ECON 1113 1st Edition Lecture 23 Outline of Last Lecture I Monetary Policies to Combat Unemployment II Monetary Policies to Combat Inflation III The Government Budget Deficit Outline of Current Lecture I The Government Budget Deficit continued A The Short Run Effects B The Long Run Effects II Keynesian versus Monetarist Current Lecture I The Government Budget Deficit continued A Review 1 Government spending G taxation T budget deficit 2 Financed by the Treasury not the Fed by selling or supplying Treasury Bonds in the Open Market B The Short Run Effects 1 Suppose G increases from G0 to G1 or delta G so that now G T creating a deficit of 1trillion 2 The Treasury finances the deficit by selling bonds in the Open Market 3 Fiscal policy is not as powerful as the basic Keynesian model 4 The reduction in investment delta I caused by a deficit financed increase in G delta G is called crowding out 5 Bond Market a Horizontal axis quantity of bonds time b Vertical axis price of bonds in dollars bond c Demand curve and supply curve present d Equilibrium of the two curves gives original bond price which also implies an interest rate e Due to the Treasury selling bonds the supply curve moves to the right lowering bond prices which subsequently affects interest rates 6 Money Market a Horizontal axis quantity of money time b Vertical axis interest rate in percent These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute c Money demand curve and vertical money supply curve present d Equilibrium of the two curves gives original interest rate which also implies a bond price e Due to the Treasury selling bonds the money demand curve moves to the right raising interest rates which subsequently affects bond prices f The money supply curve is controlled by the Fed not the Treasury 7 Investment Market a Horizontal axis investment spending in dollars b Vertical axis interest rate in percent c Marginal efficiency of investment curve present as dependent upon the interest rate equilibrium of the money market diagram d When the interest rates increase this lowers investment spending I by change of delta I 8 Domestic Income or Product a Horizontal axis nominal GDP in dollars b Vertical axis planned total expenditure in dollars c Keynesian aggregate supply 45 degree curve from origin and total expenditure curve present d Equilibrium of the two curves gives the equilibrium of nominal GDP e Delta G causes the total expenditure curve to increase by that amount initially however the negative delta I value lowers the TE level toward the original TE curve f The same pattern applies to the Y values along the horizontal axis 9 Conclusions a Increases in G fiscal expansion policies that are finance by Treasury borrowing do not stimulate increase Y as much as the simple Keynesian model would suggest b Deficit financed increases in G lead to changes in the composition of total spending in the economy with more G and less private I C The Long Run Effects 1 Deficit induced crowding out of private I results in fewer capital goods being produced over time and fewer capital goods ceteris paribus leads to slower economic growth a Production Possibilities Analysis Diagram a Horizontal axis consumer goods C b Vertical axis capital goods K c The production possibilities curve is a negative concave up line connecting the horizontal and vertical axes II d Without a budget deficit the point of production at full employment on the curve will exemplify the production of more capital goods than with a budget deficit e Over time a PPC with a budget deficit in place will grow less quickly than a situation without such a deficit 2 Deficits reduce the efficiency of the economy overtime by transferring resources from the private sector to the government or public sector a Public sector decision makers have weaker incentives to maximize outputs and or minimize costs than their private sector counterparts b In the private sector higher outputs and lower costs result in bigger profits which the decision makers get to keep c In the public sector such efficiencies are not as directly rewarded d Example a Output target educate 500 student semester b Department of Economics budgeted at 100 000 c Change target output to 600 without changing budget no incentive d In the private sector instructor gains a raise e Milton Friedman People do not spend other people s money as carefully as they spend their own Keynesian versus Monetarist