Ranjit Dighe
WEEK 13 (LECTURES 33-35)
April 24-28, 2000

[This week's lectures go with Case & Fair's Chapters 10 (The Government and Fiscal Policy) and 14 (Aggregate Demand and Aggregate Supply) and parts of Chapters 16 (the section on "Deficit Reduction and Macropolicy") and 18 (the section on "Supply-Side Economics").]

Mon., April 24, 2000

* Today:
I.   The deficit's influence on the economy
II.  Reintroducing the price level (P)
III. Aggregate demand (AD) and P


Where we left off: In simple multiplier models, the government-spending multiplier, as 1/(1-MPC), is huge, and the tax and balanced-budget multipliers are also very large. Plugging in the estimated MPC for the U.S. today, which is .95, the multiplier would be 20 (=1/(1-.95)=1/.05). The tax multiplier would be -19 (= -.95/(1-.95) = -.95/.05 = -95/5), and the balanced-budget multiplier would be 1.
-- In the real world, however, those multipliers are a lot smaller. The spending multiplier is about 1.4, the tax multiplier is about -1.3, and the balanced-budget multiplier is about 0.1, even though the U.S. MPC, as noted, is about .95.
Parting question from last time:
Q: What makes the real-life multiplier so much smaller than 20? (Or, how do we "beat the multiplier down" from 20 to 1.4?)
A: In real life, there are several LEAKAGES from that whole chain of consumption that drives the multiplier process, namely:
(1) taxes on incomes and sales, which mean that some fraction of every dollar spent goes not to the person selling the good or service but to the government.
(2) imports - some of every extra dollar of consumer spending is spent on imported goods instead of U.S.-produced goods, and imports are subtracted from GDP. Also, the money spent on imports is mostly re-spent in the foreign country that produced the import, not in the U.S.
(3) inflation - instead of passively responding to the increased product demand by simply supplying more goods at the same price as before, many producers will respond (and maximize their profits) by raising their prices. Those higher prices mean inflation, and the increase in real GDP will therefore be smaller than the increase in nominal GDP.
(4) higher interest rates as a result of the extra aggregate demand. Some of that extra consumption spending is on expensive durable goods, like cars and dishwashers, that are normally financed through consumer loans. Increased demand for durable goods means increased demand for loans, and the equilibrium interest rate will increase, thereby crowding out some of that durable-goods consumption and also crowding out some investment.
-- The CROWDING-OUT EFFECT refers to the tendency for larger budget deficits to cause private investment (and durable-goods consumption) to fall.
---- How it works: (1) To run a bigger deficit, the government must sell more Treasury bonds; (2) To sell more T-bonds, it must offer a higher interest rate; (3) Interest rates on loans and corporate bonds go up, too; (4) At those higher interest rates, businesses don't borrow as much for new investment.

We should also note that when these multipliers are so small (1.4 for spending, -1.3 for taxes, 0.1 for BBM), the impact of any change in G or T on equilibrium GDP is easily offset by a change in monetary policy, such as a raising or lower of interest rates, by the Federal Reserve.

Still, even if the multipliers are only 1.4 (for government spending) and -1.3 (for taxes), in simple multiplier models, like the ones we've seen, the deficit helps the economy and doesn't hurt it at all. In such models, the bigger the deficit the better, because it will increase equilibrium GDP.
-- There is no "limit" to GDP (no concept of "potential GDP" or "capacity GDP") in the multiplier model.
Q: So, then, why not have as big a deficit as possible? Eliminate all taxes. Let every Congressperson's request for greater spending for his or her district be granted, so that the government spends as much money as it could ever imagine.

A: First off, the multiplier model applies to a depressed economy, operating on the flat part of the AS curve; if we're only looking at a range of low values of GDP, then we're so far away from potential GDP that we don't need to worry about pushing the economy beyond its sustainable limit. But bigger and bigger deficits would eventually increase GDP to the point where it reached the intermediate part of the AS curve, at which point larger deficits become inflationary.
-- Once real GDP (Y) reaches potential GDP (Y*) (i.e., once the unemployment rate falls below the NAIRU), larger deficits cause not just increased inflation but also accelerating inflation.
---- There are additional reasons (see "Week 12A" makeup lecture notes) why government deficits are not entirely a blessing.


The multiplier model is a fixed-price model -- it never mentions prices, and implicitly assumes the price level (P) is fixed at all times.

The most widely used macro model, at the introductory-course level, is the aggregate demand-aggregate supply (AD-AS) model, in which aggregate demand (AD) and aggregate supply (AS) curves, which look a bit like the micro supply and demand curves, are plotted in (Y,P) space. That is, Y (real GDP) is on the horizontal axis and P (the price level) is on the vertical axis.
-- The AD-AS model, unlike the multiplier model, is a variable-price model, because it realistically assumes that the price level can and does change from time to time.

The aggregate demand (AD) curve is a schedule or curve that shows the level of real domestic output that will be demanded at each price level.
-- The AD curve slopes downward, just like a micro demand curve; and the AS curve slopes upward, just like a micro supply curve. The similarity to micro supply-and-demand models ends there, however, because the factors driving the shapes and shifts of these curves are different. First, note that P represents the aggregate price level -- not, as in micro supply-and-demand diagrams, the price of a specific commodity (say, bananas) with all other prices held constant. The AD curve (or "schedule") tell us how the aggregate quantity demanded of all goods and services (by households, firms, government, and foreigners) is affected by the price level.

The aggregate supply (AS) curve is a schedule or curve showing the level of real domestic output that will be produced at each aggregate price level.
-- The AS curve tells us how the aggregate quantity supplied of all goods and services (by firms) is affected by the price level.


Aggregate demand (AD) has an inverse relationship with the price level (P)
-- A lower price level is good for AD (i.e., increases the sum of C, Iplanned , G, and EX - IM )
-- A higher price level is bad for AD (i.e., decreases the sum of C, Iplanned , G, and EX - IM
--> The AD curve slopes downward.

There are three reasons why the AD curve slopes downward (or, equivalently, why a lower price level raises AD):

(1) Real-wealth effect
-- A lower price level raises the real value of the money in people's pockets and bank accounts, and raises real wealth in general. (This is the flip side of how inflation -- a higher price level -- lowers people's real wealth.) Wealthier people consume more, so the increase in aggregate real wealth raises household consumption.

* (2) Interest-rate effect
-- (This one has the asterisk {*} next to it because it's the most important of the three reasons.)
-- A lower price level will reduce interest rates, which will stimulate durable-goods consumption and business investment (both of which are types of interest-sensitive spending), through the following channel:
---- P falls --> in the money market, less money is needed for a given level of transactions --> money demand falls --> the price of money (which is the interest rate, i) falls -> investment rises, durable-goods consumption increases
------ Shorthand: P falls -> Md falls -> i falls -> Ip increases, Cdurables increases (AD increases)

(3) Foreign purchases effect (real-exchange-rate effect)
-- A lower domestic price level, relative to the price levels of other countries, means the home country's products become cheaper relative to foreign products (and hence the real foreign exchange rate rises). If the American price level falls, relative to the world price level, then foreigners will buy more American exports and Americans will buy fewer foreign imports, and American net exports increase.

Q: Hey, wait a minute: What about the fact that a lower price level is bad for debtors by raising the real burden of debt? Think back to our unit on inflation; we call this phenomenon the debt-deflation effect, and it has severe, adverse effects on AD, because an increased debt burden forces indebted consumers and firms to retrench (the households' consumption falls, the firms' investment falls) and, in many cases, declare bankruptcy or default on their debts, in which case their creditors take a hit, too.
A: Based on the empirical evidence, it seems that the combined positive effects -- (1), (2), and (3) -- of a lower price level on AD outweigh the negative debt-deflation effect, so the net effect of lower prices on AD is still positive. But the debt-deflation effects on debtors and many creditors are sufficiently severe that U.S. economic policymakers have made sure to keep the U.S. out of deflation ever since the 1940s.

A summing up

A lower price level raises aggregate demand (AD = C + Iplanned + G + EX - IM) as follows:
AD = C + Iplanned + G+ EX - IM 
increases through (1) real wealth effect and (2) interest-rate effect on durable-goods consumption increases through (2) interest-rate effect increases through (3) foreign-purchases effect

(Note: The favorable effect of lower prices on interest-sensitive consumption and investment spending outweighs the debt-deflation effect.)


Wed., April 26, 2000

* Today: The Aggregate Demand-Aggregate Supply (AD-AS) Model, continued
I.   Determinants of AD
II. AS and the price level
III. AD-AS equilibrium (moved to Friday's notes)


-- [I drew a graph of the AD curve shifting outward, or rightward. It's identical to the graph in Case & Fair's Figure 14.3 (page 296).]

Determinants of AD / Factors that shift the AD curve

(1) Changes in consumer spending
-- consumer wealth (wealthier consumers will consume more. Rising household wealth because of, say, rising stock prices, will cause consumption to increase.)
-- consumer expectations (a.k.a. "consumer confidence," which measures consumers' willingness to buy big new durable goods, based on their expectations of what their individual financial situations will be in the future)
-- household indebtedness (puts pressure on households to cut back their consumption, so this is bad for consumption)
-- taxes (higher taxes lower disposable income and thus lower consumption)
-- interest rates (affect durable-goods consumption in particular)

(2) Investment spending (firms' expenditures on new plant and equipment)
-- interest rates (lower interest rates raise the level of investment spending, by making the cost of borrowing cheaper and by lowering the opportunity cost of investment projects -- an investment with an expected return of 6% is not worth pursuing if you can earn 8% by holding bonds, but it is worth pursuing if you can only earn 4% by holding bonds.)
-- expected returns on investment projects (the higher the expected return on investing, the more likely firms are to invest. Expected returns will be higher when the economy appears strong and growing and when the political situation appears stable. Changes in business psychology -- what Keynes called "animal spirits" -- can also strongly affect expectations of future returns.)
-- business taxes (higher business taxes lower the after-tax return on any investment, so they are bad for investment)
-- technology (the availability of good new technology will tend to induce firms to invest in new, state-of-the-art plant and equipment)
-- degree of excess capacity (the higher this is, the less need there is for investment, since firms with a lot of excess capacity, such as the typical firm in a recession, can expand just by utilizing more of their existing capacity.)
-- stock prices (when stock prices are low, a company that is looking to expand can often do so most cheaply by buying up another firm in the same industry. When stock prices are high, acquiring other firms becomes more costly, and it is often cheaper to expand "from scratch," by building new plant and equipment on one's own.)

(3) Government spending
-- The determinants of government spending are mostly political, not economic.
-- A few types of government spending, such as unemployment insurance and anti-poverty spending like food stamps and welfare, depend on the state of the economy because they are higher in recessions, when many people are thrown out of work and into poverty. Such programs are called automatic stabilizers; we will learn more about them in our unit on fiscal policy.

(4) Net export spending
-- national income abroad (prosperity in foreign countries, especially among our biggest trading partners, means greater spending by their citizens on U.S. exports, and recessions in foreign countries lower spending on U.S. exports)
-- exchange rates (when the dollar depreciates, becoming less expensive in terms of foreign currency, U.S. exports rise, because they have become cheaper relative to foreign products, and Americans buy fewer foreign imports, because those have become more expensive relative to American products. Both of those effects cause U.S. net exports to rise).
-- tariffs (taxes on foreign imports) -- Other things equal, if a country imposes higher tariffs on imports, that country's spending on imports will fall, raising its net exports. (Other things, however, are often not equal, since higher tariffs in one country often invite retaliation in the form of higher tariffs in other countries, which hurt the first country's exports and may make the net change in net exports a wash.)

When the AD curve shifts outward or rightward (AD increases), it means that people are willing to buy more goods and services at any given price level than they were before.

When the AD curve shifts inward or leftward (AD decreases), it means that people are willing to buy fewer goods and services at any given price level than they were before.

Recall from the multiplier model that the levels of consumption and aggregate demand depend not only on those above, autonomous factors but also on the level of real GDP. When real GDP is higher, then (typically) real disposable, or after-tax, income is higher, too, and consumption and AD both increase. Then, through the multiplier process, that induced increase in consumption spending leads to still more consumption spending, because anyone who receives payment for providing goods and services will spend most of the income he receives on his own consumption, and so on. It's still true that an initial increase in autonomous spending will ultimately result in a total increase in spending (or, equivalently, an increase in AD) that is much larger.
--> One could think of an initial shift in the AD curve as touching off a cascade of progressively smaller shifts, until the cumulative shift is many times as large as the initial shift. In other words, the multiplier process is a series of increases in AD. But for the sake of simplicity, we draw just one big AD shift, the cumulative shift, which includes both the initial change in autonomous spending and the induced change in spending that occurs through the multiplier process. In other words,

horizontal amount of shift in AD curve = (change in autonomous spending)*(multiplier)


Aggregate supply (AS) is roughly the same thing as GDP. Both differ from aggregate demand (AD) because they include all goods or services that are produced, not just all the ones that are sold. Unsold goods are counted in GDP as inventory investment (unintended inventory investment if sales fall short of producers' expectations). Only in equilibrium does AD=GDP, and only in equilibrium does AD=AS (more on this later. Also note that in equilibrium there is no unintended inventory investment.)

We draw the AS curve in (Y,P) space, with three ranges:

-- [I drew a graph of the AS curve. See Case & Fair's Figure 14.6 (page 299) for a similar graph.]

The intermediate or upward-sloping part of the AS curve closely corresponds to the Phillips Curve. Recall that the Phillips Curve shows the tradeoff between unemployment and inflation, whereas the upward-sloping part of the AS curve shows how real output (Y) and the price level (P) move in the same direction.
-- Start with a Phillips Curve [drawn on board; see Case & Fair's Figure 15.5 (page 326) if you've forgotten what a Phillips Curve looks like]
--> Recall that low rates of unemployment and high levels of real GDP go hand in hand. Combining the Phillips Curve tradeoff between unemployment and inflation with the inverse relationship between unemployment and real GDP, we note that higher levels of real GDP (relative to potential GDP) are associated with higher rates of inflation.
----> Since higher inflation rates mean higher price levels, it's a short step to note that higher levels of real GDP (relative to potential GDP) are associated with higher price levels. So we can now draw an AS curve that is upward-sloping. (Potential GDP is assumed fixed in the short run, which is what these diagrams represent.)

For the record, a shift of the aggregate demand (AD) curve corresponds to a movement along the Phillips Curve.
-- An outward (rightward) shift of the AD curve corresponds to a northwest movement along the Phillips Curve, toward lower unemployment and higher inflation.
-- An inward (leftward) shift of the AD curve corresponds to a southeast movement along the Phillips Curve, toward higher unemployment and lower inflation.

A shift of the aggregate supply (AS) curve corresponds to a shift of the Phillips Curve.

Determinants of AS / Factors that shift the AS curve:

(1) changes in input prices
-- domestic resource availability-- land, labor, capital, entrepreneurial ability
-- prices of imported resources (oil, foreign exchange)
-- market power / degree of monopoly (monopolies raise prices and restrict output, so greater industrial concentration means a leftward or inward shift of the AS curve)

(2) changes in productivity

(3) changes in the legal and institutional environment (government)
-- business taxes and subsidies
-- government regulation
---- bad for AS: constraints on what businesses can and can't do; "red tape"
---- good for AS: police and property-rights protection

[I drew graphs of an outward shift of the AS curve and of an inward shift of the AS curve. They are just like (though in reverse order) the graphs in Case & Fair's Figure 14.7 (page 302).]

Things that cause aggregate supply to increase (AS curve shifts out):
* lower input prices / more labor, capital, or land
* higher productivity
* lower business taxes
* less regulation

Things that cause aggregate supply to decrease (AS curve shifts in):
* higher input prices (e.g., OPEC oil shocks, higher wages)
* lower productivity
* higher business taxes
* increased regulation


Fri., April 28, 2000


* Today: The Aggregate Demand-Aggregate Supply (AD-AS) Model, continued
I.    AD-AS equilibrium (finish)
II.  Changes in the AD-AS equilibrium
III. Supply-side economics (Chapter 18, pp. 395-98)
IV. Quiz (at end of class)

* Third exam is on Monday
-- Coverage:
---- (1) Problem Sets 7 & 8
---- (2) Lectures from April
---- (3) Chapters 9, 10, 11, 12, 13, 14, 16 (deficits), 18 (supply-side)
----Me:  12-6, Mahar 425 (call ahead-- x3480)
----Rem: 7-9, Group Study Area of library


... corresponds to the point where the AS and AD curves intersect. At that point, AD=AS and there is no unintended inventory accumulation, just like in the multiplier-model equilibrium. Since the graph has two dimensions, P and Y, the AS-AD equilibrium shows the equilibrium levels of Y (real GDP) and P (the price level).
-- [See Case & Fair's Figure 14.9 (page 303), which was shown in class.]

The AD curve corresponds to equilibrium in both the goods market (Y = AD, or Y = C+Ip+G+EX-IM) and the money market (Ms = Md).
-- If the economy is in disequilibrium, then it is not on the AD curve.
-- [To depict the goods-market equilibrium, I drew a graph of the "Keynesian cross" diagram in which an AD function crosses a 45-degree line that represents the equation AD=Y. The graph is much like the one in Case & Fair's Figure 10.2 (page 204).]
-- [To depict the money-market equilibrium, I drew a graph of the intersection of money demand and money supply curves, just like the one in Case & Fair's Figure 12.6 (page 261).]
-- [The AD curve I drew in class is just like the one in Case & Fair's Figure 14.2 (page 293). I drew a recessionary gap as a point to the right of the AD curve, because at that point AD < Y. I drew an inflationary gap as a point to the left of the AD curve, because at that point AD > Y.]

The economy is always on the AS curve, just as the economy is always on the Phillips Curve. The AS curve just shows the combinations of P (the price level) and Y (real GDP) that the economy happens to generate, given different levels of aggregate demand.
-- [The AS curve I drew in class is just like the one in Case & Fair's Figure 14.6 (page 299).]


P and Y will change when either the AS or the AD curve shifts. When the AD curve shifts, the nature of the changes in P and Y will depend on what region of the AS curve the economy is on. If it's on the flat region, shifts of the AD curve affect real GDP but not the price level, just as in the multiplier model. If it's on the vertical region, GDP is already equal to capacity GDP and a higher level of AD cannot raise real GDP but will only raise the price level. But since the economy is usually on the upward-sloping portion of the AS curve, shifts of AD will affect both P and Y.

What happens when one of the curve shifts?  Four possible shifts, and their effects:

(1) increase in AD --> Y increases, P increases (demand-pull inflation, economic expansion)
-- [The graph I drew of this in class is similar to Case & Fair's Figure 14.11 (page 306), except that I did not draw it with the economy on the nearly flat part of the AS curve.]

(2) decrease in AD --> Y decreases, P decreases (deflation and recession)
-- Caveat: in real life, deflation is almost nonexistent -- what more likely happens is merely a decline in the inflation rate.
-- [The graph I drew of this class does not have an exact counterpart in Case & Fair's book.]

(3) increase in AS --> Y increases, P decreases (supply-driven growth)
-- [The graph I drew of this class does not have an exact counterpart in Case & Fair's book.]

(4) decrease in AS --> Y decreases, P increases (stagflation; cost-push inflation)
-- [The graph I drew of this in class is similar to Case & Fair's Figure 14.13 (page 310).]

Ex.: Expansionary fiscal policy (Congress raises G and cuts T) causes the AD curve to shift out, as in (1)
==> P increases, Y increases. (AD increases because G and C increase.)

Ex.: Contractionary monetary policy (Fed reduces money supply) causes the AD curve to shift in, as in (2)
==> P decreases, Y decreases. (AD falls because Cdurables and Ip fall.)

Ex.: The OPEC oil cartel collapses, and gas prices fall to 25 cents a gallon.This would cause the AS curve to shift out, as in (3)
==> P decreases, Y increases. (AS increases because production becomes cheaper, on account of lower input prices.)

Ex.: The government imposes strict new regulations on business. This would cause the AS curve to shift in, as in (4)
==> P increases, Y decreases. (AS decreases because the cost of doing business has gone up.)


Keynesian economics took a beating in the 1970s. The basic Keynesian model, which focused on AD, had virtually nothing to say about supply shocks and stagflation. Since those were two of the dominant economic issues of the 1970s, along with the productivity slowdown, it's perhaps no wonder that a "crisis in Keynesian economics" developed.

Alternative schools of macroeconomics gained ground during the 1970s. One alternative approach that became popular with only a handful of economists but with several very influential politicians was SUPPLY-SIDE ECONOMICS. President Ronald Reagan, Congressman Jack Kemp, and Senator William Roth were among the most powerful backers of supply-side economics. The most famous supply-side economist was Arthur Laffer.

The supply-siders emphasized the role of aggregate-supply (AS) factors in movements in GDP. They said Keynesians were overly preoccupied with aggregate-demand fluctuations and neglected supply. They said that by cutting tax rates and eliminating many regulations on business, the government could generate big increases in aggregate supply (big rightward shifts of the AS curve), because tax cuts and reduced regulation would increase labor supply, productivity, and investment. Those increases in AS would correspond to increases in potential GDP (Y*) as well as actual GDP.

The promises of the supply-siders were seductive. If you were given the choice of stimulating the economy by shifting the AD curve out or by shifting the AS curve out, which would you choose? (Probably shifting the AS curve out-- no demand-pull inflation; instead, P actually falls[or, if there's also an increase in AD, then P might rise, but by a much smaller amount than if there were no shift in AS.])
-- Keynesian theory implies, however, that there's really no way for government policies to generate big AS shifts. (So does the empirical evidence, which we'll see a bit later.)
-- In the supply-side case, AS shifts are more important than AD shifts. If cutting taxes raises GDP, it's because the lower tax rates produce a dramatic increase in labor supply and Y*; the increase in consumption, which Keynesians would say is the reason why a tax cut raises GDP, is secondary.

The favorite supply-side remedy was for the government to pursue policies that increase AS. They especially favored cuts in income tax rates. Arthur Laffer said that U.S. tax rates were so high that they were strangling economic growth and yielding lower revenues than could be attained with lower tax rates. The reason, he said, was because current tax rates were so high that they discouraged people from working long hours and discouraged some people from working at all.
-- The "LAFFER CURVE" [which I drew in class and which appears in Case & Fair's Figure 18.2 (page 396)] illustrates this argument. It is a graph showing total tax revenues (T) as a function of the tax rate (t). If the tax rate is 0%, then obviously the government gets zero tax revenues. If the tax rate is 100%, then nobody will work and the government will also get zero tax revenues. Somewhere in between is the optimal or revenue-maximizing tax rate. Laffer said the income tax rates of the late 1970s were higher than that optimal rate, so that you could cut tax rates and actually increase tax revenues.

The Kemp-Roth "supply-side" tax cuts (of July 29, 1981) cut income tax rates by 25%, and began the indexation of taxes for inflation. Reagan, Laffer, and other supply-siders said the tax cuts would pay for themselves, because the increase in people's after-tax wages would cause a huge increase in labor supply, so that the tax base would increase by more than the tax rate fell. You could have a big tax cut and have a balanced budget, they said, because with more people working and putting in more hours, tax revenues would go up.
-- Did supply-side economics work? Most economists would say no, or at least not in the way that they were intended to work. Big AS shifts did not occur; nor did labor supply increase appreciably because of the tax cut. What did happen was that the economy began to recover, beginning in late 1982, and entered a prolonged expansion that lasted until 1990. The tax cuts, and an easing of monetary policy (lowering of interest rates) by the Federal Reserve, helped the economy, but they did so in traditional Keynesian demand-side fashion -- the tax cuts generated big AD shifts, because they raised people's disposable income and consumption increased.
---- The tax cuts failed to generate big increases in tax revenues, and instead helped contribute to huge and growing budget deficits in the 1980s, of $200 billion and up.
---- In sum, the extreme promises of the supply-siders did not come true. The soaring deficits of the 1980s would not have occurred had the tax cuts raised as much revenue as the Reagan Administration's original budget projections predicted. The shortfall in taxes was the main reason that Reagan was unable to deliver on his promise to cut taxes and balance the budget at the same time.
---- Also, the huge budget deficits led to enormous political and public pressure to reduce the deficit, and made expansionary fiscal policy unthinkable in the next recession, in 1990-91. The 1981 tax cut was the last fiscal expansion the U.S. has ever seen; since the mid-1980s, expansionary fiscal policy has been dead. Now that the budget is in surplus again, fiscal policy might make a comeback during the next recession, but that remains to be seen.