Economic
Environment
Lecture 3
Joint Honours 2003/4
Professor Stephen Hall
The Business School
Imperial College London
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Revision
• The basic demand side model
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The consumption function
The consumption function shows desired aggregate
consumption at each level of aggregate income
With zero income,
C = 8 + 0.7 Y desired consumption
is 8 (“autonomous
consumption”).
8
{
0
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The marginal propensity
to consume (the slope of
the function) is 0.7 – i.e.
for each additional £1 of
income, 70p is consumed.
Income
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The aggregate demand schedule
AD = C + I
I
C
Aggregate demand is
what households plan
to spend on consumption
and what firms plan to
spend on investment.
The AD function is
the vertical addition
of C and I.
(For now I is assumed
autonomous.)
Income
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Equilibrium output
45o
E
o line shows the
The
45
line
points at which desired
spending equals output
AD or income.
Given the AD schedule,
equilibrium is thus at E.
Output, Income
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This the point at which
planned spending equals
actual output and income.
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Deflationary & Inflationary Gaps
Deflationary Gap
Deflationary Gap
Y
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Yf
Inflationary Gap
Inflationary Gap
Yf
Y
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Introduction to Prices, Policy and
Theoretical Issues
• The reason for the names given to the two disequilibrium conditions is that their existence is expected
to lead to price decreases (i.e. deflation) or price
increases (i.e. inflation), respectively.
• As we will see later, in a free market economy, prices
(including the wage rate, which is the price of labour) are
the main equilibrating mechanism, serving to match
supply to demand. Therefore, when considering “disequilibrium” conditions, we need to address prices and
price-adjustment mechanisms explicitly.
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• Keynes believed that prices - in particular, the wage rate - would
not always respond correctly to market conditions. This is the
basis for his call for government intervention.
• By contrast, “classical economists” (or now neo-classical
economists) believe that prices do adjust to equate supply to
demand and put markets in equilibrium. This is why they are
also known as “equilibrium theorists”. (Included in this family
are “monetarists”, whose beliefs and policy recommendations
will be discussed later).
• In general, “equilibrium theorists” believe that government
“meddling” in the economy only worsens the state of affairs.
They believe that the best government policy - even in times of
high unemployment - is to leave things to the market.
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The way forward
• We now need to begin to make the simple
model a little more realistic by thinking
about;
• What determines investment
• A little more on consumption
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Investment
–fixed
spending includes:
capital
Transport
equipment
Machinery
& other equipment
Dwellings
Other
buildings
Intangibles
–working
capital
stocks
work
and
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(inventories)
in progress
is undertaken by private and public sectors
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Trans
Other mc/eq
Dwellings
19
95
19
85
19
75
160
140
120
100
80
60
40
20
0
19
65
£ billion
Analysis of fixed investment in the UK by type of asset 1965-1998
Other build
Intangible
Source: Economic Trends Annual Supplement, Monthly Digest of Statistics
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The demand for fixed investment
• Investment entails present sacrifice for
future gains
– firms incur costs in the short run
– but reap gains in the long run
• Expected returns must outweigh the
opportunity cost if a project is to be
undertaken
• so at relatively high interest rates, less
investment projects are viable.
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The investment demand schedule
… shows how much investment firms wish to
undertake at each interest rate.
At relatively high interest
rates, less investment
projects are viable.
At r0, I0 projects are viable.
r1
r0
I1
I0
II but if the interest rate
rises to r1, desired
investment falls to I1.
Investment demand
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The Accelerator Principle of Investment
• If the economy is growing at a constant rate Then firms
will find a level of investment, I, compatible with that
growth rate.
• However, if aggregate demand begins to increase at a
faster rate because of, say, an increase in household
consumption, then I must also increase.
• After all, firms must invest in extra machinery in order to
produce the additional goods demanded by households.
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• But investment is itself a component of aggregate
demand. Therefore, if investment increases, this will
provide an additional boost to the economy, i.e.
cause Ye to grow further still.
• The accelerator principle of investment, which can be
expressed as
I = aY for some constant a > 0
• suggests that government- or consumer-lead
economics growth will be enhanced, or accelerated,
by increased corporate investment. (Of course, the
opposite is also true in economic downturns).
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The Accelerator Principle of Investment
• The accelerator principle provides one
explanation for economic fluctuations (i.e. the
“business cycle”).
• Of course, investment is also determined by
the price of borrowing, i.e. the interest rate.
• Therefore, it is important to explicitly
introduce interest rates into our model.
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Consumption revisited
• Income is a key determinant of consumption
• but other factors shift the consumption function
– household wealth
– availability of credit
– cost of credit
• These create a link between the financial and
real sectors
– because interest rates can be seen to influence
consumption.
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The permanent income hypothesis
• A modern theory of consumption
developed by Milton Friedman
– argues that people like to smooth planned
consumption even if income fluctuates
• Consumption depends upon permanent
not transitory income.
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The life-cycle hypothesis
A theory of consumption developed by Ando and Modigliani.
Actual
income
Permanent
income
0
Income varies over an
individual's lifetime.
Individuals try to smooth
their consumption, based
on expected lifetime
income.
Savings occur during
middle age
Death and dissaving in youth
Age
and old age.
Thus wealth and interest rates may influence consumption.
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Ricardian equivalence
• Individuals will react to a shock such as a
tax change in different ways, depending on
whether changes are seen to be
temporary or permanent.
• If the government cut taxes today, but
individuals realise this will have to be
balanced by higher taxes in the future,
then present consumption may not adjust.
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Interest rates and aggregate demand
• The position of the AD schedule is now
seen to depend upon interest rates
through the effects on
– consumption
– investment
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Model 3: with Interest Rates
• Let us continue to characterise aggregate demand as
consisting of demand from households (C), firms (I),
and the government (G).
(Therefore, AD = C+I+G as before).
• Now, however, let us make the functional forms of C,
I, and G more complex. In particular, we will make
them dependent upon a new variable, the interest
rate “i”.
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Model 3: with Interest Rates
We make the following new assumptions:
• C is positive, and a positive function of income; But it is
also a negative function of the interest rate. Because as
the interest rate increases, households will try and save
a bit more (and thus consume a bit less).
• I is positive but independent of income, (for simplicity).
But “I” is a negative function of the interest rate.
Essentially, if it costs firms more to borrow, then they will
borrow less and thus invest less.
• G is positive but independent of income and the interest
rate.
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Model 3: Example 3
We have now added another variable, the interest rate
“i”, to our analysis.This makes a visual presentation
of the model more difficult, but a mathematical
presentation is still straightforward.
• We will introduce an entirely new example.Keeping
with our assumptions, suppose:
C = 300 – 30i + 0.80Yd and T = 100 + 0.25Y
(setting Yd = Y - T solves as C = 220 – 30i + 0.60Y)
I = 250 – 20i
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G = 480
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Then by definition:
AD = 950 – 50i + 0.60Y
And, in equilibrium:
Ye = 950 - 50i + 0.60 Ye
This can be reduced to:
(1 - 0.60 ) Ye = 950 - 50i or Ye = [1/0.40] x (950 – 50i)
or Ye = 2.5 x (950 – 50i) or Ye = 2,375 – 125i
Note that we have one equation and two unknowns,
which cannot be solved for a single equilibrium value of
Ye (or ie).
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The IS Curve
Ye = 2,375 – 125i
•
Note that we have one equation and two unknowns,
which cannot be solved for a single equilibrium value
of Ye (or ie).
• The example from Model 3 shows that with the
introduction of the interest rate (and nothing else)
there is no single equilibrium value Ye ; rather, there
are many combinations of Y and I that are compatible
with one another.
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• Definition: The IS-Curve shows all combinations
of interest rate and income that put the
commodities market in equilibrium; i.e., equate
aggregate demand to income.
• Typically, the IS-curve is drawn in Y,i space. In
the preceding example, the IS-curve would look
as follows:
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The IS schedule
45o line
AD1
AD0
r
r0
Y0
Y1
Income
r1
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IS
Y0
Y1
Income
At a relatively high interest
rate r0, consumption and
investment are relatively
low – so AD is also low.
Equilibrium is at Y0.
At a lower interest rate r1
Consumption, investment
and AD are higher.
Equilibrium is at Y1.
The IS schedule shows all
the combinations of real
income and interest rate
at which the goods market
is in equilibrium.
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The IS Curve
i
19
The IS Curve
2375
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Y
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Model 3: Example 4
• The preceding Example 3 solved for a
commodity market equilibrium (i,Y
combinations) for given levels of taxation (T)
and government expenditure (G). This
equilibrium set of i, Y combinations was
embodied in the IS-curve. But what happens
when one of these variables changes?
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Example 4a:
Government Spending Increase
First, use all of the same equations as before
(where the original IS-curve solved for Ye = 2,375
– 125i) except suppose now that government
expenditure increases from G=480 to G1 = 580)
Clearly, AD1 = C+I+G1 = 1,050 – 50i + 0.6Y
Setting Ye = AD1 and solving gives the new IScurve
new IS-curve : Ye = 2,625 – 125i
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Example 4a:
Government Spending Increase
Visually, the IS-curve has shifted rightward as a result of the
increase in government spending.21i
i
21
19
2375
2625
Y
More generally, any increase in autonomous (i.e. Y-independent)
expenditure - from C, I or G - will cause the IS-curve to shift
rightward. On the other hand, any decrease in autonomous
spending will cause the IS-curve to decrease leftward.
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Model 3: Example 4 (cont.)
Recall again that the original IS-curve was
Ye = 2,375 – 125i
Example 4b: Tax Increase
Now let us use the original equations from Example 3
(with G=480), but suppose now that the income tax
code changes
from T=100+0.25Y to T1 = 200+0.25Y. This tax
increase affects demand through the consumption
function, which is now:
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C1=300-30i + 0.8Yd = 300 – 30i+ 0.8 (Y - (200+0.25Y))
which solves as: C1 = 140 – 30i + 0.6Y
(so we have C1=140 – 30i + 0.6Y, I=250 – 20i, G = 480)
clearly, AD1 = C1 + I + G = 870 -50i+0.6Y
setting Ye = AD and solving gives the new IS-curve
new IS-curve: Ye = 2,175 – 125i
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Model 3: Example 4 (cont.)
Visually, the IS-curve has shifted back leftward as a result of the
increase in government spending.19i
i
19
17.4
2175
2375
Y
More generally, any increase in the personal income tax will
cause the IS-curve to shift leftward. An income tax increase is
effectively a consumption decrease, and works accordingly. On
the other hand, any tax decrease in autonomous will cause the
IS-curve to increase rightward.
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Fiscal Policy
• In Models 1 and 2, an equilibrium output level could be
determined precisely and was a function of
government expenditure. In particular, the more
government spent, the higher was the output level.
Importantly, however, the models were timeless
models (with no future to worry about), and they
assumed that there were no supply constraints.
• Essentially, the government could increase output
without cost to anybody, because it was producing
valuable goods, and creating jobs, by using economic
resources that were simply lying about!
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• In real life, of course, those resources do have other
uses; if not today, than in the future. In other words,
there is an opportunity cost to government spending.
• “Fiscal Policy” is the term used to refer to a
government’s taxation and expenditure policies
designed to affect the state and evolution of the
economy.
• Clearly, designing an appropriate fiscal policy is more
complicated than the simple Keynesian models would
suggest (Spend! Spend! Spend!) in part because
government expenditure takes up resources that
could be (perhaps better) employed elsewhere.
However, before discussing “appropriate” fiscal
policy, we must first enquire as to what the
government is attempting to achieve.
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Fiscal Policy Objectives
Fiscal policy objectives can be several:
• Wealth re-distribution: a government may use its tax
and spend policies to transfer wealth from rich to
poor (or conversely!)
• Stabilisation: the government may attempt to “fine
tune” the economy, pursuing growth policies during
economic downturns, and attempting to slow down
the economy when it is growing too rapidly.
• Growth: the government may attempt to induce
economic growth, usually by spending more or taxing
less.
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Stabilisation and Growth Policy Problems
Historically, governments have had a very difficult time
fine-tuning their economies. The reasons are several:
• Timing problems: there is usually a long and uncertain time
between when a government sees a problem, when the
government reacts to it, and when the policy takes effect.
•
Irreversibility: it is politically easy for governments to spend
more money, but quite difficult to reduce it afterward. Taxes are
also relatively easy to raise, but difficult to lower.
• Over-spending: it is difficult to keep costs of public projects
under control (because the users of public money have little
incentive themselves to keep costs down).
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Stabilisation and Growth Policy Problems
• Historically, governments have also attempted to use
wage and price policies to fine-tune the economy.
Time and time again, these have proven so
disastrous that one would expect governments to
abandon them.
• Still, the true depth of government policy problems
cannot be fully appreciated until (i) we begin to
question where the government gets its money to
spend, i.e. “public finance”, and (ii) prices are
introduced.
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Public Finance
The government cannot spend money it doesn’t
have. Essentially, it can finance itself in one of
three ways:
• Tax - which is to take resources from private
households
• Borrow - which is to take resources from future
households
• Print money - which (because of its inflationary effect)
is to take resources from everyone who is holding
money. (*This is a monetary policy tool, to be
discussed later).
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Public Finance
Before looking into the intricacies of public
finance, the preceding list of financing methods
should point out one very important fact: as a
first approximation,
• The government cannot make the economy wealthy.
Essentially, all the government can do is to take wealth
from individuals and spends it on behalf of individuals.
• What the government can do, however, is to create an
environment where individuals can make themselves
wealthy.
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Public Finance
At an abstract level, the important questions are:
• Is the government spending money on behalf of
individuals better than could those individuals
themselves?
• There will always be winners and losers (and usually
more of the latter). So, who, exactly, is benefiting and
losing from government fiscal policies?
• “Fairness” pertains not only to today’s citizens but to
tomorrow’s as well. Is the government adequately
considering the welfare of future generations?
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Public Finance
• Finally, it should be noted that the net wealth
effect from government fiscal policy is zero
only as a first approximation. The key to
good fiscal policy is to identify the times and
places at which the government can make a
positive contribution to wealth.
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Public Expenditure
• The UK government spends vast amounts of money;
nationally, locally, and through public corporations. In
1988/89, public spending totaled £186 bil., or roughly
£3,200 per every man, woman and child.
• Its growth over time can be seen below:
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Taxation
Government receives money from several sources:
•
•
•
•
•
•
National Insurance “contributions”
surpluses from public corporations
rent, interest, and dividends
proceeds from the sale of public assets
direct user fees for government services
But, by far, the most important source of government
income is taxation.
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Taxation
Taxation is of two general types:
• Direct taxation: which is assessed on
individuals and businesses and collected by
Inland Revenue
– The rates at which individuals are assessed can either be
– progressives: higher earners pay a higher rate
– proportional/constant: everyone pays the same rate (say,
25%)
– regressive: higher earners pay a smaller rate
• Indirect taxation: which is assessed against
transactions
– (e.g. VAT) and is collect by Customs and Excise.
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Taxation
• The primary function of taxation is to raise
revenue for the government. However, taxes
can have other purposes and implications:
– To transfer wealth from rich to poor (or
conversely!)
– To protect domestic industries from foreign
competition (or to price them out of international
markets!)
– To create incentives to behave in socially
desirable ways; for example, to save more, to
reduce smoking, etc.
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Government Borrowing
• If the government does not raise enough revenue
through taxation, it can meet its additional revenue
needs either by printing money (to be discussed later) or
by borrowing.
• The amount of money the government borrows during
the fiscal year is known as the Public Sector Borrowing
Requirement (PSBR). It is also possible for the
government to have a balanced budget or even a
budget surplus. But these are seldom seen. (They did,
though, exist during the mid-1980’s. ).
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Government Borrowing
Mrs. Thatcher and other “Thatcherites” believed in a
balanced budget as a matter of principle. But there are
also economic reasons for maintaining one:
• Government borrowing drives up interest rates, and
means that there are less financial resources available
for private firm investment. This is known as “crowding
out”.
• Borrowing is a politically easy trap to get into, because
the costs are borne later, when the money must be paid
back. But this is bad for future generations, who must
pay for our debts.
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• Borrowing is quite difficult to reverse, because
it is a painful exercise with no immediate
visible benefit.
• The Bank of England may react to heavy
government borrowing by increasing the
money supply. But (as we will see) this will
lead to inflation, which itself causes private
investment to fall and so is bad for long-run
economic prosperity.
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Government Borrowing
10
8
PSBR as % of GDP
6
4
2
0
-2
-4
1963
1970
1975
1980
1985
1990
1995
Source: Economic Trends Annual Supplement
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Next Week
• Fiscal Policy is one half of the
Governments main armoury
• Next week we introduce money and
monetary policy into the analysis
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