unit 9: keynesian theory & fiscal policy “the difficulty lies not so much in developing new...
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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
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Why A New Theory? New Data. Classical Theory Can’t Explain Great Depression
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Why? Why? Classical Theory Can’t Explain Great DepressionClassical Theory Can’t Explain Great Depression
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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
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Slide 5
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
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Slide 6
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?
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Created:Jan 2008
by Jim Luke.This work is licensed
under the Creative Commons Attribution-
NonCommercial License
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
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Slide 8
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
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Slide 9
Keynesian Insight:Wages & Prices are “sticky”
“Efficiency” wages Monopolistic firms reduce output not
prices
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Slide 10
Keynesian Insight:Expectations Plans Spending
AD shifts Firms produce to expected demand Say’s Law won’t hold
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Slide 11
Keynesian Insight:Expectations are irrational
Assume current trends continue Excessively optimistic or pessimistic “Animal Spirits”
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Slide 12
Keynesian Insight:
AD Shifts creates recession or inflation
Equilibrium (stability) is possible at less than full employment.
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Let’s take another look at spending and Aggregate Demand: C, I, and G
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C: Consumer Spending
C based on expectations for future: Job security Price levels Interest rates Life expectancy Wealth, not just income
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I: Investment
“Forward looking” decisionsTwo major determinants
Market interest rate Business expectations
• NOTE: Not the current level of income!
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Business Expectations
Factors: Wars Future resource costs Technological change Changes in tax structure Other destabilizing events Recent growth rates “Animal spirits”
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G: Government Purchases
Budget controlled of public officials G “autonomous” No reason gov’t cannot borrow short-run G could be independent of T
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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”.
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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
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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.
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Recessionary Gap shifts AD
PPrice Level(price index)
Real GDP@start
Price Index @start
start
LRAS
SR-AS
ADat start
Real GDPif we had full employment
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
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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
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Slide 23
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
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Recessionary Gap: Keynesian Rx
Fiscal Policy:Increase G and/orDecrease T to offsetDeclines in C and I.
PPrice Level(price index)
Real GDP@start
Price Index unchanged
start
LRAS
SR-AS
ADat start
Real GDPif we had full employment
Government Increases G or decreases T, with result AD shifts right.
ADafter govt fiscal stimulus
after
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Inflationary Gap: Keynesian Rx
Fiscal Policy:Cut G and/or raise T reduce AD
PPrice Level(price index)
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
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Created:Jan 2008
by Jim Luke.This work is licensed
under the Creative Commons Attribution-
NonCommercial License
Fiscal Policy
Government purchases, transfer payments, taxes, and borrowing as they affect macroeconomic variables
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Created:Jan 2008
by Jim Luke.This work is licensed
under the Creative Commons Attribution-
NonCommercial License
Automatic Stabilizers
Spending and taxes automatically change in response to economic change:
Unemployment compensationWelfare assistanceIncome tax collections
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Created:Jan 2008
by Jim Luke.This work is licensed
under the Creative Commons Attribution-
NonCommercial License
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
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Slide 29
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)
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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
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Slide 31
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