Unemployment and Fiscal Policy Flashcards
Consumption function
C = c0 +c1Y
C1 is the marginal propensity to consume, Y is the current disposable income, if you differentiate you just get c1
Between 0 and 1
C0 is autonomous consumption, fixed amount one will spend, independent of current income
Expectations about future income reflected in c0
Poor households, likely to have a smaller c0 and a larger c1
Can be graphed
If income increases, (1-c1) is saved
MPC = (1 - MPS), MPS = s1
Shortcomings of consumption function
Very simple model
Not a forward looking function, future income only in c0, which isn’t always true
Not a micro founded model
Why do we care about MPC?
In order for a government to stimulate the economy, they need to know what group of people to target
Need to increase MPC, not autonomous consumption
Means they need to try to focus on poorer households as they have a larger MPC
Why does MPC differ across countries?
Economic activity
Culture and religious activity
Institutions
People stopped buying durable, luxury goods during times of crisis
What factors affect how profits are distributed?
Interest rates, r:
When high, better for firms to save
Net profit rate on investments in productive capacity
Higher profits in future, may incentivise using
Owner’s discount rate
MRS = 1 + ro
Consume the extra income (dividends) if ro > r >= pi
Save the extra income to repay debts if r > ro > pi
Invest at home or abroad if pi > ro >= r
Higher interest rates reduce investment, low IR = increase investments
Improvements in business environments will increase investments
Better property rights, lower energy prices
Increases the profit rates (pi)
The Investment Function
I = ao - a1r
R is the interest rate
A0 denotes autonomous investment
A1 is the interest sensitivity of investment and is >0
I line is negatively sloped
Increase profit expectations = increase a0
Change in r is movement along line
The good market equilibrium
Modelled as no government and closed economy:
Good market clearing:
Y = AD
Assuming no gov spending or trade
AD = C + I
AD = c0 + c1Y + (a0 - a1r)
For simplicity and to reduce maths, the interest rate is going to be held constant, so only output is allowed to change
AD = c0 + c1Y + I
Fall in investment effects
As output falls, firms start to produce less, so need less inputs, so they fire employees
Which further lowers aggregate demand
Indirect effect is larger due to the chain reaction, so the fall in output is larger, due to the multiplier
Changes in government spending
Government is spending more, better services, so people demand at a higher level, move from A - B
A => B : change in G
B => C: change in G
To match increase demand, firms hire more workers, increases incomes and increases spending
Leads to much higher level of output due to multiplier
Any effect after A to B is an indirect affect
C => D : c1(1 - t)*(change in gov spending)
E => F : (small vertical line) = [c1(1-t)]^2 * change in G
New Multiplier Model
New multiplier depends on MPC, tax rate and MPM, all three between 0 and 1
Simpler multiplier will give larger multiplier essentially
Taxes and imports reduce the size of the multiplier
Some income goes to government as taxes
Some income is used to buy goods abroad
Fiscal Stabilisation
How do govs stabilise the economy?
Size of government
Gov spending is stable
Higher taxation reduces size of multiplier
Automatic Stabilisers
Progressive taxation
Transfers, unemployment benefits, help households smooth consumption
Failure of public markets
Correlated risk (widespread shocks)
Hidden actions (moral hazard)
Hidden attributes (asymmetric info and negative selection)
Simplified government budget constraint
Gt + iBt-1 = Tt + DeltaBt + DeltaMt
Post Assumption:
DeltaBt = Gt - Tt + iBt-1
Financing fiscal stimulus
It is clear fiscal stimulus will result in:
a primary deficit, G - T > 0, or higher primary deficit if initially G doesn’t equal T
