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MIT 14 02 - Lecture Notes

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Introduction to Macro Policy and ModelsFocus TodayThe Central ModelSlide 4A First ModelSlide 6The Reduced Forms of the 7 Behavioral EquationsThe GNP Reduced Form Equation is a Useful SummarySlide 9If interest rates are fixed at i1, reducing G cuts GNP by a “multiple” of GWhat if lower GNP implies lower i due to Fed or market reactions?Slide 12What if the Fed has a strict inflation target and thus a fixed GNP target?Deficit Reduction Will Change the EconomyBuild a ModelSlide 16Slide 17Slide 18Slide 19BRINNER1902mit03.pptIntroduction to Macro Policy and ModelsFiscal Policy:Government Taxation,Spending and DeficitImpacts on the MacroeconomyBRINNER2902mit03.pptFocus TodaySetting up the questions regarding fiscal policyUnderstanding preliminary answers and their basisApplying this knowledge to a contemporary issue, the emergence of a budget surplus following huge deficitsBRINNER3902mit03.pptThe Central ModelThe Key Behavioral Actors:–Domestic Households, buying consumer goods and housing–Domestic Businesses, buying machines or building factories & offices or stocking goods in inventory–Foreign buyers and suppliers–Some Government Agencies Whose Behavior is “Regular”BRINNER4902mit03.pptThe Central ModelThe Key Exogenous Influences–Domestic Government tax, transfer and purchasing decisions (that change on an irregular basis)–Domestic Central Bank “control” of the money supply and interest rates–The International Counterparts to these–International Commodity Markets and Cartel BehaviorBRINNER5902mit03.pptA First Model7 Endogenous/ Behavioral Variables (Including ID’s) and 7 Equations–Consumer Spending : C=f ( YD, i ) –Business Spending : I = f ( d GNP, i)–Imports : M = f ( C, I , i )–Exports : X = f ( GNPW, i )–Total Output=Spending : GNP = C+I+X-M+G–After-tax Income : YD = GNP - T–Inflation : R P = f ( GNP )BRINNER6902mit03.pptA First Model4 Exogenous/Policy Variables–Government Purchases : G–Taxes (Net of Transfers) : T–Interest Rate : i–Rest-of-World Demand : GNPWOmitted Variables–Wealth–Supply CapacityBRINNER7902mit03.pptThe Reduced Forms of the 7 Behavioral EquationsC=C ( G, T, i, GNPW )I = I ( G, T, i, GNPW ) M = M ( G, T, i, GNPW )X = X ( G, T, i, GNPW )GNP = C+I+X-M +G= GNP ( G, T, i, GNPW )YD = GNP - TRP = RP ( GNP) = RP( G, T, i, GNPW )BRINNER8902mit03.pptThe GNP Reduced Form Equation is a Useful SummaryGNP = C+I+X-M +G= GNP ( G, T, i, GNPW )i=INTERESTRATEGNP2=GNP(G2,T1)GNP1=GNP(G1,T1)GNP=NATIONAL SPENDING/OUTPUTBRINNER9902mit03.pptThe GNP Reduced Form Equation is a Useful SummaryGNP = C+I+X-M +G= GNP ( G, T, i, GNPW )Why does GNP=GNP(i) slope down?Both Consumers (C) and Businesses (I) spend less if credit costs are higher.Higher interest rates tend to boost the exchange rate, which cuts Exports (X) and boosts Imports (M)How do changes in G, T shift GNP(i)?For any given C or I , less G subtracts from GNP, and sets up multiplier, feedback effectsExtra T reduces YD which reduces C and thus cuts GNP.BRINNER10902mit03.pptIf interest rates are fixed at i1, reducing G cuts GNP by a “multiple” of G GNP = C+I+X-M +G= GNP ( G, T, i, GNPW )i=INTERESTRATEGNP2=GNP(G2,T1)GNP1=GNP(G1,T1)GNP=NATIONAL SPENDING/OUTPUTi1GNP2GNP1BRINNER11902mit03.pptWhat if lower GNP implies lower i due to Fed or market reactions?i=INTERESTRATEGNP2=GNP(G2,T1)GNP=NATIONAL SPENDING/OUTPUTi=i(GNP)BRINNER12902mit03.ppti1i2GNP2GNP1What if lower GNP implies lower i due to Fed or market reactions?BRINNER13902mit03.pptWhat if the Fed has a strict inflation target and thus a fixed GNP target?i1i2GNP2GNP1BRINNER14902mit03.pptDeficit ReductionWill Change the EconomyBut it might not boost unemployment.What sectors will offset lower G?What does the Fed need to do?What might change the equilibrium level of GNP?Who gains and loses, considering incomes, wealth, skill-building?Is a constitutional amendment necessary?BRINNER15902mit03.pptBuild a ModelBuild a basic model of an economy from the following description:1. BusinessesFor each $100 dollars of revenue (GDP) they receive, they have costs and profits of: GDP$70 wages W$30 profit, and this is paid as dividends to consumer households Profit=DividendThey buy new plant and equipment equal to profits each year, plus I$10 extra(less) for each 1 percentage point the interest rate is below(above) 5%. r (interest rate)Hint: r, the interest rate, enters the equations as a whole number like 4,5, or 6 and not .04, .05, .06.2. Consumers Pay a flat 1/3 of their gross wages and profits in taxes. W, Profit, TBuy consumer goods equal to 75% of their after-tax wage and dividend income, EXCEPT....C...they reduce purchases by $20 for each 1 percentage point interest rates exceed 5% r (interest rate)( and symmetrically raise purchases when rates fall below 5%)Hint: r, the interest rate, enters the equations as a whole number like 4,5, or 6 and not .04, .05, .06.3. GovernmentThe Government buys $250 in goods. GNo taxes other than income taxes are collected. T4. Foreign Buyers and Sellers are excluded from this first economy.BRINNER16902mit03.pptBuild a ModelBehavioral EquationsT=(1/3)*(W+D)C=(3/4)*(W+D-T)-20*(r-5)=((3/4)*(2/3))*(W+D)-20*(r-5)W=.7*GDPD=.3*GDPI=.3*GDP-10*(r-5)IdenityGDP=C+I+GReduced form equation: the endogenous variable is a function of only exogenous variablessubstitute for W, D to derive the C reduced form equationC = ((3/4)*(2/3))*(W+D)-20*(r-5)= ((3/4)*(2/3))*(.7*GDP+.3*GDP)-20*(r-5) = .5*GDP - 20r + 100simply the I function to derive the I reduced form equationI = .3*GDP-10*(r-5)= .3 * GDP - 10*r + 50Add together to obtain the GDP reduced form equation----the "IS" curveGDP = .5*GDP - 20r + 100 + .3 * GDP - 10*r + 50 + G= .8* GDP - 30 r + 150 + G= 750 + 5 G -150 rChange G in Year 4 and note the resultsBRINNER17902mit03.pptBuild a ModelGDP = .5*GDP - 20r + 100 + .30 * GDP - 10*r + 50 + G= .80* GDP - 30 r + 150 + G= 750 + 5 G -150 rChange G in Year 4 and note the resultsYear 1 2 3 4 5 6 7 8 9 10 C 625 625 625 500 500 500 500 500 500 500 I 375 375 375 300 300 300 300 300 300 300 G 250 250 250 200 200 200 200 200 200 200 GDP 1,250 1,250 1,250 1,000 1,000 1,000 1,000 1,000 1,000 1,000 W 875 875 875 700 700 700 700 700 700 700 D 375 375 375 300 300 300 300


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MIT 14 02 - Lecture Notes

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