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Chapter 14 (1) - Unemployment and fiscal policy - Coggle Diagram
Chapter 14 (1) - Unemployment and fiscal policy
Unit 1
The fact that the fluctuations in output growth dramatically reduced while the size of government expanded does not mean that increased government spending stabilized the economy (remember: statistical correlations do not mean causation).
The big increase in the size of government after the Second World War was accompanied by a reduction in the size of business cycle fluctuations.
The red line shows the share of federal (national), local, and state government tax revenue as a share of GDP. This is a good measure of the size of the government relative to that of the economy.
After 1990, the business cycle in advanced economies became even smoother, until the global financial crisis in 2008. This led to the period from the early 1990s to the late 2000s being called the great moderation.
A dramatic reduction in the severity of business cycles occurred after the end of the Second World War.
In a capitalist economy, private investment spending is driven by expectations about future post-tax profits.
Figure 1 shows the annual growth of real GDP in the US economy since 1870.
Spending on investment projects tends to occur in clusters. Two reasons for this observation are:
Firms may adopt a new technology at the same time.
Firms may have similar beliefs about expected future demand.
Instability in the economy as a whole is characteristic not only of economies dominated by agriculture, but also of capitalist economies
The circular flow of expenditure, income, and output previously shown in Chapter 13 Figure 5 illustrates this process.
If the total increase in GDP is equal to the initial increase in spending: We say that the multiplier is equal to 1.
If the total increase in GDP is greater or less than the initial increase in spending: We say that the multiplier is greater than 1 or less than 1.
1
To see why GDP may rise by more than the initial increase in investment spending, we explain what economists call the multiplier process.
If a single household saves, its wealth necessarily increases, but if all households save this may not be true, because without additional spending by the government or firms to counteract the fall in demand, aggregate income will fall.
In this aggregate consumption function, consumption depends on current income, among other things.
An increase in the size of government following the Second World War coincided with smaller economic fluctuations.
The multiplier is greater than 1 if the additional consumption spending resulting from a temporary €1 increase in income is greater than zero but less than €1 (say, for example, 60 cents).
Fluctuations in aggregate demand affect GDP growth through a multiplier process, because households face limits to their ability to save, borrow, and share risks.
Unit 2
Spending on consumer durables can easily be postponed. In this sense it is more like an investment than a consumption decision
As a result, we would expect the series for consumer durables to be more volatile than for non-durable consumption.
Why the sudden drop in consumption of consumer durables? An important reason is that households were suddenly fearful about the future of their jobs, as shown by the sharp decline in the consumer sentiment index in Figure 3
4
We notice:
Consumption of non-durable goods went down slightly more than disposable income: It fell by 3% during the period. Contrary to the predictions of consumption smoothing, households were sufficiently worried about their future prospects that they made adjustments to their spending on non-durables.
Consumption of durables decreased much more dramatically than disposable income: It decreased by 10% in the first year.
In Figure 4 we show the amount of output produced by the economy (on the horizontal axis) and the demand for output (on the vertical axis).
The figure also plots the evolution of a number of key macroeconomic indicators: disposable income, consumption of durable goods like cars and home furnishings, and consumption of non-durable goods, such as food.
The 45-degree line from the origin of the diagram shows all the combinations in which output is equal to aggregate demand.
The figure shows how consumer confidence changed in the US over the course of the crisis.
We saw that spending on goods and services in the economy (aggregate demand) is equal to production of goods and services in the economy (aggregate output).
Figure 3 illustrates how expectations affected consumption in the financial crisis of 2008 and highlights the exceptional nature of this episode.
output = aggregate demand for goods produced in the home economy
Y=AD
3
The equation for aggregate demand is therefore:
aggregate demand = consumption + investment
AD = 𝐶+𝐼
= 𝑐0 + c1 𝑌 + 𝐼
The term c₀ in the aggregate consumption function captures all the other influences on consumption that are not related to current income.
So adding investment to the consumption line simply leads to a parallel upward shift
This means that for rich households, an increase in current income of €1 would raise their consumption by just a few cents.
We can see from Figure 4 that the aggregate demand line has an intercept of c₀ + I, a slope of c1, and is flatter than the 45-degree line.
Households with low wealth smooth consumption very little if their income falls sharply. The marginal propensity to consume for this group is closer to 0.8.
Changes in autonomous consumption or investment displace the old equilibrium because they change aggregate demand, which in turn alters the level of output and employment.
We will work with an aggregate consumption function in which the marginal propensity to consume, c1, equals 0.6. This means that an additional unit of income (Euros in this case) increases consumption by €1 × 0.6 = 60 cents.
Point A is called a goods market equilibrium: the economy will continue producing at that output level unless something changes spending behavior
A flatter line means that households are smoothing their consumption so that it does not vary much when their incomes change.
5
A steeper consumption line means a larger consumption response to a change in income.
In Figure 5, we take the multiplier diagram and reduce investment. We choose a reduction in investment of €1.5 billion.
In Figure 2, the slope of the consumption line is equal to the marginal propensity to consume.
The first-round effect is that the fall in investment cuts aggregate demand by €1.5 billion. But lower spending also means lower production and lower incomes, and firms will fire workers as a result, leading to a further decline in spending.
The term c1 gives the effect of one additional unit of income on consumption, called the marginal propensity to consume (MPC).
The new aggregate demand line - This goes through point Z and shows the new goods market equilibrium of the economy following the investment shock
aggregate consumption 𝐶 = autonomous consumption + consumption that depends on income = 𝑐0 + 𝑐1 𝑌
Following the investment shock, the intercept of the line has moved down by €1.5 billion, causing a parallel shift in the aggregate demand line. Output has fallen by €3.75 billion, more than the fall in investment of €1.5 billion: this is the multiplier process.
In this case, the multiplier is equal to 2.5, because the total change in output is 2.5 times larger than the initial change in investment.
We assume that aggregate consumption spending has two parts:
A fixed amount: How much people will spend, independent of their income. This fixed amount, also known as autonomous consumption, is shown as c₀ on the vertical axis of Figure 2.
A variable amount: This depends on current income, and is an upward-sloping red line in Figure 2.
We call the model of aggregate demand that includes the multiplier process the multiplier model. This is a summary:
A fall in demand leads to a fall in production and an equivalent fall in income: This leads to a further (smaller) fall in demand, which leads to a further fall in production, and so on.
The multiplier is the sum of all these successive decreases in production: Eventually, output has fallen by a larger amount than the initial shift in demand. Output is a multiple of the initial shift.
Production adjusts to demand: Firms supply the amount of goods demanded at the prevailing price. When demand falls, firms adjust production down. The model assumes that they do not adjust their prices.
2
If the economy is not characterized by spare capacity and constant wages, the multiplier will be smaller than what we find here.
We begin with a simple model that excludes the government and foreign trade. In this model, there are two types of expenditure:
Consumption
Investment
If k is the multiplier, we have:
𝑘=(1+𝑐1+𝑐21+…+𝑐𝑛1)
Now multiply both sides by (1 – c1) to get:
𝑘(1−𝑐1) = 1−𝑐𝑛+11
Now divide again by (1 − c1):
𝑘=(1−𝑐𝑛+11) / (1−𝑐1)
As n gets large, assuming c1 < 1, the numerator tends to 1. So, in the limit:
𝑘=1 / (1−𝑐1)
In the example, the marginal propensity to consume is, on average, 0.6. This implies that the multiplier is equal to:
1 / (1−𝑐1) = 1 / (1−0.6) = 2.5
Unit 3
The dotted line from point B shows the level of output that would have been observed in the business cycle trough if the usual multiplier process had been at work.
But the downturn was made much worse because there was a fall in the demand for consumer goods, even by those who kept their jobs.
Point A shows the initial situation of the economy in the third quarter of 1929. There was then a fall in investment. This shifts the aggregate demand curve from the pre-crisis to the crisis level.
Consumption was cut back through two mechanisms:
The shift from A to B: As output and employment fell, some households cut spending on housing and consumer durables because they were credit-constrained, and therefore unable to borrow in the deteriorating conditions. Some economists have estimated that the size of the multiplier at the time was about 1.8.
The shift from B to C: Even households that remained in work cut back spending because it became increasingly clear that the downturn was the new reality, not a temporary shock. This shifted the consumption function down and pulled the economy further into depression from B to C in Figure 6.
6
Explanations for the fall in autonomous consumption in the US:
Uncertainty
Pessimism and the desire to save more
The banking crisis and the collapse of credit
The fall in output and employment during the Great Depression highlights two ways in which aggregate consumption might fall—credit constraints in the multiplier process, and changes in wealth relative to target wealth.
7
If this adjustment involves precautionary saving, it is modelled as a fall in autonomous consumption.
In Figure 7 we extend the concept of wealth to broad wealth so as to include the household’s expected future earnings from employment, known as the value of its human capital
When something happens to affect the stock of the household’s wealth relative to this target, it reacts by either increasing or decreasing its savings to restore wealth back to its target level.
Follow the analysis in Figure 14.7 to see the composition of the household’s broad wealth, which is equal to the value of all its assets, minus its debt (which we assume is a mortgage on the house).
As we shall see:
If target wealth is above expected wealth: The household will increase savings and decrease consumption.
If target wealth is below expected wealth: The household will decrease savings and increase consumption.
A shift in aggregate demand can be caused by a shift in autonomous consumption, represented by the term c₀ in the aggregate consumption function, C = c₀ + c1Y
8
Consumption and saving behaviour can also shift the aggregate demand curve.
In early 1929, how would a household with the wealth position shown in column A of Figure 8 have interpreted news about factory closures, the collapse of the stock market, and bank failures? How would it have adjusted spending on consumer durables, housing, and non-durables? Answers to these questions help tell us why the Great Depression happened.
Before the Depression: Viewed from early in 1929 (column A in Figure 14.8), households are shown as making consumption decisions in line with their expectations: total wealth is equal to target wealth.
The Depression: By late 1929 (column B), the downturn was underway and beliefs had changed. With job losses throughout the economy, households revised expected earnings downward. Falling asset prices (of shares and houses) reduced the value of the household’s material wealth. The result was a gap between the household’s target wealth and expected wealth. This helps to explain the cutback in consumption by households who could (and in an ordinary downturn, would) have helped to smooth a temporary fall in aggregate demand. Instead, these households increased their saving. This fall in autonomous consumption is part of the explanation for the downward shift of the aggregate demand curve from crisis to trough in Figure 6
The financial accelerator, collateral, and credit constraints: Changes in household wealth affect consumption through another channel. In Unit 10, we saw that having collateral may enable a household to borrow. An important example is the case of home loans, where the bank extends a loan using the value of the house as collateral. If the value of your house falls, the bank will be willing to lend less, making you more credit-constrained, which may reduce your consumption.
A shock to investment shifts the aggregate demand curve, and is transmitted through the economy as households adjust their spending in response to changes in income.
The same mechanisms are at work if house prices increase, which will tend to increase consumption:
For those who are not credit-constrained: If the value of your house increases, this improves your net worth and raises your wealth relative to target. We would predict that this would reduce your precautionary savings, increasing consumption.
For those who are credit-constrained: A rise in the price of your house can lead you to increase your consumption spending because the higher collateral enables you to borrow more.
Consumption is the largest component of GDP in most economies.
Unit 4
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Unit 5