Government Spending and Price Levels - Term Paper Example

? Government Spending and Price Levels Contents ISLM Model 3 Keynesian model of cross planned expenditure 5 Phillips Curve 7 Imperfect Information 8 Monetary effects on output, work, and investment 13 References 15 ISLM Model The total supply of goods in the economy is denoted by Y. The case for a closed economy is considered here. In a closed economy net exports are always zero. According to the circular flow diagram, Y=C+I+G, where consumption= C, Investment=I and Government purchases= G. The equation can be rearranged as Y-C-G=I The left hand side denotes the savings made by the consumers while right hand side shows the investment. A part of the consumer’s income is taxed. Let the fixed rate of tax be t. Then the savings can be written as S = (1-t)Y-C+ tY-G. Consumption can be written as C=c(1-t)Y, c is the marginal propensity to consume. Therefore, S=(1-c)(1-t)Y-tY-G. Let us concentrate on the monetary side. The assumption here is that the supply of money (M) is determined by the central bank. The consumer’s decision on their holdings is the sole driving force behind the demand for money. The consumers allocate a part of their wealth as currency and the remaining part in the form of bonds. It is expected that an increase in the interest rate will induce consumers to keep a smaller proportion of their income as currency which, in turn, reduces the demand for money. An expansionary monetary policy will reduce the interest rate and increase output in the short run while an expansionary fiscal policy will do just the opposite (Weins, n.d.). A reduction in marginal propensity to save will increase the rate of interest along with the output. A shock of drop in consumer’s confidence will have its effects on savings, investment, money supply and demand assuming rate of interest and output remains constant. (Massachusetts Institute of Technology, 2009, p. 1) The original point A is still equilibrium of the money market. Therefore, the LM curve must include point A. But investment is same as before but savings has increased. So the point A which originally was in the IS curve is now a point where S>I. If there is movement to the right from A, then interest rates and investments are same and savings increases due increase in output. This will make the savings even bigger and so the actual movement should have been to the left of A. (Massachusetts Institute of Technology, 2009, p. 1) An increase in money supply will have no effect on savings and investment or demand for money. Therefore, savings and investment will remain the same and so IS curve must include point A. Keynesian model of cross planned expenditure The cross planned expenditure is given by Ep. Ep= C+I+G. Investment Demand Schedule (Cooke, 2010, p. 10) Ip is planned investment. Ep=E(Y,r,G,T)=C(Y-T)+Ip(r)+G Keynesian Cross (Cooke, 2010, p. 12) Government Spending (Cooke, 2010, p. 13) Phillips Curve The relationship between inflation and unemployment is represented through Phillip’s curve. There is a relation between the prices charged by the company and the wages. (Hoover, n.d.) Suppose the government plans for an expansionary fiscal and monetary policy in order to bring the unemployment below the natural rate. This results in increase in demand conditions. The firms are encouraged to raise the prices. The rate of increase in prices is faster than that anticipated by the workers. Workers in this situation are likely to suffer from money illusion. They witness a rise in the wage rate and thereby supplies more labor. This results in fall unemployment rate (Liaudes, 2005, p. 31). Imperfect Information The real economy is significantly affected by monetary policy in the short run. The non-neutral effects of monetary policy rise because of temporary nominal price rigidities. The short term interest rate is taken as the instrument of monetary policy. The Central Bank should adjust the nominal rate so that it cannot offset the movement in expected inflation. The nature of the disturbances has a role to play in this part. The Central Bank may not have sufficient information regarding the state of the economy while setting the interest rate. Collection of data is time consuming and sampling is not considered as perfect. Suppose the Central Bank is unaware of the values of output, inflation or any of the shocks. Let the information set be denoted by ?t at the time of setting up the interest rate (t). The target variables are denoted by xt and ?t. Choose xt and ?t to maximize for each period: Subject to Taking as given Ft and ft, where and ft= The optimality condition is Whenever the rate of inflation is above the target, demand has to be lowered by raising the rate of interest. A tradeoff in the short run exists between inflation rate and variability in output as cost push inflation is present. The Central Bank will be able to hit the targets of output and inflation by setting xt=0 for all t. The optimal policy calls for adjustment in the rate of interest that will perfectly offset demand shocks. By keeping the nominal rate as constant, the policy calls to accommodate shocks to potential output perfectly. A short run tradeoff between output and inflation is not forced by demand (Clarida, Gali, & Gertler, 1999, p. 24). Producers and consumers have knowledge on local price level, Pt(z) but are uncertain about the average price level, Pt. The idea of rational expectation is taken into account. The model assumes that if people are unaware of something, they tend to form estimates of the variable. People are unable to forecast the price level before the time period t, i.e. they are uncertain of whether the price level will be higher or lower than average level. Past information and knowledge affect the expectations of the general price level. One can think of this expectation as incorporating information about the quantity of money and about variables that influence the aggregate real demand of money. People are able to get useful information about the variables from the lagged values of prices and money. Response of local market to the perceived relative price (Barro, n.d. p. 523) The above figure shows the supply and demand conditions when people do not observe the price levels. It is assumed that the expected real interest rate, rte, and plot the perceived relative demand price, Pt(z)/Pte, on the vertical axis. A sudden increase in the stock of money will enable a person to overestimate the relative price that he faces and reacts to raising the goods supplied and lowering the goods demanded for consumption. The rise in Pt(z)/Pte implies a rise in [Pt+1(z)/Pt+1]e and therefore, expansion of goods demanded for investment. Effect of a surprise increase in money on the typical commodity market (Barro, n.d. p. 524) The expected real interest rate, rte equals nominal rate, Rt. The expected rate of inflation for the general price level is ?te. For any given value of expected real interest rate, the above figure shows that the supply of goods would exceed the demand in the typical market. This excess supply will lead to a change in the expected real interest rate. Clearing the typical commodity market after a surprise increase in money (Barro, n.d. p. 525) The supply of goods prevails along the line labeled as B, where Pt(z)/Pte>1. This situation prevails in a typical commodity market after a positive monetary shock if the expected real interest rate does not change. If the expected real interest rate falls, then the demand curve will shift to the right while the supply curve will shift to the left. A fall in the expected real interest rate motivates people to consume and invest more and to work and produce less. Although people still perceive a high relative price in the typical market, this reduction in the expected real interest rate allows the market to clear. Monetary effects on output, work, and investment The above figure shows that output Yt (z) rises in a typical market, although the sign of this change is generally ambiguous. A number of forces act on local output. First, the high price ratio, Pt(z)/Pte increases money supply but reduces consumption demand. Second, the increase in perspective relative price, [Pt+1(z)/Pt+1]e, stimulates investment. Finally, a decrease in the expected real interest rate boosts investment and consumption but discourages supply. The presumption is that output increases in the typical market depends on a strong positive effect from the perspective relative price on investment demand. If the response is strong, then a positive monetary shock will raise investment, output and work effort. Since the results apply in a typical market, it shows up also in the aggregates of investment, output and work (Aiyagari, Rao, Christiano, & Eichenbaum, 1992). During recessions, variables such as output, employment and investment tend to be depressed for periods of a year or more. One may be interested to know whether the theory can account for the effects of monetary disturbances on real variables. Misperception about general price level persisting for a long time is one such possibility. But the outcome is implausible. The theory has argued that households would have incomplete information about the prices in other markets, the general price level and the aggregate quantity of money. But households presumably receive enough information about the prices and they would not repeat the same mistake for very long. Thus, it is implausible that the persistence in these errors would be as long as the persistence of booms and recessions. References Massachusetts Institute of Technology. (2009). Simple notes on ISLM Model. Retrieved from: http://web.mit.edu/rigobon/www/Robertos_Web_Page/15.012_files/ISLM.pdf. Cooke, D. IS-LM Model. (2010) Retrieved from: http://www.tcd.ie/Economics/staff/dcooke/EC2010_T1.pdf. Hoover, K. Phillips Curve. n.d. Retrieved from http://www.econlib.org/library/Enc/PhillipsCurve.html. Clarida, R., Gali, J., & Gertler, M. (1999). The science of monetary policy: A new Keynesian perspective,1661-1707. Barro, R., (1987). Government spending, interest rates, prices, and budget deficits in the United Kingdom, 1701–1918. Journal of Monetary Economics, 221-247. Aiyagari, R., Christiano, L., & Eichenbaum, M. (1992). The output, employment and interest rate effects of government consumption. Journal of Monetary Economics, 73-86. Weins, E. (n.d.) Macroeconomics aggregates, markets and agents. Retrieved from http://www.egwald.ca/macroeconomics/basicislm.php. Liaudes, R. (2005). The Phillips Curve and long term unemployment. Retrieved from http://www.ecb.int/pub/pdf/scpwps/ecbwp441.pdf. Barro, Robert J., & Charles J. (2010). Macroeconomic effects from government purchases and taxes. Harvard Working Paper. Caldara, D., & Kamps, C. (2006). What are the effects of fiscal policy shocks? A VAR-based comparative analysis. Read More