WE'LL WRITE DOWN TOTAL TAX REVENUES. THESE ARE THE TOTAL REVENUES COLLECTED BY THE GOVERNMENT FROM ALL TAXPAYERS. THIS MARGINAL TAX RATE, OF COURSE, IS EXPRESSED AS A PERCENT OF INCOME. AND THE LAFFER CURVE LOOKS LIKE THIS. IT STARTS OFF AT THE ZERO POINT AND IT GOES UP, AND FINALLY COMES BACK DOWN AGAIN. THIS IS A ZERO PERCENT TAX RATE AND WHAT ARTHUR LAFFER SAID IS THIS: IF THE GOVERNMENT CHARGES A ZERO TAX RATE, ZERO PERCENT, THEN OF COURSE IT'S GONNA COLLECT ZERO REVENUE. OKAY. AND HE ALSO SAID IF THE GOVERNMENT WOULD CHARGE A MARGINAL TAX RATE -- AND THAT IS TO SAY, JUST TAKE ONE HUNDRED PERCENT OF ANY GAIN IN INCOME THAT A PERSON EARNS, THEN THE GOVERNMENT'S TAX REVENUES WOULD AGAIN BE ZERO DOLLARS AND THE REASON FOR THAT IS PEOPLE WORK JUST SO THEY CAN PAY TAXES. IF THERE'S NOTHING IN IT FOR THEM, THEY DON'T WORK AT ALL. AND SOMEPLACE IN-BETWEEN -- THIS IS ABSOLUTELY NOT SUPPOSED TO BE FIFTY PERCENT, ALTHOUGH IT COULD BE BY ACCIDENT. BUT SOMEPLACE IN-BETWEEN ZERO AND A HUNDRED PERCENT THERE'S A CERTAIN TAX RATE, AND I'LL PUT PM THERE. BUT THERE'S A CERTAIN TAX RATE THAT MAXIMIZES THE GOVERNMENT'S REVENUES FROM CHARGING

31 ECO LECTURE INCOME TAXES. AND SO THAT WAS THE SIMPLE IDEA BEHIND THE LAFFER CURVE, WAS JUST THAT BASICALLY THE GOVERNMENT AS IT RAISES THE TAX RATE STARTING AT ZERO AND FIVE PERCENT, TEN, FIFTEEN, TWENTY, AND SO FORTH -- AS THE GOVERNMENT RAISES THE TAX RATE, TOTAL REVENUES ARE RISING. SO THERE IS A REWARD TO THE GOVERNMENT OR A PAYOFF TO THE GOVERNMENT FROM RAISING TAX RATES. ON THE OTHER HAND, ACCORDING TO ARTHUR LAFFER, ONCE YOU PASS THE MAGIC POINT HERE -- I'VE LABELED THIS TM -- THEN FURTHER INCREASES IN TAX RATES CAUSE GOVERNMENT REVENUES TO GO DOWN. AND WHY IS THIS? AND ARTHUR LAFFER SAID, YOU KNOW, THERE'S A NUMBER OF REASONS FOR IT. THERE'S TWO OR THREE THAT ARE BEST KNOWN. ONE IS THAT AS THE TAX RATE GOES UP, THE INCENTIVE TO WORK AND INVEST GOES DOWN. OKAY. SO A HIGHER TAX RATE RESULTS IN A -- LET ME JUST WRITE "DECREASES." A HIGHER TAX RATE LOWERS THE INCENTIVE TO WORK AND INVEST. AND SO IF WE RAISE THE TAX RATE BEYOND THIS MAGIC POINT HERE OR THIS CERTAIN POINT, THEN WE'VE CREATED DISINCENTIVES FOR WORKING AND INVESTING AND THEN PEOPLE DON'T PAY TAXES. LET'S WRITE DOWN A FORMULA AND THEN MAYBE THIS'LL BE A LITTLE EASIER TO UNDERSTAND. TOTAL TAX REVENUES -- THIS IS THE KEY THAT WE'VE GOT UP HERE, THE DOLLAR AMOUNT. TOTAL TAX REVENUES EQUAL THE TAX RATE TIMES THE TAX BASE. OKAY. THIS IS A PERCENT, THE TAX RATE, AND THE TAX

32 ECO LECTURE BASE IS A NUMBER OF DOLLARS. IT'S THE THING BEING TAXED SUCH AS YOUR INCOME. AND SO BASICALLY, THE ARTHUR LAFFER STORY IS THAT AS WE START INCREASING THE TAX RATE, THE TAX BASE -- THERE'S A DISINCENTIVE TO EARNING INCOME AND SO THE TAX BASE GOES DOWN. THESE TWO THINGS ARE HAPPENING ALL THE TIME. AND MANY ECONOMISTS, INCLUDING LAFFER, THEY CALL THIS THE ARITHMETIC EFFECT OF A TAX RATE INCREASE. THAT IS TO SAY, IF THE TAX BASE WERE TO STAY THE SAME AND THE TAX RATE GOES UP, THEN TAX REVENUES WOULD DEFINITELY HAVE TO GO UP. LET ME GET RID OF THIS DECREASE HERE. JUST SIMPLE ARITHMETIC TELLS US THAT. IF THE TAX BASE IS, LET'S SAY, TEN THOUSAND DOLLARS AND WE'RE TAXING THAT AT A TEN PERCENT RATE, THEN TAX REVENUES ARE GONNA BE ONE THOUSAND DOLLARS. AND THEN IF, ON THE OTHER HAND, THIS TAX RATE IS RAISED TO TWENTY PERCENT AND IF THE TAX BASE REMAINS AT TEN THOUSAND DOLLARS, GOVERNMENT REVENUES MUST GO UP TO TWO THOUSAND DOLLARS. OKAY. AND SO THERE'S THE ARITHMETIC EFFECT. SIMPLE ARITHMETIC TELLS US HIGHER TAX RATE, HIGHER TAX REVENUES. OKAY. THERE'S SOMETHING ELSE, THOUGH, CALLED THE INCENTIVE EFFECT OR YOU COULD SAY THE ECONOMIC EFFECT. AND THE INCENTIVE EFFECT SAYS THIS: AS THE TAX RATE GOES UP AND THE GOVERNMENT'S TAKING A LARGER PERCENT OF OUR EARNINGS AS TAXES, THEN THERE'S THIS DISINCENTIVE ABOUT WORKING AND INVESTING. AND, BY THE WAY, THERE

33 ECO LECTURE ARE OTHER INCENTIVES THAT ARE CREATED AS WELL. WE'VE ALL HEARD OF TAX LOOPHOLES. AND IF THE TAX RATE GOES UP, IT CREATES AN INCENTIVE TO BASICALLY FIND THOSE LOOPHOLES, TO HIRE EXPERTS THAT CAN HELP US DO THAT. THERE'S OTHER INCENTIVES. FOR EXAMPLE, THE INCENTIVE TO INVEST OVERSEAS. YOU'RE STILL INVESTING JUST AS MUCH BUT MAYBE NOT IN THIS COUNTRY. THERE'S THE INCENTIVE TO CHANGE THE TYPES OF INVESTMENTS THAT WE MAKE. BUY SOME MUNICIPAL BONDS WHERE WE DON'T HAVE TO PAY INCOME TAXES ON OUR INTEREST INCOME AS OPPOSED TO BUYING, LET'S SAY, CORPORATE BONDS OR GOVERNMENT BONDS -- TREASURY BONDS OR CORPORATE STOCKS. AND SO A LOT OF INCENTIVES ARE CREATED. BUT THE POINT IS, THEY ALL GO IN THE SAME DIRECTION. THAT IS TO SAY, A HIGHER TAX RATE CAUSES THE TAX BASE TO SHRINK AND THAT'S THE INCENTIVE EFFECT. AND THAT SHRINKING TAX BASE, THAT CAUSES TAX REVENUES TO GO DOWN, OTHER THINGS BEING EQUAL. AND SO REALLY WHAT THE ARTHUR LAFFER STORY IS -- AND, BY THE WAY, BEFORE I GO ON WITH ARTHUR LAFFER, LET ME REDO THIS AND PUT IN THE INCENTIVE EFFECT. WHAT WE'RE SAYING IS THIS: IF THE TAX RATE GOES UP TO TWENTY PERCENT, THEN THE TAX BASE IS GOING TO GO DOWN -- AND I'LL JUST USE A HYPOTHETICAL NUMBER HERE. LET'S SAY TO EIGHT THOUSAND DOLLARS. AND SO GOVERNMENT REVENUES IN THIS PARTICULAR CASE WOULD BE SIXTEEN HUNDRED DOLLARS. THE GOVERNMENT -- ITS

34 ECO LECTURE REVENUES WOULD DOUBLE BECAUSE OF THE ARITHMETIC EFFECT. BUT BECAUSE TWENTY PERCENT OF THE TAX BASE HAS BEEN ELIMINATED DUE TO THE INCENTIVE EFFECT, THEN WHAT THE GOVERNMENT GETS IS JUST THE SIXTY PERCENT INCREASE IN ITS REVENUES. SO ANYWAY, THESE TWO THINGS ARE WORKING ON THE OPPOSITE DIRECTION. NOW, BACK TO THE LAFFER CURVE. REALLY WHAT WE'RE SAYING IS THIS: UP TO THIS PEAK ON THE LAFFER CURVE THE ARITHMETIC EFFECT IS THE STRONGER EFFECT. THAT IS TO SAY, A HIGHER TAX RATE -- WE'RE DESTROYING INCENTIVES AS WE RAISE THE RATE. WE'RE JUST DOING THAT AT A VERY SLOW PACE. LET ME CHANGE THE SIZE OF MY ARROWS TO SORT OF INDICATE WHERE WE ARE. AS WE MOVE UP THIS LAFFER CURVE, THE TAX RATE RISES AND THE TAX BASE SHRINKS BUT JUST A LITTLE BIT. AND SINCE THE RATE GOES UP BY A BIGGER PERCENTAGE THAN THE BASE SHRINKS, TOTAL REVENUES RISE. THEN WE FINALLY REACH A CERTAIN POINT AND BEYOND THAT, FURTHER INCREASES IN THE TAX RATE CAUSE THE TAX BASE TO SHRINK BY A LOT DUE TO THIS INCENTIVE EFFECT. AND SO AGAIN, JUST SHOWING THE MAGNITUDES OF THE ARROWS, WE RAISE THE RATE SOME MORE. THE BASE SHRINKS BY A LOT AND SO NOW TAX REVENUES BEGIN TO DECLINE, AND, OF COURSE, ALL THE WAY DOWN TO ZERO. NOW, THIS WAS A BIG PART OF THE STORY. BY THE WAY, THIS IS REALLY JUST SUPPLY-SIDE ECONOMICS WHICH WE TALKED ABOUT IN CLASS EARLIER. SUPPLY-SIDE ECONOMICS SAYS THAT IF THE TAX RATE GOES UP --

35 ECO LECTURE WE'LL PUT REAL GDP HERE AND THE PRICE LEVEL, THE, WHAT, SHORT-RUN AGGREGATE SUPPLY CURVE. WHAT WE SAID BEFORE WAS A HIGHER TAX RATE SHIFTS THIS CURVE TO THE LEFT. WE'D HAVE A SMALLER AGGREGATE SUPPLY CURVE, DECREASED AGGREGATE SUPPLY. AND THAT'S ALL WE'RE SAYING HERE IS THAT THE TAX BASES SHRINK. AND SO WE'VE GOT THAT STORY AND I'M SAYING THAT WHEN ARTHUR LAFFER WAS DOING HIS WORK, TALKING ABOUT TAXES, THAT WAS AN IMPORTANT PERIOD FOR SUPPLY-SIDE ECONOMICS. THAT'S WHEN THE CAMPAIGN OF, WHAT, WAS IT 1980, WITH RONALD REAGAN AND JIMMY CARTER, THAT TURNED TO A LOT OF DISCUSSION ABOUT TAXES AND THE EFFECT ON THE ECONOMY. AND REAGAN AT THE TIME WAS ARGUING FOR CUTTING THE TAX RATE. AND WHAT HE WAS SAYING IS THAT THAT WOULD MAKE THE ECONOMY STRONGER. NOW, AT THE SAME TIME THAT REAGAN WAS SAYING CUT THE TAX RATE AND WE'LL MAKE THE ECONOMY STRONGER, OTHER ECONOMISTS, INCLUDING ARTHUR LAFFER, THEY WERE COMING ALONG AND SAYING, "WELL, NOT ONLY WILL THE ECONOMY GET STRONGER IF WE CUT THIS TAX RATE, BUT ALSO TAX REVENUES WILL GO UP. LET'S CUT THE RATE A LITTLE BIT." AND THEY WERE SAYING THE BASE WILL GROW SO MUCH THAT TAX REVENUES WILL RISE. AND SO IF THEY BELIEVE THAT -- HERE'S WHAT THEY THOUGHT. THEY THOUGHT, "WELL, WE'RE AT A CERTAIN POINT LIKE RIGHT HERE -- HERE'S THE TAX RATE. GETTING KIND OF AN UGLY PICTURE HERE. BUT HE WAS

36 ECO LECTURE SAYING SOMETHING LIKE, "OUR TAX RATE IS PRETTY HIGH." LET'S SAY HERE'S AND THE IDEA IS, IF YOU CUT THE TAX RATE BACK TO HERE, A MUCH SMALLER RATE, THEN WHAT WILL HAPPEN IS THE ARITHMETIC EFFECT WILL CAUSE THE GOVERNMENT TO LOSE REVENUE BUT THE TAX BASE WILL GROW SO GOVERNMENT REVENUES WILL ACTUALLY RISE AND BECOME A LARGER AMOUNT. SO ANYWAY, PRESIDENT -- OR CANDIDATE REAGAN RAN FOR OFFICE AND WAS SUCCESSFUL. IN HIS FIRST YEAR OF OFFICE, HE PROMOTED, ADVOCATED, AND ARGUED FOR, AND FINALLY RECEIVED, ACROSS-THE- BOARD TAX CUTS SO TAX RATES DID GO DOWN. AND HERE'S WHAT WE OBSERVED. WE OBSERVED THAT THERE WERE SOME AMERICANS -- WHEN THEIR TAX RATE WENT DOWN, SOME AMERICANS ACTUALLY DID PAY LESS TO THE GOVERNMENT IN THE FORM OF REVENUES. OKAY. THEIR TOTAL TAX BILL FELL. BECAUSE FOR SOME AMERICANS, THE ARITHMETIC EFFECT WAS STRONG AND THEY JUST -- THE LOWER RATE, THEY PAID LESS REVENUE. BUT FOR OTHER AMERICANS, WHEN THE TAX RATE WAS CUT, THEY PAID MORE TO THE GOVERNMENT. AND AS IT TURNS OUT, WE'VE SEEN THIS OVER AND OVER: 1920S, 1960S, 1980S. IN EACH ONE OF THOSE DECADES WHEN WE HAD TAX RATE CUTS, WHAT WE OBSERVED IS EXACTLY THIS: THERE'S A CERTAIN SEGMENT OF THE PUBLIC THAT DOES PAY LOWER TAXES IN TOTAL DOLLAR AMOUNT TO THE GOVERNMENT WHEN THE RATES ARE CUT AND THERE'S A DIFFERENT SEGMENT OF THE POPULATION THAT WHEN THEIR RATES ARE CUT, THEY PAY MORE TO THE GOVERNMENT. AND AS IT