UNIT 1: THE CAPITALIST REVOLUTION
PRINCIPLES OF ECONOMICS
Practical Session N°12
José Elías Durán Roa
A. Solution to Problem Set 11
B. Conceptual Questions Problem List 11 [Discussion]
OUTLINE
Solution to Problems
Problem List 11
Problem N°1
Assume the economy is in a recession. The government has a high level of debt and wants to set a balanced budget, that is, G = T. How can the government achieve a fiscal stimulus effect on GDP whilst keeping the budget balanced?
a
Show how this is possible in a multiplier diagram, ensuring that you label the relevant intercepts and angles. Make the diagram sufficiently accurate so that the exact size of the multiplier is visible.
Scenario 1
Scenario 2
Scenario 3
Remember:
Autonomus consumption
Problem N°1
Explain in words how the government can achieve such a fiscal stimulus effect whilst keeping the budget balanced.
b
The key to the balanced budget multiplier lies in the fact that the multiplier applies to the initial change in spending and that consumption takes place out of disposable (i.e. post-tax) income. Hence, a tax rise (or cut) triggers the multiplier because it causes a change in spending in the form of consumption. But since consumption takes place out of disposable income, only a fraction of the tax change is converted into an initial change in spending. In the example above, we see that the balanced budget effect is the net outcome of two changes.
BLACKBOARD
c
Derive the balanced budget multiplier using algebra. (Hint: You will need to write down expressions for the change in GDP associated with a change in both G and T and set these equal to each other.)
Problem N°1
Comment briefly on any disadvantages you see with the use of this balanced budget fiscal stimulus.
You can make the following assumptions:
Problem N°1
d
The multiplier may be less than one, because people can cut consumption based on psychological effects of the tax increase. It could also be greater than one if higher-income people cut their consumption by relatively less than lower-income people. In certain circumstances it might be impossible for the government to borrow (for example, if the debt-to-GDP ratio is high and lenders fear a sovereign debt crisis).
Lastly, there are political issues related to changes in taxation: the political climate may not permit government to increase taxation, because most of the benefits of this plan would go to the minority of the unemployed, while the extra taxes would however be paid by the majority in employment. There might also be political objections that the actual expenditures benefit one group rather than another.
Consider the multiplier model:
Compare two economies, which differ only in their share of credit constrained households but are identical otherwise. In which economy is the multiplier larger? Illustrate your answer using a diagram.
a
The consumption line will be steeper (and the multiplier larger) in the economy with the greater proportion of credit-constrained households (whose consumption largely varies with income, compared to households with credit access).
Problem N°2
Here I´m increasing the investment
On the basis of your comparison of the two economies, would you expect the multiplier in an economy to vary over its business cycle?
b
In a recession, banks are more reluctant to provide loans. Households are thus more credit constrained and the multiplier is larger. On the other hand, in a boom banks tend to be more relaxed with lending, credit constraints are less severe, the multiplier is thus smaller.
Problem N°2
The diagram depicts a consumption function of an economy, where C is the aggregate consumption spending, Y is the current income of the economy, and c0 is the fixed (or autonomous) consumption such that c0 > 0. Assume that households that are not credit-constrained would completely smooth their consumption. Which of the following statements is correct?
Other Problems N°1
a
b
If a higher proportion of households have "weakness of will", then the aggregate consumption line would be flatter.
c
If the current income falls to zero, there will be zero consumption.
d
In this case, all households can completely smooth consumption and would not react to temporary changes in income, so the aggregate consumption line would be horizontal.
In a credit crunch, more households would become credit-constrained so their marginal propensity to consume would increase. Therefore the line would become steeper.
“Weakness of will” means that when there is an expected fall in the income, the households are less likely to adjust their consumption ahead of the fall, in order to build up some savings so that they can smooth consumption. In this case their marginal propensity to consume would be higher, implying a steeper aggregate consumption line.
c0 > 0 means that even if the current income is zero, the households will consume a strictly positive amount.
Other Problems N°2
The multiplier is given by 1 / (1 – c1).
a
b
The boost in the economy’s output is the same, regardless of whether the aggregate demand shock comes from an increase in investment I or in autonomous consumption c0.
c
A larger c1 means a smaller 1 – c1, which in turn means a larger multiplier 1 / (1 – c1).
d
If c1 = 1/3, then a £1 million increase in investment would result in a £2 million increase in output, ceteris paribus.
When c1 = 1/3, then 1 / (1 – c1) = 1.5, and therefore a £1 million increase in I would result in a £1.5 million increase in Y.
REMEMBER
Other Problems N°3
In the US and the UK, loans are widely available based on a rise in home equity. Additionally, unlike in France and Germany where large down-payments (as a percentage of the house price) are required, in the US and the UK only small down-payments are required for house purchases. On the basis of this information, which of the following statements is correct for the US and the UK when there is a rise in housing prices.
There is a positive financial accelerator effect for the existing homeowners who are credit-constrained.
a
There would be no effect on the consumption of existing homeowners who are not credit-constrained.
b
Aspiring homeowners are likely to increase saving and reduce their consumption more than they would in France and Germany.
c
A rise in housing prices is likely to dampen consumption in the US and the UK
d
For credit-constrained homeowners, an increase in their house price can increase consumption spending because the higher collateral would enable higher borrowing.
For those for are not credit-constrained, a rise in housing prices would improve their net worth and raise their wealth relative to target levels. This leads to reduced precautionary savings, increasing their consumption.
As only small down-payments are required, the negative effect on the consumption would be smaller in the US and the UK than in France and Germany.
As opposed to France and Germany, the positive financial accelerator effect and the positive collateral effect are likely to outweigh the effect of the increased saving by the aspiring homeowners, resulting in higher consumption.
Which of the following statements regarding the multiplier is correct?
Other Problems N°4
a
If two countries were identical except for the share of credit-constrained households, then the country with the higher share would have a smaller multiplier.
A higher share of credit-constrained households means a higher marginal propensity to consume. Therefore the multiplier will be larger.
b
The multiplier is constant over the business cycle.
The proportion of credit-constrained households would vary over a business cycle. The multiplier would therefore vary accordingly.
An increase in the level of exports leads to a higher multiplier.
c
The multiplier in an open economy depends on the marginal propensity to consume, the marginal propensity to import, and the income tax rate. The level of exports does not affect the multiplier (it affects the level of the aggregate demand curve, but not the slope).
d
Taxation and imports are “leakages” from the circular flow of income, which reduce the size of the multiplier..
Some household income goes back to the government via taxes, and some is spent on goods and services produced abroad. These both reduce the effect of government spending on the domestic economy.
Conceptual Questions
Problem List 11
Conceptual Problem N°1
Conceptual Problem N°4
Discussion A
Discussion B
In France and Germany, it is difficult for a household to increase its borrowing based on an increase in the market value of the house. In addition, large down-payments (as a percentage of the house price) are required for house purchases. On the basis of this information, how would you expect a rise in house prices in France or Germany to affect spending by households?
In the US or UK, loans are more easily available based on a rise in home equity and only a small down-payment is required. How would you expect your answer to question 1 to change when considering the US or UK? What do you conclude about the role of the financial accelerator in France and Germany compared with the UK and the US?
Conceptual Problem N°3
Conceptual Problem N°4
Discussion A
Discussion B
Consider the three methods discussed in this unit that have been used to estimate the size of the multiplier: the Mafia-related dismissals in Italy, the stimulus highway spending in the US, and wartime defence spending in the US. Why do you think estimates of the size of the multiplier vary? Use the material in this unit to support your explanation.
In an article from August 2014, ‘The Fall of France’(http://tinyco.re/7111032), Paul Krugman criticizes the austerity policy implemented in France. Use what you have learned about the fiscal multiplier to explain why, in Krugman’s opinion, fiscal austerity in France (and more generally in Europe) would fail (explain carefully what you think Krugman means by ‘fail’).