Unit 3: Government Budget Spending, Consumption Demand, and Investment Demand Flashcards
Deficit (Surplus) Definition
the annual difference between government spending and government tax revenue.
Debt (Conc.)
The debt is total sum of past deficits minus the total sum of past surpluses.
Two Primary Components of Government Spending
- Purchases of Goods and Services
- Transfer Payments
Federal Purchases of Goods and Services
Federal Transfer Payments
Federal Government Receipts (3)
How long has the government run a deficit (except for what period?)
State and Local Purchases of goods and Services
State and Local Transfer Payments
State and Local Government Receipts
Pros of Balanced Budget Amendments
It prevents politicians from passing policy today in order to get high favorability without any regard to the future.
Cons of Balanced Budget Amendments
It causes the economy to be highly procyclical as spending is high and people are hired when the economy does well and spending is low and people are fired during recessions.
Cyclical Deficit
Depends on what Assumption?
It depends on the assumptions that we know what potential output is.
Budget deficit (surplus) (Alg.)
Tax revenue moves ___ with the economy. Often, the percent change in tax receipts is ____ than the percentage change in output. Why?
Because Taxes = t x Y in the model.
What is one reason the average tax rate (t) fluctuates more than output?
It automatically adjusts with income because of the progressive income tax system in the US. (Rise in t → Rise in Y).
What is a discretionary policy choice that causes t to move with Y?
Governments will typically adjust t in order to increase output during recessions.
Relationship between Tax Receipts to GDP and the Unemployment Rate
Government purchases do not respond very much to ______. Instead, they respond most to changes in ______.
business cycle fluctuations; defense spending.
Transfer payment move ______in order to dampen fluctuations in the economy.
countercyclically;
Automatic Stabilizers in terms of transfer payment programs (Conc.)
Most transfer payment programs that automatically increase as output falls without discretionary intervention by the government.
Examples of transfer payment programs
unemployment insurance, food stamps, welfare programs, Medicare, and Social Security.
Relationship of government transfers to GDP and the unemployment rate (Graph)
The federal government can finance its debt by issuing (2)
- Interest-bearing bonds
- Non-interest bearing money
The deficit tends to ___ during recessions (expansions) as ___ _____ government spending and as tax revenue _____.
rise (fall); automatic stabilizers push up (down); falls (rises)
Full employment or structural deficit
the size the deficit would be at if the economy were at full employment
Cyclical Deficit
the amount of deficit that is attributed to the deviation of output from its potential.
Actual Deficit
The sum of the structural and cyclical deficits.
Our model says that an increase in the deficit ________ which causes the interest rate ____.
reduces government savings; to rise.
Empirical evidence, however, shows that interest rates tend to ___ when the budget is in deficit.
fall
Two important things to note about the relationship between the deficit and interest rates. (Once conceptual about IS Curve and the other historical).
Graph showing relationship between budget deficit and interest rates (US)
Government’s budget constraint equation of Debt at the start of next year (Alg.)
Current Period Budget Deficit (BD) (Alg.)
Data on the federal deficit and the debt
Shifts of the IS curve. (Increase in G and Decrease in T)
Two ways automatic Stabilizers impact slope of the IS Curve.
Effect of Rise in R with and without Automatic Stabilizers (Alg.)
Increase in R’s impact on IS Curve with and without Automatic Stabilizers (Graph)
Consumption and GDP (Relationship in SR and LR)
In the long run, consumption and GDP grow at the same rates.
Over the short-run business cycle, consumption fluctuates less than GDP.
The behavior of the components of consumption
Services vary the least over the business cycle.
Non-durables vary a bit more than services but less than durables.
Durables are responsible for the majority of the fluctuations in consumption over the business cycle.
Consumption and disposable income
- Consumption is less volatile than GDP in part because consumption is dependent on disposable income.
- Disposable income tends to be less volatile than GDP for a number of reasons.
- a. Transfer payments from the government to consumers are countercyclical.
b. The average proportional tax rate is procyclical because of the progressive income tax.
c. Corporations tend to keep dividends constant and instead vary retained earnings over the business cycle.
Over the long run, the relationship between consumption and disposable income is ____
very stable.
Estimates of the consumption function from 1959-2002 find that ___ (Alg. Function for C)
C = 0.94×Yd, where 0.94 is the estimate of the long-run marginal propensity to consume.
Problems with the relationship b/w C and Yd that make forecasting consumption difficult.
The short-run vs. long-run marginal propensity to consume (MPC) [5]
Two assumptions of forward-looking theory about consumers
- Two assumptions of forward-looking theory about consumers
- prefer to keep their consumption fairly constant from year to year.
Consumer’s permanent income (Conc.)
roughly the average level of current and expected future disposable income over the remainder of his or hers lifetime.
Components of the budget constraint [6]
Intertemporal budget constraint equation
Other Key Relationships in the IBC model
Any feasible consumption plan cannot exceed the sum of ____ plus _____.
current assets plus current and expected future income.
Effects of an unanticipated permanent rise in disposable income. (Yd is higher now and in every period in the future.)
- Consumer’s permanent income will rise by the change in disposable income.
- In this case, the marginal propensity to consume will be close to one.
Effects of am unanticipated temporary rise in disposable income. (Yd rises only in this period.)
- Since the change is temporary, most of the additional income is saved in interest-bearing assets because consumers prefer to have a constant consumption path.
- This temporary change increases consumers’ permanent income by a little more than the annual interest earned on the additional income.
- In this case, the marginal propensity to consume will be slightly higher than the interest rate.
- Therefore, the marginal propensity to consume for a temporary change in Yd is much less than when the change in Yd is permanent.
Effects of an anticipated change in income (permanent or temporary).
the consumer’s level of permanent income would have already been adjusted so no change in consumption would occur.
Implications of the forward looking model on differences between SR MPC and LR MPC
Statistical evidence suggests the MPC from a temporary tax cut is about ____ the MPC from a permanent tax cut.
half
Three potential reasons why the forward-looking model underpredicts the response of consumption to a temporary change in income.
- Empirical tests might incorrectly estimate expectations of future income
- People are uncertain about their lifetime income which leads to impatience. Thus, they consume based on their current income and expected future income over the next few years.
- Consumers may not be able to borrow as easily as the forward-looking theory suggests so they cannot keep their consumption smooth during economic downturns. In this case, the consumers are said to be liquidity constrained.
Factors that influence the decision to consume today or in the future.
- The rate of time preference
- The real interest rate (R – π^e)
The rate of time preference
a. People prefer present consumption to future consumption.
b. Some reasons why consumers prefer current consumption include impatience and uncertainty.
c. If people have a high rate of time preference, they will prefer to consume more now and less in the future.
The real interest rate (R – π^e) [Alg.]
The real interest rate (R – π^e) [Conc.]
Real Rate of Return
How is consumption related to the real interest rate?
Empirical evidence is inconclusive on whether the substitution effect dominates the income effect, i.e. consumption is negatively related to R – πe, or these effects cancel each other out, i.e. consumption is not related to R – πe.
What is the impact on the IS curve’s slope when the interest rate is included in the consumption function?
Consumption and Tax Rate Changes
Three types of investment and their stability.
- Capital(Business) Investment: most stable of the three as it takes a long time to plan and build capital expansions.
- Residential Investment: Very sensitive to r, and since r is procyclical, it turns down just before the recession but is one of the first areas to recover.
- Inventory investment: Most volatile component. Planned inventory investment is a sign an expansion is in progress but unplanned inventory is a sign a recession is looming.
The two markets affecting the amount of investment in the economy.
- The loanable funds market
- The market for investment goods.
The Loanable Funds market
- Firms finance their investment purchases by borrowing funds from the loanable funds market. The OC for internal financing is the interest they would have earned.
- Investment Demand determined the demand for loanable funds
- Savings decisions by private agents, governmental budget
decisions, and the amount of direct foreign investment
determine the supply of loanable funds. - The interest rate clears this market
The Market for Investment Goods
- Investment demand is determined by how much
investment businesses decide to undertake. - Investment supply is determined by how much the
producers of investment goods decide to supply. - The relative price of investment goods to other goods in
the economy (PK) clears this market.
Firms Make Two Separate Decisions Regarding Their Level of
Capital Investment
A. What is their optimal level of capital stock (K*)? (i.e., How
many factories and machines does the company want?)
B. What is their flow of investment? (i.e., How fast do they build
factories and buy machines?)
Marginal Product of Capital [Alg.]
MPK = (YB – YA)/(KB – KA)
Firms Choose K* at the Point Where ______
the Marginal Product of Capital Equals the Marginal Cost of Capital.
What is the demand for capital (Dk) and why?
It is the MPk schedule (just like DL) because as marginal product decreases, the marginal cost needs to decrease in order to justify the additional unit of capital.
Marginal Cost of Capital
Rk, the rental price per unit charged by the renting firm.
- In the case where a firm owns its own capital, that firm’s
opportunity cost of utilizing its own capital is the rental
revenue it forgoes. - Otherwise, it uses the Rk formula.
Rental Price of Capital Function
RK = (R + δK)×PK.
Factors that shift the demand for capital
- A rise (fall) in Y increases (decreases) the demand for capital
which causes DK to shift rightward (leftward). - A rise (fall) in the real wage (W/P) means that the price of a
substitute factor of production is higher (lower). This leads to
an increase (decrease) in the demand for capital, which causes
DK to shift rightward (leftward).
A rise in DK (Graph)
An inc. in Rk (Graph)
An increase (decrease) in RK to RK′ raises (lowers) the cost of K so firms reduce (expand) their level of K to KB.
Expected changes in the future price of capital (Alg.) When does it apply?
When Pk is expected to change
Investment Demand Function
What does the relationship associated with the inputs and output?
K* = f(Y, W/P, RK)
K* depends positively on Y and W/P and negatively on RK
Actual level of capital investment (Conc.)
IK = f(Y, W/P, RK) – K-1 + δK×K-1
- Gross capital investment is IK.
- Net capital investment is IK – δK×K-1.
- The amount of replacement investment due to
depreciation (δK×K-1) is typically a large fraction of
capital investment each year.
The Accelerator Effect
The positive effect of output on investment
K* = v×Y
where v depends on W/P and RK.
Capital Investment Function with the Accelerator Effect
Tells us that the level of IK depends on the change in Y.
IK = v×(Y – Y-1) + δK× v×Y-1
Lags in the capital investment function (Alg.)
where s is the fraction of the difference between K* and K-1
that firms change their capital stock by. (i.e., 0 ≤ s ≤ 1).
Permanent changes in taxes and subsidies on investment
impact the _____
marginal cost of investment, RK
Equating after-tax income with after-tax costs and solving for RK (Alg.)
What assumptions are made?
Tax rates are permanent and unanticipated.
If tax changes are anticipated, say a subsidy decrease, ____
Pk will rise (fall) next period, so more DK inc. this period and firms will charge a lower RK. The result is that IK rises this period.
The demand for residential investment (DH) depends
______
negatively on the rental price of houses (RH).
The Rental Price of Housing (Alg.)
RH = (R + δH)×PH
Since the estimates of household depreciation, (δK), are
around ___, ____ is a large component of RH, which
causes housing to be _____.
2% annually; R; very sensitive to changes in R
Since housing can usually be built in ___, lags
in housing investment (IH) are usually not a problem such that
less than one year;
IH = H* – H-1 + δH× H-1
Inventory investment
Inventories are the stock of goods in the production process
and final goods waiting to be sold.
Pipeline Function of Inventories
- Inventories held that are an intrinsic part of the production process.
- Inventory levels held due to the pipeline function tend to be procyclcial. This helps accelerate investment as Y rises.
- About 2/3 of all inventories are held because of the
pipeline function.
Buffer Stock
- Inventories held by firms to buffer against unplanned changes in demand
- Occasionally, unplanned increases (decreases) in demand deplete (boast) inventories below (above) planned levels.
- About 1/3 of all inventories are held as buffer stock.
The Rental Price of Inventories
RIN = R×PIN
This is the opportunity cost of the resources that are
held as inventories
