unit 9: keynesian theory & fiscal policy “the difficulty lies not so much in developing new...

Unit 9: Keynesian Theory & Fiscal Policy

“The difficulty lies not so much in developing new ideas as in escaping from old ones.”

"In the long-run we are all dead."

--- John Maynard Keynes

Created:2013

by Jim Luke.This work is licensed

under the Creative Commons Attribution-

NonCommercial License

Why A New Theory? New Data. Classical Theory Can’t Explain Great Depression

Why? Why? Classical Theory Can’t Explain Great DepressionClassical Theory Can’t Explain Great Depression

Crash and Great Depression

U.S. Depression DataU.S. Depression Data 19291929 19311931 19331933 19371937 19381938 19401940

Real GNPReal GNP 101.4101.4 84.384.3 68.368.3 103.9103.9 103.7103.7 113.0113.0

Consumer Price Index Consumer Price Index 122.5122.5 108.7108.7 92.492.4 102.7102.7 99.499.4 100.2100.2

Unemployment (% )Unemployment (% ) 3.13.1 16.116.1 25.225.2 13.813.8 16.516.5 13.913.9

Unprecedented Deflation Unprecedented Deflation + Unemployment+ Unemployment LargerLarger LongerLonger Persistent, Persistent, notnot temporary temporary WorldwideWorldwide

Context: Keynesian Theory

Global Economy Stumbles Versailles Treaty & Inflations Failed Gold Standard Tariff Wars Declining Trade Financial bubbles

Great Depression Rise of Fascism & Communism

Fears capitalism won’t survive

Keynesian Questions

• Is market capitalism inherently unstable?

• Can depressions continue forever?

• Any alternative to state socialism?

• Can “democratic” governments restore full-employment in a modern industrial economies?

Created:Jan 2008




Assumptions Compared

Classical• Competitive markets

• Flexible prices

• Current income/prices drive C & I

• S = I

Conclusion:• SRAS/LRAS matter

Keynes• Monopolistic markets

• Sticky prices

• Expectations drive C & I

• I =/= S.

Conclusion:• AD matters

Keynesian Insights

Wages & Prices are 'sticky' “Efficiency” wages Monopolistic firms reduce output not prices

Expectations Plans Spending but can be wrong Say’s Law won’t hold

Expectations are irrational Assume current trends continue Excessively optimistic or pessimistic

AD Shifts creates recession or inflation

Keynesian Insight:Wages & Prices are “sticky”

“Efficiency” wages Monopolistic firms reduce output not

prices

Keynesian Insight:Expectations Plans Spending

AD shifts Firms produce to expected demand Say’s Law won’t hold

Keynesian Insight:Expectations are irrational

Assume current trends continue Excessively optimistic or pessimistic “Animal Spirits”

Keynesian Insight:

AD Shifts creates recession or inflation

Equilibrium (stability) is possible at less than full employment.

Let’s take another look at spending and Aggregate Demand: C, I, and G

C: Consumer Spending

C based on expectations for future: Job security Price levels Interest rates Life expectancy Wealth, not just income

I: Investment

“Forward looking” decisionsTwo major determinants

Market interest rate Business expectations

• NOTE: Not the current level of income!

Business Expectations

Factors: Wars Future resource costs Technological change Changes in tax structure Other destabilizing events Recent growth rates “Animal spirits”

G: Government Purchases

Budget controlled of public officials G “autonomous” No reason gov’t cannot borrow short-run G could be independent of T

The Keynesian Theory Using AD-AS Model

The Classical Theory says the economy corrects itself in the long-run.

But after seven years of continuing depression, in 1936 John Maynard Keynes counters with the observation that “in the long-run we are all

dead”.

Circular Flow: Keynesian View

Govt may run deficits or surpluses.

G not equal to T

Expectations & plans, not Interest rates drive S. (“save for a rainy day”).

Closed economy:

Ignore ROW.

Spending on I depends on

expectations, not interest

rate

Financial markets may

not reach equilibrium.

S > I

Recessionary Gap: High unemployment

PPrice Level(price index)

Real GDP@start

Price Index @start

start

LRAS

SR-AS

AD

Real GDPif we had full employment

Gap represents amount of

unemployment

Prices & wages are “sticky” –SRAS stays where it is.Firms lay-off workers instead of cutting wages.

Recessionary Gap shifts AD


Real GDP@start

Price Index @start

start

LRAS

SR-AS

ADat start


Real GDP declines further instead of recovering. The economy moves AWAY from full employment.

Workers & firms cut spending plans

RESULT: AD shifts to the left, making the recessionary gap worse.

ADafter layoffs & loss of confidence

after

Real GDPdeclines even further

Price Index after

Conclusions from Keynesian Model - Recession

Modern industrial economy: Can get “stuck” in long recession with very high

unemployment May NOT automatically correct itself.

Conclusion: Optimism, expectations, plans are critical

THE Rx: Counter-cyclical Fiscal policy “manage” AD

Keynesian Rx:Fiscal Policy to Manage AD

Improve Confidence & Expectations Disaster safety nets Unemployment insurance Social Security Banking deposit insurance Securities regulation

Manage business cycle Counter-cyclical fiscal policy Change G to offset changes in C and I Borrow in recession, surplus in boom

Recessionary Gap: Keynesian Rx

Fiscal Policy:Increase G and/orDecrease T to offsetDeclines in C and I.


Real GDP@start

Price Index unchanged

start

LRAS

SR-AS

ADat start


Government Increases G or decreases T, with result AD shifts right.

ADafter govt fiscal stimulus

after

Inflationary Gap: Keynesian Rx

Fiscal Policy:Cut G and/or raise T reduce AD


Real GDP@start

start

LRAS

SR-AS

ADat start

Real GDP

if we had full employment

Government decreases G or increases T, with result AD shifts left

ADafter govt fiscal policy

after

Created:Jan 2008




Fiscal Policy

Government purchases, transfer payments, taxes, and borrowing as they affect macroeconomic variables

Created:Jan 2008




Automatic Stabilizers

Spending and taxes automatically change in response to economic change:

Unemployment compensationWelfare assistanceIncome tax collections

Created:Jan 2008




Discretionary Fiscal Policy

Congress & President must decide to spend more/tax less and pass a new law or budget to do it.

often called “stimulus” program

Fiscal Policy - How

Federal Budget, Expenditures & Tax Revenues • G+Gtransfer > T budget deficit • G+Gtransfer < T budget surplus • G+Gtransfer = T balanced budget

Stimulus effect: • Raise G, lower T• Increase deficit (or reduce the surplus)

Contractionary effect: • lower G, raise T• Increase surplus (or reduce deficit)

Which Is Better: T or G?

Spending Multiplier: MPC: marginal propensity to consume = 1/(1–MPC) If MPC is 0.8 1 / 0.2 5 initial increase G of $100 billion

will eventually boost real GDP by 5 times, or $500 billion

In theory, multiplier of G is greater than multiplier of T Increased G is directly spent –all affects GDP Part of a Tax cut is saved and doesn’t affect GDP BUT, timing is important too

Keynesian Theory: Summary

Industrial Economy inherently unstable Equilibrium possible with unemployment Extended depressions possible

AD matters‘Equilibrium’: when actual = planned Confidence & Expectations important

Self-fulfilling Fiscal Policy can work

unit 9: keynesian theory & fiscal policy “the difficulty lies not so much in developing new...

Documents

g slide

income slide

great depression slide

temporary worldwide

independent of t slide

classical theory

prices expectations

keynesian questions