Notes 11: Examples of Fiscal Policy - Government Spending and Taxes
This set of notes is designed to put our model to work by looking at the role of government spending and taxes in the economy.
Example 1: Assume we are in a situation of long run equilibrium (economy is in equilibrium at Y*). Suppose the Government (Congress and the President) decreases government spending (G) and there is no effect on the PVLR of consumers. As we saw throughout the class, changing G does not affect PVLR. (In class last week, we did an increase, now I am doing a decrease - I want you to see the situation both ways. For those paying attention, G increase versus G decrease is exactly the same - except all the signs are reversed.). Analyze the new short term and long term dynamics of the economy. I am going to assume the AS curve is upward sloping in the short run (you should be able to do this with a horizontal AS curve). Remember, with an upward AS curve - prices are allowed to adjust, but nominal wages are fixed!
1) G falls:
A)Does this affect the labor market in terms of labor demand or labor supply? The answer is a resounding NO! (We did this before the first test).
B)Does this affect the AD and the IS curve? Of course! A decrease in G decreases the demand for goods (Y = C + I + G + NX). If G decreases, demand for Y should decrease.
Let us look at this graphically: I am going to start in the AS – AD market.
P
P0 (c)
(a)
P1(b)
AD1(G1)
Yp Y1
The economy is initially in equilibrium at point (a). As the AD curve shifts in (due to lower government spending), prices should fall (from P0 to P1) AND equilibrium level of output should fall to Y1 – which I refer to as the equilibrium GDP in the short run). The new short run equilibrium is at (b) for the economy.
NOTE: P0 is the initial price level in the economy. Suppose, prices were fixed in the economy and we had a horizontal SRAS curve (ie, prices didn’t change in the short run – we told some stories why this might be the case). In this case, if prices were fixed at P0, the leftward shift of the AD curve would result in the economy ending up at point (c) (where output is equal to Yp (the output level which would have occurred if prices where fixed)). The fall in GDP would be bigger (from a given change in AD) if prices were fixed than if firms were allowed to adjust prices (point b versus c). Why is that? If firms lower prices with a negative demand shock (which we assume they do in this example), then the lower prices will increase real money balances (M/P). An increase in M/P, all else equal, will increase the real supply of money and this will cause lower real interest rates. The lower real interest rates will cause firms to undertake new investment. GDP doesn’t fall as much when prices are allowed to adjust because the change in prices will cause interest rates to fall further and spur on some new additional investment (as we will see in a second, even if prices are fixed, interest rates will fall!). So, the fall in G is offset by an additional increase in I when prices adjust! Firms adjusting their prices will dampen the effect of recessions! We see, if prices are ‘sticky’ in the economy, recessions will be more severe (larger decreases in Y). <Regardless of whether prices are fixed in the short run, we assume nominal wages are always fixed in the short run>. Let’s look at the IS-LM market to see the effects on interest rates and investment!
LM0 (P0)
r
LM1(P1)
G falls
r0 (d)
(a)
(c)
(b)
P falls
IS1 (G1)
Yp Y1
Like in the AS-AD market, a fall in G will shift in the goods demand curve. Remember, the IS curve represents the goods side of the market Y = C + I + G + NX just like the aggregate demand curve. As G, decreases the IS curve (and the AD curve – they are both the same – just drawn in different spaces) will fall. This causes interest rates to fall (as does output). A lower level of output will decrease the demand for money (we need less money in the economy because there is less stuff to buy). The lower money demand will drive down interest rates (this is represented as point (c) on the above graph). The lower interest rates will spur on investment. If interest rates didn’t fall because of the fall in the demand for money, the fall in GDP would be a lot more severe (we would move to point (d) - the point where interest rates are fixed!). But, as interest rates fall as output falls (due to lower money demand), investment will pick up and offset some of the fall in output. This causes us to move to point (c). If prices were fixed, that would be the end of the story in the short run. We would end up at point (c) in the economy (same point (c) from AD-AS graph). But, in our model, we are allowing firms to adjust prices. The lower prices due to lower demand for goods will increase real money balances and shift out the LM curve slightly. This will lower interest rates a little bit further and spur on some ADDITIONAL investment so output will not fall quite as far as it would if prices were fixed. We know from the AS-AD graph that output will definitely fall, just not as much because prices increase real money supply.
The two shifts together – the fall in the IS and the increase in the LM will create a new equilibrium at point (b) with output equal to Y1. Remember, there are no new shifts! As interest rates fall, investment will increase. This, however, will not shift any of the curves. The change in investment as interest rates change is represented by the slope of the curves!
So, interest rates will fall (and investment will rise) for TWO REASONS! The first reason is as G falls - Y will fall and the demand for money will fall (this is balanced with the fact that lower G implies less government borrowing and/or more government savings - lowering the price of savings - this is the IS-LM analysis). But, there is an additional effect on interest rates. As P falls, M/P rises. Real money increases, which further reduces interest rates. Both of these cause I to increase. If I did not respond, the economy would move from (a) to (d). If prices were fixed (no effect on real money supply), the economy would move from (a) to (c). With prices allowed to adjust, you get an extra kick to investment. In this case, output only falls from (a) to (b). This is subtle!!!! Try hard to understand what role changing prices and changing output has on investment.
Let us, one last time, think about labor market in the short run. There will be no shifts in the labor supply or labor demand curves. Remember - we are not in equilibrium (we may not be on either the labor supply or the labor demand curves). As a rule (see the notes from Thursday), all we know about N in the short run is that if Y < Y*, N will be less than N*.
Here is one graphical representation of labor market in short run.
NS
(a)
W/P
Nd
(b)
N1 N*0 N
Summarizing the Short Run Effects of a fall in government spending.
Y falls, P falls, r falls, G falls, I increases (but by a smaller amount then G falls – we know in the end that output falls), NX and C stay the same, real wages rise in the short term (nominal wages are fixed and prices fall), national savings increases (I increases and NX stays the same). Cyclical unemployment rises; we are in a recession!
What happens in the long run?
NS
(b)
(a) = (z)
W/P
Nd
N1 N*0 = N*1 N
There is no effect of changing G on labor supply or labor demand! A and K do not change so labor demand does not change. PVLR, taxes, population or VL do not change so labor supply does not change. So, N*0 = N*1. The new equilibrium in the economy is (z) which is the same as (a) - which was the old equilibrium.
In the short run, N < N*. How do we get back to N* (and Y*)? Here is where some fun begins. We stated in class (and above) when N > N*, workers will put pressure on firms to increase wages. Nominal wages will increase. Here we have N < N*. In this case, firms will want to CUT nominal wages. As we talked about early in the class, firms may not like to cut nominal wages.
The process of wages adjusting to restore the economy to its long run level is often called the self- correcting mechanism. This refers to the fact that when the labor market is in disequilibrium, it will eventually correct itself causing nominal wages to rise or fall. When N > N*, we tend to believe that the economy will correct itself quickly. If you ask workers to work harder than their wage says they should, workers will generally respond quickly. The reverse is not true. Firms will be hesitant to cut nominal wages (money illusion). As a result, we may tend to stay in recessions longer than we would stay above Y* (From now on, I will define a recession as being when Y is below Y* - this is slightly different than the technical definition. Remind me in class this week and I will explain it more). Now you may say ‘Erik, we saw from lecture 1 that recessions only average 1 year and expansions average 6-8 years. Isn’t that inconsistent with the fact that you just said that recessions should last longer because the self-correcting mechanism will work slower because firms do not want to cut nominal wages?’ My answer to that would be NO. Why? Because policy makers will often come in and help us get out of a recession. This will tend to make recessions short lived (we don’t rely on the self-correcting mechanism to bring us back to Y*. We will do an example of this soon.).
So, how do firms cut nominal wages? Well, some firms will suck it up and just cut them. Others will wait for some workers to quit (or in the extreme example, die) and bring in new workers at lower wages.
Eventually, nominal wages will fall. Nominal wages are fixed in the short run (that got us to point (b)). In the long run, they can adjust. The fall in nominal wages makes production cheaper which will shift out the SRAS curve. If production is cheaper, firms want to produce more at every given price!
P
AS1(W1)
P0 (c)
(a)
P1
(b)
P2 (z)
AD1(G1)
Ysr
Equilibrium is restored at Y* at point (z) which has lower prices than where we started (point (a)). So, in the long run, a fall in G will have no affect on output, but will result in lower prices. Prices will fall further between (b) - the short run equilibrium and (z) the long run equilibrium.
What happens to interest rates?
LM0 (P0)
r
LM1 (P1)
LM2 (P2)
(a)
(c)
(b)
(z)
P falls
IS1 (G1)
Y1
As prices fall further, the real money supply will increase, causing interest rates to fall further. The LM curve will shift from LM1 to LM2 as prices fall from P1 to P2.
In this case, investment will increase even further between the short run and the long run, restoring Y to its original level. Now, the change in investment will EXACTLY offset the change in government spending. How do we know? Y is back to its initial level – no change in Y!!! If G goes down by $100 and there is no change in consumption and NX, then I must rise by $100! (in the long run).
It is just that simple!
Let us summarize our short run and long run results of a decrease in G with time paths (this is how variables (like GDP) evolve over time):
Today (time 0)Short Run Long Run
Y
P
r
G
I
W
W/P
M/P
How to read the time paths? Basically, they tell us how the variables move over time. For example, output falls between now and the short run and then increases between the short run and the long run. However, between now and the long run, output does not change (real wages also return to their initial level). Nominal wages are fixed in the short run. Government spending decreases in the short run and remains at the new low level between the short run and the long run. Investment increases in the short run and increases further in the long run. Real money increases (Why? M is fixed and P falls). Nominal wages fall between short run and long run (as self-correcting mechanism kicks in). No change in consumption (Why? PVLR did not change).
That is how the economy responds to a fall in government spending. NOTHING new here. We learned the basic elements of this 4 weeks ago. What happens when G decreases and T is fixed? Deficits fall, r falls, I increases, no effect on labor market. This is exactly what we have in the long run above! The first part of the course is to set up our intuition for what we are doing now.
Let me do one more example before we move on to taxes. I will not draw the IS-LM curve now, but you should! I just want to highlight a few fact. Note, when you draw the IS-LM analysis remember: if prices change - real money changes and the LM curve will shift. I am only going to focus on the AS-AD graphically. We will do everything else in words.
Basically, let us see how the government could get us out of a recession using fiscal policy. Fiscal policy is the use of government spending and taxes to influence Y and P.
Suppose Consumer Confidence falls. Suppose further that prices are fixed in the short run (SRAS curve is horizontal). Remember, by definition, nominal wages are ALWAYS fixed in the short run. For simplicity, we will assume that households are just skittish about consumption today (no fundamentals have changed in the economy – A and A(future) are both assumed to be fixed by firms – (ie, no effect on investment demand or labor demand)). Furthermore, we will assume that household labor supply does not change in response to the fall in consumer confidence. We could relax any of these assumptions if we so desired, but it would make the analysis more complex.
The above situation is not too far from what we observed in 1990. Consumer confidence fell (as measured by official government statistics and ask me in class about consumer confidence measures – I want to say a few words on it). Why did consumer confidence fall? There are a few reasons. The first is that consumers did not believe that the expansion in the 1980s could go on forever. They were just coming out of the 70s, when economic conditions were really bad (we will discuss this next week). Between 1982 and 1990, the economy did not experience a recession. People were ready. Additionally, there were signs that oil prices were on the rise. Getting involved in the Gulf War caused many Americans to fear the worst – not politically, but economically. Most of these same Americans realized that it was oil prices that were to blame for the 1970s (partially true – more on this soon). Fearing that oil prices would shoot up again (and the 70s would be revisited) consumer confidence fell. Households stopped spending! C fell.
Another explanation of the Gulf War recession is that the banking system experienced a ‘credit crunch’. A credit crunch is a period when banks stop lending (loans fell dramatically in some parts of the country!) Property markets fell in the North East and the Mid Atlantic region during the late 1980s and early 1990s. Additionally, the savings and loan crisis made some banks more cautious. Although not technically true, we can think of this credit crunch in terms of our model as causing banks to hold higher excess reserves. Bank lending fell (and hence the money supply). As a result, Investment slowed.
Regardless of the explanation (consumer confidence and a fall in C or a credit crunch and a fall in I), the AD curve shifted in. Graphically, we represent this below:
(b) (a)
P0SRAS0
AD1 AD0
Y1 Y*0
As C and/or I fell, AD shifted in and the equilibrium in the economy fell from (a) to (b). Y fell below Y* (a recession) and prices remained fixed. In the data for 1990, we actually see I and C falling, prices remaining fairly constant and output falling. If Y < Y*, N < N* and unemployment is higher (cyclical unemployment is positive). Some people want to work at the given market wages and cannot find a job. In the money market, the IS curve would have shifted in (r would have fallen). There may have been an effect on LM (bank loans dried up and M fell – not from Fed action, but from bank optimizing behavior – we now have an example where M can fall without the Fed taking action – this is a newer literature in macro – Professor Kayshap is on the forefront of this topic. Notice, however, that the LM would not change because of prices, as prices did not change. The predicted effect on r is ambiguous. As stated earlier, we did see I falling in the data.
This analysis looks very similar to that where G fell (see above). Why am I going through it? Two reasons – 1) to describe the 1990s recession and 2) to illustrate the potential benefits of fiscal policy. As noted above, the self-correcting mechanism could take a long time to move the economy back to Y* when we are in a recession. We need firms to cut nominal wages and they are reluctant to do so. In this case, there may be a role for the government to come in and speed the process along. What could Congress and the President do to speed the process along? (We will talk about the Fed next time. That is what actually happened in the 1990s, but I want first to talk about what the President and Congress COULD have done).
Suppose that when in a recession, Congress and the President increase G. We know that at any given time, Y = C + I + G + NX. If C and I fell, the President could increase G so as to offset the decline in C and I. For example, the government could increase expenditures on highways (more construction workers) or increase the amount of defense contracts they offer or increase spending on education (fund more teachers). All of those types of spending will increase demand in the economy! Let us look at this graphically: