Begränsad delning

Unit 14
UNEMPLOYMENT AND FISCAL POLICY
 Begränsad delning

OUTLINE
A. Introduction
B. The Aggregate Demand function and the
multiplier model
C. Household wealth
D. Investment
E. The role of government
F. Linking Aggregate Demand and unemployment
 Begränsad delning

A. Introduction
 Begränsad delning

The Context for This Unit

Aggregate demand (GDP) can fluctuate due to consumption and
investment decisions (Unit 13).

Sometimes the aggregate decisions of households and firms

can destabilize the economy.

• How can the government stabilize the economy?

• Why might government policies be ineffective?
• How can we model the link between output and
unemployment?
 Begränsad delning

B. The Aggregate Demand

function and the multiplier
model
 Begränsad delning

Consumption function C = c0+c1Y

Aggregate consumption (C) has 2
parts:

1. Autonomous consumption = the

fixed amount one will spend,
independent of income (c0)

2. Consumption dependent on
income (parameter c1)

Slope of consumption function

= marginal propensity to consume (c1)
 Begränsad delning

Consumption function
Marginal propensity to consume varies across people:

• poor households with credit constraints react a lot to

variation in current income, so their MPC is large

• for wealthy households, current income matters little for

current consumption, so their MPC is small

Expectations about future income are reflected in

autonomous consumption.
 Begränsad delning

Goods market equilibrium

1. Aggregate demand (AD) = consumption
function + investment (AD=C+I)

(no government and no foreign trade)

Investment (I) is assumed to be

independent of output (Y)

the slope of AD line is below 45°

because MPC<1

1. 45° line is where Y = AD

(remember that GDP is a measure of
income and production) Goods market equilibrium: Y = AD
 Begränsad delning

The multiplier process

Initial equilibrium in point A:

Fall in investment → fall in aggregate

demand → AD curve shifts down →
lower output and income → further fall
in demand and income → new
equilibrium (Z)

Note that the fall in output (3.75) is

larger than the initial fall in
demand (1.5)!
 Begränsad delning

The multiplier effect

The total change in output is greater than the initial change in aggregate
demand.

This is because of the circular flow of expenditure, income, and output!

The multiplier represents the relative magnitude of this change.

The marginal propensity to consume (c1) will affect the size of the
multiplier.
 Begränsad delning

The goods market equilibrium

Aggregate demand: AD = c0+c1Y + I (no government and no foreign trade)

Equilibrium when output is equal to aggregate demand: Y = AD

è Y = c0+c1Y + I

Solve for Y (output in equilibrium):

Y - c1Y = c0+ I

Y(1- c1) = c0+ I

!
Y= (c0+ I)
!"#!
 Begränsad delning

The goods market equilibrium

Equilibrium output in the goods market:

!
Y= (c0+ I)
!"#!

!
The multiplier:
!"#!

An initial change in autonomous consumption (c0) or Investments (I) will

have a greater final impact on output (Y) through the multiplier.
 Begränsad delning

Changes in consumption function

Credit constraints and consumption smoothing is reflected in the slope of
the AD curve and the size of the multiplier.

Consumption decisions can also shift the AD curve.

For example, a fall in house prices will be bad news for a household with a
mortgage. They may choose to save more (precautionary saving) and
hence their autonomous consumption would fall.
 Begränsad delning

The Great Depression 1929

A: goods market equilibrium (1929)

B : fall in investment = downward shift of AD

C: fall in autonomous consumption = further

downward shift of AD

Uncertainty due to stock market crash,

pessimism, banking crisis and collapse of
credit
 Begränsad delning

C. Household wealth
 Begränsad delning

Household wealth
Household wealth impacts autonomous consumption (c0).

Broad wealth = broad assets – debt

 Begränsad delning

Precautionary saving
Target wealth = the level of wealth that a
household aims to hold, based on its
economic goals (or preferences) and
expectations.

Precautionary saving = An increase in saving

to restore wealth to its target level.

A fall in expected earnings will lead to cut in consumption

(precautionary savings) to restore target wealth.
 Begränsad delning

Consumption and the housing market

Changes in house prices affect consumption through two
channels:

1. Via change in household wealth (home equity)

2. Via change in credit constraints: lower house value

makes it more difficult to borrow (greater credit
constraint)
 Begränsad delning

D. Investment
 Begränsad delning

Investment spending
Firms’ decision about what to do with its profits depends on

• Owner’s discount rate (ρ)

• Interest rate on assets (r)
• Net profit rate on investment (Π)

1. Consume the extra income (dividends) if ρ > r ≥ Π

2. Save the extra income/repay debts if r > ρ ≥ Π
3. Invest (at home or abroad) if Π > ρ ≥ r

A lower interest rate makes investment more likely.

 Begränsad delning

Investment spending: supply side effects

Higher expected rate of profit increases investment, holding r

constant.

Improvement in business environment (such as fall in the risk of

expropriation by the government) also increases investment.

Change in interest rate is a demand-side factor.

 Begränsad delning

Aggregate investment function

Aggregate investment function = An

equation that shows how investment
spending in the economy as a whole
depends on other variables (interest rate
and profit expectations).

In practice, investment is not very sensitive to interest rate.

Instead, the shift factors are much more important.
 Begränsad delning

E. The role of government

 Begränsad delning

Adding government to aggregate demand

AD = C + I + G + X – M

Government enters AD via

• Government spending: exogenous; shifts AD curve upwards

• Consumption: household’s MPC is out of disposable income

• Investment: depends on the interest rate and after-tax rate of profit

 Begränsad delning

Taxes and disposable income

Consumption function C=c0+c1YD

Where YD is disposable income YD = Y – T

A simple model: lump sum tax (T), independent of income level.

C=c0+c1(Y – T)

A more realistic model: a proportional income tax (t = a percentage of income) which

means that T=tY and we write
C=c0+c1(Y – tY) or C=c0+c1Y(1 – t)
 Begränsad delning

Net exports and aggregate demand

AD = C + I + G + X - M

NX = exports - imports
The amount of exports is taken as exogenous (depends on foreign
income).

The amount of imports depends on domestic income (Y).

Marginal propensity to import (m) = The fraction of each additional

unit of income that is spent on imports (NX = X – mY)
 Begränsad delning

Savings in the equilibrium

The equilibrium condition in the closed economy:
Y=C+I+G
We can rewrite this:
Y–C–G=I

Savings in the private sector = Y–T–C (savings = income - tax – consumption)

Savings in the public sector = T–G (gov savings = tax revenues – spending)

Total savings: Y – T – C +(T – G) = Y – C – G

This is equal to the left-hand side of the rewritten equilibrium condition (above).

Thus, total savings in the closed economy must be equal to investments (I)
 Begränsad delning

Savings in the equilibrium

Equilibrium condition in the open economy: Y=C+I+ G+X–M X – M = Net exports (NX)

We can rewrite this as: Y – C – G = I + NX

Savings in the private sector = Y–T–C

Savings in the public sector = T–G
Total savings = Y – T – C +(T – G) = Y – C – G

This is equal to the left-hand side of the rewritten equilibrium condition (above). Thus, total savings in the
closed economy must be equal to investments (I) + net exports (NX) or total savings minus investments
must be equal to net exports:

Y - C – G - I = NX
 Begränsad delning

Savings in the equilibrium

What is the interpretation? Y – C – G – I = NX

If savings (Y – C – G) are larger than investments è positive net export

§ increase our holdings of foreign assets
§ we are producing more in the economy than we are using (C+G+I)

If savings are smaller than investments è negative net export

§ we are using more (C+I+G) than we are producing, need to import
§ we borrow from abroad, increases our indebtedness to foreign countries
 Begränsad delning

China and the US – trade balance

 Begränsad delning

US Treasurys owned by China

 Begränsad delning

A simple example …..

Imagine a very simple economy with only one person, Robinson Crusoe.

The only production is sweet potatoes.

Robinson grows 100 potatoes during a period. The total production (Y) is then 100 potatoes.

Assume that Robinson consumes 80 potatoes and saves 20. The potatoes saved are used to plant
potatoes (to get a harvest next period), this is the investment in the economy.

Y = consumption + investments = C + I = 80 + 20 = 100

Savings must equal investments in an economy without trade with the outside world.

32
 Begränsad delning

If Robinson can trade with the outside world …..

Suppose Robinson's output is 100 potatoes, but he plant (invest) 20 and consumes 90. How does it
add up?

Robinson finds another island where they also produce sweet potatoes …..If Robinson imports 10
potatoes, the equation adds up. But note that Robinson uses more potatoes than he produces.

At the same time that Robinson imports 10 potatoes, he puts himself in debt to the other island (rest
of the world) with the equivalent of 10 potatoes....

Note that this is only possible if the other island (country) produces more than it uses …..

A negative trade balance (X-M) in one country must be matched by a positive trade balance (X-M) in
other countries and the sum of trade balances in the world must sum to zero!

33
 Begränsad delning

The multiplier model again

𝐴𝐷 = 𝑐$ + 𝑐! 𝑌 − 𝑡𝑌 + 𝐼 𝑟 + 𝐺 + 𝑋 − 𝑚

Saving, taxation and imports are referred to as leakages from the circular flow of
income. They reduce the size of the multiplier.

• some household income goes directly to the government as taxes

• and some income is used to buy goods abroad

Smaller multiplier = flatter AD curve.

 Begränsad delning

𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + 𝑋 − 𝑀

𝐴𝐷 = 𝑐! + 𝑐" 𝑌 − 𝑡𝑌 + 𝐼 𝑟 + 𝐺 + 𝑋 − 𝑚𝑌

𝐸𝑞𝑢𝑖𝑙𝑖𝑏𝑟𝑖𝑢𝑚: 𝑌 = 𝐴𝐷

𝑌 = 𝑐! + 𝑐" 𝑌 − 𝑡𝑌 + 𝐼 𝑟 + 𝐺 + 𝑋 − 𝑚𝑌

𝑌 = 𝑐! + 𝑐" 𝑌 − 𝑐" 𝑡𝑌 + 𝐼 𝑟 + 𝐺 + 𝑋 − 𝑚𝑌

𝑌 − 𝑐" 𝑌 + 𝑐" 𝑡𝑌 + 𝑚𝑌 = 𝑐! + 𝐼 𝑟 + 𝐺 + 𝑋

𝑌 1 − 𝑐" + 𝑐" 𝑡 + 𝑚 = 𝑐! + 𝐼 𝑟 + 𝐺 + 𝑋

𝑌 1 − 𝑐" (1 − 𝑡) + 𝑚 = 𝑐! + 𝐼 𝑟 + 𝐺 + 𝑋

"
𝑌= (𝑐! +𝐼 𝑟 + 𝐺 + 𝑋)
"#$! ("#&)()
 Begränsad delning

!
Equilibrium condition: 𝑌= (𝑐A +𝐼 𝑟 + 𝐺 + 𝑋)
!"=! (!">)?@

Multiplier Demand that does not depend on income

 Begränsad delning

Multiplier without government 1

=
and foreign trade: 1 − 𝑐!

Multiplier with government 1

=
but no foreign trade: 1 − 𝑐! (1 − 𝑡)

1
Multiplier with government =
1 − 𝑐! (1 − 𝑡) + 𝑚
and foreign trade:
 Begränsad delning

Multiplier without Multiplier with government Multiplier with government

government but no foreign trade: and foreign trade:
and foreign trade:

1 1 1
> >
1 − 𝑐! 1 − 𝑐! (1 − 𝑡) 1 − 𝑐! (1 − 𝑡) + 𝑚

This is not so difficult. In a closed economy without government (or government with lump-sum tax) an increase in
aggregate demand is directed only to domestic production.

With a government and proportional income tax – there is a leakage – some of the income increases will be paid in
taxes

In the open economy – there is an additional leakage since some of the increase in aggregate demand will be
directed towards imported goods.
 Begränsad delning

Stabilising the economy

The government stabilises economic fluctuations in several ways:

1. Government spending is large and exogenous

2. Higher tax rate lowers the multiplier

3. Unemployment insurance helps households smooth consumption

(failure of private market because of correlated risk, hidden actions, hidden
attributes)

4. Deliberate intervention via fiscal policy

The unemployment benefit scheme and proportional tax rate are automatic stabilizers
= they automatically offset an expansion or contraction of the economy.
 Begränsad delning

The paradox of thrift

In a recession, faced with a household budget deficit, a family worried
about their falling wealth cuts spending and saves more.

But in the economy as a whole, spending and earning go together.

The paradox of thrift = the aggregate attempt to increase savings leads to

a fall in aggregate income.

Fallacy of composition: what is true for one part of the economy (a single
household) is not true of the whole economy.
 Begränsad delning

Fiscal stimulus
Government can counteract the fall in AD
from the private sector via fiscal stimulus.

• cut taxes to encourage the private sector

to spend more

• increase spending (G), which directly

increases AD

(Do the exercise found in CANVAS!)

The rise in G operates via the multiplier, so the increase in Y will typically
be greater than the increase in G.
 Begränsad delning

Financing fiscal stimulus

Budget balance = T - G

Fiscal stimulus will result in a negative budget balance (government

budget deficit).

If it is not reversed after the recession, it will increase government debt.

A government budget surplus is when tax revenue is greater than

government spending.

(Do the exercise in CANVAS - the balanced budget multiplier!)

 Begränsad delning

Austerity policy
Austerity policy can reinforce a recession by further reducing
aggregate demand.

Positive/Negative Feedback Mechanisms
DAMPENING MECHANISMS
OFFSET SHOCKS (STABILISING)
PRIVATE SECTOR
DECISIONS
Consumption smoothing
Automatic stabilisers (e.g.
GOVERNMENT AND unemployment benefit)
CENTRAL BANK
DECISIONS Stabilisation policy
(fiscal or monetary)
Begränsad delning
AMPLIFYING MECHANISMS REINFORCE
SHOCKS (MAY BE DESTABILISING)
Credit constraints limit
consumption smoothing
Rising value of collateral
(house prices) can increase
wealth above the target level
and raise consumption
Rising capacity utilisation in a
boom encourages investment
spending, adding to the boom
Policy mistakes, such as
limiting the scope of
automatic stabilisers in a
recession or running deficits
during low demand periods,
while not running surpluses
during booms
 Begränsad delning

The multiplier in practice

In our model of aggregate demand, the multiplier depended only on the
marginal propensity to consume, the marginal propensity to import, and
the tax rate.

In reality, it also depends on:

• rate of capacity utilisation (the phase of the business cycle): with fully
employed resources, an increase in government spending would crowd
out private spending

• expectations of the private sector: the multiplier could be negative if

rising fiscal deficit erodes consumer confidence
 Begränsad delning

The government’s finances

Primary budget deficit = G –T

• pro-cyclical
• the government must borrow to cover the gap between spending and
revenue, by issuing bonds

Government debt = sum of all the bonds sold over time to finance
budget deficit – matured bonds (repaid debt).

Sovereign debt crisis = a situation in which government bonds come to

be considered risky (default risk).
 Begränsad delning

Government debt
A large stock of debt relative to GDP can be a problem because the
government has to pay interest on its debt.

However, there is no point at which the government has to pay off all its
stock of debt—it can roll it over instead by issuing new bonds (but
financial markets may demand a risk premium on bonds è higher
interest on the debt).

An ever-increasing debt ratio is unsustainable, but there is no rule that

says exactly how much debt is problematic.
 Begränsad delning

Debt-to-GDP ratio
The level of indebtedness of a government is measured relative to the size
of the economy (debt-to-GDP ratio).
Indebtedness can fall

• if the primary budget balance is

positive

• if GDP is growing faster than

government debt

• if inflation is high (real value of

debt falls)
Begränsad delning
 Begränsad delning

Foreign markets and aggregate demand

1. Fluctuations in the growth rate of
important markets abroad
influence the domestic economy
via demand for exports.

2. Demand for imports dampens

domestic fluctuations.

3. Foreign trade limits the use of

fiscal stimulus if the marginal
propensity to import is large!
 Begränsad delning

F. Linking Aggregate
Demand and
unemployment
 Begränsad delning

Aggregate Demand and Unemployment

Supply-side = labour market model

Medium-run model: wages and prices can

change, but capital stock, technology and
institutions are fixed

Demand-side = multiplier model

Short-run model: all variables fixed

Production function connects employment

(N) and output (Y)
 Begränsad delning

Cyclical unemployment

Fluctuations in aggregate
demand around the labour
market equilibrium cause
cyclical unemployment.
 Summary
Begränsad delning

1. The aggregate demand function and its components:

AD = C + I + G + NX

2. Shocks to aggregate demand are amplified by the multiplier

3. Government can stabilise economic fluctuations

• Automatic stabilisers
• Fiscal stimulus – offset decline in aggregate demand from the
private sector
• Austerity policies amplify the negative demand shock

4. Fiscal stimulus in a recession must be reversed in a boom to prevent

government debt from escalating (sovereign debt crisis)
 Begränsad delning

In the next unit

• The relationship between unemployment and
inflation: The Phillips curve

• How governments use monetary policy to affect

inflation

• Developing our model of aggregate demand: What

happens to wages and prices in booms/recessions