COMPETITIVE EQUILIBRIUM

FISCAL POLICY

Intermediate Macroeconomics.ECON 304

Prof. Elisa Belfiori

Colorado State University

These notes are based on Chapter 5 of the book. This is myadvise on how to use these slides:

1 Skim over them. You will not understand many concepts butyou will get an idea of what is covered in the chapter. Youwill also have a sense of which parts of the chapter you needto focus on and which ones you can read just for fun.

2 Read the chapter. Take your own notes on the mostimportant parts of it.

3 Get back to the lecture notes and complete them with yourpersonal notes. Make sure you understand every single bullet Ihave included in here. If I wrote it in my notes, it means Ithink it is important so you need to make sure you know andunderstand it.

4 Enjoy !

Note: In this chapter, the book uses the idea of a social planner and introducesa “Production Possibility Frontier”. You do not need to go over that. Instead,our analysis here will take the form of demand and supply curves. Please readthe chapter to get a general feeling of the topic and to extract the intuition forthe results we derive. But follow the slides in terms of the approach taken.

Fiscal Policy

We want to use the model to study policy

Suppose we are in a recession

Suppose the government is planning to increase spending inorder to boost the economy

We call “Government stimulus” to short run increases ingovernment expenditures aimed at increasing output

What is the effect of this policy in the economy?That is: How does this policy affect Consumption, Employmentand Output?

1 Taxes have to increase to finance the higher level of G (SinceG = T )

2 An increase in taxes (⇑ T) is a negative income effect forthe consumers

1 The consumer feels poor, wants to consumer less of the twogoods he consumes: ⇓ C ⇓ `

3 Less `, implies more Ns ⇒ the Labor supply curve shifts tothe right

4 At the original wage, there is unemployment in the labormarket ⇒ w decreases until the unemployment is gone

The overall effect of the increase in government expenditure is ⇑N, ⇑Y, ⇓ w, ⇓C

(The effect on consumption is actually ambiguous. To see that, note that

C=Y-G ⇒ Y increases with an the increase in G. Since both go up,

consumption goes up if Y increases more than the increase in G. However,

evidence seems to show that the increase in Y is less than the one in G)

Graphically:

The take-away conclusion of this policy analysis is that:

There are some tradeoffs in using government spending toboost the economy

1 The policy is effective: Output and employment increase

2 But people end up consuming less and working more for alower wage

3 Overall welfare decreases ⇓ U(c , `) (people are less happy)

The American Recovery and Reinvestment Act(ARRA) of 2009

The ARRA was a law signed by President Obama in Feb 2009

It responds to the idea that the government has to introducepolicies to increase output when it falls below trend (like inthe 2008-2009 recession)

We learn from our model that there are some tradeoffs inintroducing this policy (we may all end up worse-off with it!)

It is worth mentioning that we are neglecting some aspects ofthe policy that we still need to address later in the class

1 The increase in G has implications also for the governmentdeficit and for how the deficit is financed

We will study those later since for now G = T (no deficit)

2 Government spending might be productive (roads, bridges) ⇒what if G increases the national stock of capital orproductivity?

A “productive” Government Spending

Suppose that the government stimulus makes firms moreproductive. For example, spending on roads lower the cost oftransportation or reduces the commuting time of workers, whichincrease they productivity. That is, suppose there is an increase inG which has associated an increase in z (⇑ G and ⇑z)

What is the effect of this policy in the economy?

This means: How does this policy affect Consumption,Employment and Output?

On the consumer’s side , the effect of this policy is basically thesame we just discussed

1 Taxes have to increase to finance the higher level of G (SinceG = T )

2 An increase in taxes (⇑ T) is a negative income effect forthe consumers

1 The consumer feels poor, wants to consumer less of the twogoods he consumes: ⇓ C ⇓ `

3 Less `, implies more Ns ⇒ the Labor supply curve shifts tothe right

On top of that, on the firm’s side the increase in productivity (⇑z)means that:

1 Even with the same amount of workers, the firm can producemore because it is overall more productive (maybe theconstruction of roads by the gov allows workers to get to workfaster) ⇒ the Production function shifts up

2 Each worker is more productive as well (the marginalproductivity of labor increases) ⇒ the Labor demandfunction shifts to the right

The overall effect of the increase in government expenditure is ⇑N, ⇑Y, ⇑ w, ⇑C (the effect on consumption is ambiguous)

(The effect on consumption is actually ambiguous. Again, C=Y-G ⇒ but

now note that Y increases both due to the increase in G and due to the

increase in z. It is more likely now that overall Y increases more than the

increase in G, specially if the associated increase in productivity is large

enough)

Graphically:

The take-away conclusion of this policy analysis is that:

Most of the tradeoffs in using government spending toboost the economy are gone if the increase in G is allocatedto productive uses

1 The policy is effective: Output and employment increase

2 People end up consuming more and working more but alsobeing paid more (higher wage)

3 Overall welfare increase ⇑ U(c , `)

The lesson we draw from our model so far is that the effect ofgovernment stimulus packages depend on how the gov spendsthe money

1 If it is spent in unproductive uses (transfers, employingunproductive workers in the government sector, etc), there aretrade-offs that may end up making americans worse off

2 If it is spent in productive uses (roads, bridges, publictransportation, etc), the stimulus can become a good policy toboost the economy