Econ 219 Spring 2006
Lecture #9
Two period economic model: equilibrium effects
•
Temporary increase in government purchases:
– Current government expenditure increases, while future G’ stays constant
– There are two effects:
• Effect on output supply
• Effect on output demand
– Increase in G Æ taxes must increase (in present value) Æ lifetime wealth falls:
• Leisure decreases (normal good) Æ supply of labor increases
Æ output supply increases
• Consumption falls (normal good), and G increases (we started with that!)
• Overall net demand for goods decreases less than increase in G (MPC < 1)
Æ output demand increases
Two period economic model: equilibrium effects
•
What are equilibrium effects?
– Interest rate increases:
• Small effect on output supply (lifetime income change is small)
• Large effect on output demand (C decrease is small compared to increase in G)
– Current consumption decreases:
• Increase in present value of taxes reduces consumption
• Increase in equilibrium interest rate reduces consumption
• Increase in current income increases consumption (small effect due to temporary
increase in G)
– Investment decreases:
• Interest rates increase
– Increase in G results in crowding out of private consumption and investment:
• Increase in G decreases future productivity of economy!
– Employment increases, wage rate falls
Figure 9.19 A Temporary Increase in Government Purchases
Two period economic model: equilibrium effects
•
Permanent increase in government purchases:
– Both, current and future government expenditure increases by
– Two effects in current period:
• Decrease in lifetime wealth Æ C decreases
• Direct increase in G Æ increase in demand for goods
– No net impact on demand for goods
• Permanent income hypothesis: decrease in permanent income by
decreases consumption by the same amount
– Labor supply increases (decrease in lifetime wealth) Æ Output supply increases
– Interest rate decreases
Two period economic model: equilibrium effects
•
Interest rate decreases:
– Investment increases
•
Equilibrium output increases
•
Consumption:
– Consumption decreases due to decrease in lifetime wealth (crowding out effect)
– Decrease in interest rate increases consumption
– Increase in current income increases consumption (wealth effect)
•
No crowding out results: Investment increases!
•
Employment increases:
– Labor supply increases due to decrease in lifetime wealth
– Labor supply decreases due to intertemporal substitution (fall in the interest rate)
Figure 9.20 A Permanent Increase in Government Purchases
Comparing permanent and temporary increase in G
•
Temporary increase in G:
– Large output demand effect + small output supply effect
•
Permanent increase in G:
– Large output supply effect
•
Which increase affects output more, depends on relative significance of
these effects
•
To find a definite answers we look at the data
•
Theory only guides us what to be looking for!
Two period economic model: equilibrium effects
•
Decrease in current capital stock (K):
– Current MPL decreases Æ demand for labor decreases
Æ Output supply decreases
– There is an increase in investment demand due to higher future MPK:
Æ output demand increases
– Real interest rates increase:
• This is another effect on investment
• Overall: investment must increase to be consistent with diminishing MPK
– Effect on current output is ambiguous
– Current consumption falls (interest rate increases)
– Equilibrium employment (ambiguous):
• Labor supply increases (intertemporal substitution effect)
• Labor demand decreases (MPL falls)
• Equilibrium wage falls
Figure 9.22 The Equilibrium Effects of a Decrease in the Current Capital
Stock
Two period economic model: equilibrium effects
•
Increase in current total factor productivity (z):
– MPL and MPK increase
– Demand for labor increases Æ output supply increases
Æ equilibrium output increases and interest rates fall
– Labor supply decreases (intertemporal substitution effect)
Æ overall: wage rate will increase, effect on equilibrium employment is
ambiguous
– Data shows us that intertemporal substitution effect is small so that employment
has a tendency to increase
– With increase in employment and increase in productivity output will increase
also
– Falling interest rates increase current consumption and investment demand
– Increasing current income adds to increasing current consumtion
Figure 9.23 The Equilibrium Effects of
an Increase in Current Total Factor Productivity
Comparison with the data
•
Procyclical:
–
–
–
–
–
Consumption
Investment
Employment
Real wage
Labor productivity
•
This is exactly what the model predicts in case of productivity shock!
•
There is a consensus that shocks to total factor productivity are the driving
force of business cycles
Two period economic model: equilibrium effects
•
Increase in future total factor productivity (z’):
– Future MPK increases Æ investment demand increases
– In equilibrium current output increases and interest rates increase
– Consumption tends to decrease due to increasing interest rates, while it tends to
increase due to increasing current income
– Investment must increase (if there is no increase in investment, there is no
impact of the shock)
– Increasing interest rates increase labor demand:
• In equilibrium employment increases
• Equilibrium wage decreases
Figure 9.24 The Equilibrium Effects of
an Increase in Future Total Factor Productivity