ECOS3997 Interdisciplinary Impact in Economics
Interdisciplinary Impact in Economics
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ECOS3997
Interdisciplinary Impact in Economics
Stream 1: Implications of Macroeconomic Policies
Lecture 2: Basic Model and the short-run Effects
of Macroeconomic policies
1
This lecture
• Equilibrium in goods markets
1- Consumption function and multiplier
2- Investment/savings (IS) approach
3- Application: Government spending multipliers
• Equilibrium in the financial market
1- Money demand and monetary policy
2- Liquidity/money (LM) approach
• IS-LM model and its implications in the short-run
• Reading:
• Blanchard chapter 3, 4, 5
• Articles (next page)
2
This lecture, cont
• Articles:
• Christiano, L., Eichenbaum, M., & Rebelo, S. (2011). When is the
government spending multiplier large?. Journal of Political
Economy, 119(1), 78-121.
• Corsetti, G., Meier, A., & Mu¨ller, G. J. (2012). What determines
government spending multipliers?. Economic Policy, 27(72),
521-565.
3
Short-run Effects
Economy in the short-run
• Year-to-year movements in output are primarily driven
by movements in aggregate demand
• Unemployment is negatively related to output
• Changes in demand can lead to a decrease in output (a
recession) or an increase in output (an expansion)
• Many prices are sticky (not fully flexible) at a
predetermined level
4
The Goods market
5
Goods market: GDP components
• Consumption: purchases of goods and services, C
• Investment: purchases of capital goods, I
– non-residential investment (plant and equipment)
– residential investment (new houses, etc)
– Inventory investment = production − sales
• Government Spending: purchases of goods and services, G
– does not include transfer payments
– does not include interest payments on the government debt
• Net exports (or trade balance): exports minus imports,
X − IM
6
Composition of U.S. GDP, 2018
Source: Survey of Current Business, February 2019, Table 1-1-5
7
Basic model: Demand for goods (and services)
• Total demand for goods Z written
Z ≡ C + I +G+X − IM
• For simplicity, we often assume a closed economy
X = IM = 0 so
Z ≡ C + I +G
• C as a linear function with key behavioral assumption in
short-run (where YD = Y − T ):
C is a function of aggregate disposable income YD → C (YD)
• Take I as exogenous (I¯) or alternatively, endogenous
• Take G, T as exogenous where G and T describe fiscal policy
8
Consumption function
• For simple algebra, linear consumption function
C = C (YD) = c0 + c1YD, c0, c1 > 0 and c1 < 1
c1 is the marginal propensity to consume (MPC)
9
Investment function
• Case 1: Investment demand as an exogenous variable
(taken as given), I¯
or alternatively,
investment demand as an endogenous variable
• Case 2: Let investment depend on the aggregate level of
sales Y and interest rate i
I = I (Y, i) = b0+ b1Y − b2i, b0, b1, b2 > 0 and b1 < 1
I depends positively on Y and negatively on i
10
Equilibrium in the goods market
• In the short run, demand for goods Z determines
production/output Y
Z = Y
• Demand for goods is a function of aggregate income Y
Z ≡ c0 + c1(Y − T ) + I¯ or I(Y, i) +G
• Case 1: need to solve
Y = c0 + c1(Y − T ) + I¯ +G
(one equation in one unknown, Y )
11
Case 1: Equilibrium output, given I¯
• Solution
Y =
1
1− c1
(
c0 − c1T + I¯ +G
)
• Product of two terms
⋄ multiplier
1
1− c1
⋄ autonomous spending
c0 − c1T + I¯ +G
• Multiplier is the marginal effect of a change in autonomous
spending on output
12
Case 2: Equilibrium output, given I (Y, i)
• Case 2: Plugging in for consumption and investment
Z ≡ c0 + c1(Y − T ) + b0 + b1Y − b2i+G
• Solution
Y =
1
1− c1 − b1 (c0 − c1T + b0 − b2i+G)
(assume c1 + b1 < 1), Y depends negatively on i
• Two equivalent ways to state equilibrium in goods market:
output = demand
investment = savings (private + public)
13
IS curve
Investment/Savings (IS) curve
• combinations of {Y, i} consistent with goods market
equilibrium
• changes in fiscal policy G,T shift curve in or out
• one of two building blocks of IS-LM model
14
Equilibrium in the goods market
15
Effect of a change in autonomous spending
16
The multiplier
• Consider increase in G by one unit.
Differentiating gives
dY
dG
=
1
1− c1 > 1
• Intuition
– 1st round increase in demand (Direct effect)
* triggers equal increase in output
* triggers equal increase in income
– 2nd round increase in demand (Indirect effect)
* 1st round increase times c1 in output
– After n rounds:
1 + c1 + c
2
1 + · · ·+ cn−11
17
The multiplier
• Multiplier is the limit of this sum
lim
n→∞
(
1 + c1 + c
2
1 + · · ·+ cn−11
)
=
1
1− c1
• Examples:
– if c1 = 0.5, then multiplier is 1/0.5 = 2.00
– if c1 = 0.8, then multiplier is 1/0.2 = 5.00
– a reasonable estimate of c1 in Australia today: 0.5
• Increase in output is greater than increase in government
spending by factor equal to the multiplier
– multiplier is a key parameter in short-run macroeconomics
– the more sensitive consumption is to income, the larger the
multiplier
18
Application:
Government spending multipliers
• Corsetti, G., Meier, A., & Mu¨ller, G. J. (2012). What determines
government spending multipliers?. Economic Policy, 27(72), 521-565.
• Christiano, L., Eichenbaum, M., & Rebelo, S. (2011). When is the
government spending multiplier large?. Journal of Political Economy,
119(1), 78-121.
19
Application:
Government spending multipliers
• To stimulate the economy, an expansionary fiscal policy
may be effective in terms of boosting the economic activities
• Long-standing debate on the size of the fiscal multiplier (or
government spending multipliers)
20
Corsetti, Meier, and Muller (2012)
What determines government spending multipliers?
• This paper carries out
• an empirical exploration into
the determinants of government spending multipliers
by studying how the fiscal transmission mechanism
depends on the economic environment
21
Corsetti, Meier, and Muller (2012)
What determines government spending multipliers?
• The authors argue that the multipliers vary based on
• Economic environment:
1- Exchange rate regimes: flexible v.s. peg
2- State of public finances: strong v.s. weak public finances
(i.e., high government debt to GDP ratio)
3- Health of the financial sector: normal times v.s. financial crisis
22
Corsetti, Meier, and Muller (2012)
What determines government spending multipliers?
• Conduct an empirical analysis of 17 OECD countries
• Australia, Austria, Belgium, Canada, Denmark, Finland, France,
Ireland, Italy, Japan, the Netherlands, Norway, Portugal, Spain,
Sweden, the United Kingdom, and the United States
• Sample period from 1975 to 2008
• Trace the effects of government spending in different
economic environments
23
Corsetti, Meier, and Muller (2012)
What determines government spending multipliers?
• Estimate a fixed-effects panel regression:
xt,i = αi + µitrendt + χixt−1,i + σ1ϵˆt,i + σ2ϵˆt−1,i + σ3ϵˆt−2,i
+σ4ϵˆt−3,i + κ1(ϵˆt,i × dt,i) + κ2(ϵˆt−1,i × dt−1,i)
+κ3(ϵˆt−2,i × dt−2,i) + κ4(ϵˆt−3,i × dt−3,i)
+λ1dt,i + λ2dt−1,i + λ3dt−2,i + λ4dt−3,i + ut,i
(1)
where
xi,t: macroeconomic variables of interest (e.g., output),
σ, κ: capture dynamic effect upto 3 years,
dt,i: dummy variable indicating a certain economic environment in a
particular year (e.g., currency peg or financial crisis)
24
Corsetti, Meier, and Muller (2012)
25
Corsetti, Meier, and Muller (2012)
26
Corsetti, Meier, and Muller (2012)
• In general, a positive government spending shock increases
output across 17 OECD countries (i.e., 0.7 on average)
• Government spending multipliers vary depending on
economic environment
1- Under the fixed (or peg) exchange regime, output multiplier is
positive and larger than the flexible exchange rate
• Mundell-Fleming model (more in Week 7)
• fiscal expansion → ↑ ex. rate → to keep from rising, CB ↑ Ms
27
Fixed v.s. Flexible exchange rate
28
Corsetti, Meier, and Muller (2012)
• In general, a positive government spending shock increases
output across 17 OECD countries
• Government spending multipliers vary depending on
economic environment
2- In the case of weak public finances (i.e., Govt debt > 100% of
GDP), the impact response of output is lower
• fiscal expansions at high levels of debt may increase the
likelihood of a sharp future retrenchment
29
Weak v.s. Sound Public Finances
30
Corsetti, Meier, and Muller (2012)
• In general, a positive government spending shock increases
output across 17 OECD countries
• Government spending multipliers vary depending on
economic environment
3- During the period of financial crisis, the response of output to
a fiscal expansion is positive and larger than normal times
• In deep recessions, when monetary policy is limited by the
zero lower bound on interest rates, fiscal policy becomes
more impactful
31
Financial Crisis v.s. Normal times
32
Christiano, Eichenbaum, and Rebelo (2011)
When Is the Government Spending Multiplier Large?
• Barro (1981): 0.8, Ramey (2011): 1.2
• Investigate the size of the multiplier in a dynamic stochastic
general equilibrium (DSGE) model
• This paper argues that the government spending multipliers
can be much larger than one when the zero lower bound on
the nominal interest rate binds
33
Christiano, Eichenbaum, and Rebelo (2011)
34
The Financial market
35
Financial market: Money demand
• Money M (e.g. currency, checkable deposits) pays no interest.
• Bonds B pay interest i. Cannot be used for transactions
• Two assumptions
1- demand increasing in level of transactions; transactions
proportional to nominal income $Y ≡ PY
2- demand decreasing in opportunity cost i of holding money
• Money demand Md ($Y, i)
Md = PY︸︷︷︸
≡$Y(+)
×L(i)︸︷︷︸
(−)
where L(i) function is decreasing in the interest rate i
dL
di
< 0
36
Equilibrium in the financial market
• Money supply M s =M given by Reserve Bank
• Equilibrium in money markets Md =M s so
M︸︷︷︸
Money supply
= PY × L(i)︸ ︷︷ ︸
Money demand
Determines interest rate i for given M & nominal income PY
or equivalently,
• Money supply (in real terms) = Money demand (in real terms)