PowerPoint Slides
to accompany
Prepared by Apostolos Serletis
University of Calgary
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1
Chapter12
Government Expenditure
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Data on Government Expenditure
• Government expenditure is the dollar amount
spent at all levels of government for purchases
of goods and services, transfer payments
(amounts given to households and businesses),
and interest payments.
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Data on Government Expenditure
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Data on Government Expenditure
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Data on Government Expenditure
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Data on Government Expenditure
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Just How Much Bigger is Government in
Canada?
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The Government’s Budget Constraint
• Gt represents government purchases in real
terms for year t.
Ct + It + Gt, is the aggregate real spending on goods
and services in year t.
• Vt represent the government’s real expenditure
on transfers.
• The real revenue from money creation for year t
is (Mt −Mt−1)/Pt
• Tt is the total real taxes collected by the
government in year t. We assume that there is
no public debt in the model, Bt = 0.
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The Government’s Budget Constraint
• Government budget constraint:
total uses of funds = total sources of funds
Gt + Vt = Tt + (Mt− Mt−1)/Pt
(real purchases + real transfers
= real taxes + real revenue from money creation)
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The Government’s Budget Constraint
• Government budget constraint
Gt + Vt = Tt
(real purchases + real transfers = real taxes)
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Public Production
• We are assuming that the government
subcontracts all of its production to the private
sector.
• Public investment, publicly owned capital, and
government employment are zero.
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Public Services
• Begin with the hypothetical case in which public
services have zero effect on utility and
production.
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The Household’s Budget Constraint
• Household budget constraint (with π = 0)
C + (1/P)·∆B+∆K = (w/P)·Ls+ i·( B/P+K)
Ct + (1/P)·∆Bt+∆Kt
= (w/P)t·Lst + rt−1·(Bt−1/P + Kt−1)
• With Government (with π = 0)
Ct + (1/P)·∆Bt+∆Kt
= (w/P)t·Lst + rt−1·( Bt−1/P + Kt−1) +Vt − Tt
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The Household’s Budget Constraint
• Multiyear household budget constraint with
transfers and taxes:
• C1 + C2/(1+r1) + · · · = (1+r0)·( B0/P+K0)
+(w/P)1·Ls1 +(w/P)2 · Ls2 /(1+r1) + ·· ·
+( V1 − T1) + ( V2 − T2)/( 1 + r1)
+( V3 − T3)/[(1+ r1) · ( 1 + r2) ] + ·· ·
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Permanent Changes in Government
Purchases
• Theory
G+V=T
or
V − T = −G
– If G rises by one unit each year, V − T falls by one
unit each year.
– Household’s disposable real income falls by one unit
each year.
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Permanent Changes in Government
Purchases
• Theory
– Since the typical household has one less unit of real
disposable income each year, we predict that the
decrease in C each year will be roughly by one unit.
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Permanent Changes in Government
Purchases
• Theory
– How the increase in government purchases affects
the demand and supply of capital services and real
GDP.
• An increase in government purchases, G, does not
shift the curves for the demand or supply of capital
services.
– The market-clearing real rental price, (R/P)∗, and quantity
of capital services, (κK)∗, do not change.
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Permanent Changes in Government
Purchases
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Permanent Changes in Government
Purchases
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Permanent Changes in Government
Purchases
• Theory
– We found that the quantity of capital services, κK, is
unchanged, and we assumed that the technology
level, A, and the quantity of labour input, L, are fixed.
– Therefore, Y is unchanged.
– The important conclusion is that a permanent
increase in government purchases does not affect
real GDP.
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Permanent Changes in Government
Purchases
• Theory
r = ( R/ P) · κ − δ(κ)
• A permanent increase in government purchases
does not affect the real interest rate.
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Permanent Changes in Government
Purchases
• Theory
G, does not shift labour supply, Ls, which is fixed at L,
and does not shift the labour demand curve, Ld.
• The market-clearing real wage rate, (w/P)∗, does
not change.
• We conclude that a permanent increase in
government purchases does not affect the real
wage rate.
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Permanent Changes in Government
Purchases
• Theory
– We know from our analysis of income effects that a
permanent rise in government purchases, G, by one
unit reduces C in each year by roughly one unit.
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Permanent Changes in Government
Purchases
• Theory
– The intertemporal-substitution effect depends on the
real interest rate, r. Since r does not change, the
intertemporal-substitution effect does not operate.
Another substitution effect involves consumption and
leisure, but we have assumed that the quantity of
labour and, hence, the quantity of leisure, is fixed. In
any event, this substitution effect depends on the real
wage rate, w/P, which does not change.
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25
Permanent Changes in Government
Purchases
• Theory
– Our prediction is that a permanent increase in
government purchases by one unit causes
consumption to decrease by about one unit.
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Permanent Changes in Government
Purchases
• Theory
Y = C+ I + G
• The changes in C and G fully offset each other
and, thereby, allow investment, I, to remain
unchanged.
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Permanent Changes in Government
Purchases
• Theory
– We predict that a permanent increase in government
purchases, G,
• Reduces consumption, C, roughly one to one.
• The variables that do not change include real
GDP, Y; gross investment, I; the quantity of capital
services, κK; the real rental price, R/P; the real
interest rate, r; and the real wage rate, w/P.
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Permanent Changes in Government
Purchases
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Temporary Changes in Government
Purchases
• Theory
– Assume now that year 1’s real government
purchases, G1, rise by one unit, while those for other
years, Gt, do not change. That is, everyone expects
that Gt in future years will return to the original level.
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Temporary Changes in Government
Purchases
• Theory
Vt− Tt= −Gt
Vt− Tt falls by one unit, and households have one unit
less of real disposable income. In subsequent years,
Vt − Tt and, hence, real disposable income return to
their original levels.
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Temporary Changes in Government
Purchases
• Theory
– Households would spread their reduced disposable
income in year 1 over reduced consumption, Ct, in all
years t. Therefore, the effect on year 1’s consumption,
C1, will be relatively small. The propensity to consume
out of a temporary change in income is greater than
zero, but much less than one.
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Temporary Changes in Government
Purchases
• Theory
Y = C+ I + G
Y, is unchanged; real government purchases, G, are
higher in year 1 by one unit; and consumption, C, is
lower, but by much less than one unit. Consequently,
equation (12.9) implies that gross investment, I, must
fall.
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Temporary Changes in Government
Purchases
• Theory
– Since the decrease in C is relatively small, the decline
in I is large. That is, year 1’s extra G comes mainly at
the expense of I, rather than C.
– When the change in G was permanent, we predicted
that most or all of the extra G came at the expense of
C.
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Government Purchases and Real GDP
During Wartime: Empirical
• We test the model by studying the response of
the economy to the temporary changes in
government purchases that have accompanied
U.S. wars.
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Government Purchases and Real GDP
During Wartime: Empirical
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Government Purchases and Real GDP
During Wartime: Empirical
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Government Purchases and Real GDP
During Wartime: Empirical
• The data also show that the rises in real GDP
are by less than the increases in government
purchases. That is, aside from military
purchases, the totals of the other components of
real GDP are down during wartime. The model
accords with this pattern. However, the
components of real GDP other than military
purchases do not fall nearly as much as
predicted by the model.
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Wartime Effects on the Economy
• Employment during wartime
– The basic pattern is that the military took in a
significant number of persons total employment
expanded a little more.
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Wartime Effects on the Economy
• Effects of war on labour supply
– At this point, there is no settled view among economists about
the best way to understand labour supply during wartime.
• A large expansion of real government purchases,
G, means that households have less real
disposable income.
• Casey Mulligan (1998) argues that labour supply,
Ls, increases during wartime because of patriotism.
• The military draft would affect the labour supply of
single women.
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Wartime Effects on the Economy
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Wartime Effects on the Economy
• Employment Effects on Labour Markets
– Prediction that a war reduces the real wage rate, w/P.
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Wartime Effects on the Economy
• Effects of war on the rental market
– A wartime increase in labour supply, Ls, led to an
increase in labour input, L. This change affects the
rental market, because the rise in L tends to increase
the MPK (for a given quantity of capital services, κK).
• The demand curve shifts right because the higher
quantity of labour, L, raises the MPK for a given
quantity of capital
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Wartime Effects on the Economy
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Wartime Effects on the Economy
• Effects of war on the rental market
– For a given capital stock, K, the rise in κK
corresponds to an increase in the capital utilization
rate, κ.
r = ( R/ P) · κ − δ(κ)
• Increases in R/P and κ imply that r increases.
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Wartime Effects on the Economy
• Effects of war on the rental market
– The predictions for higher real interest rates during
wartime conflict with the U.S. data.
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