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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)