Macroeconomic theory policy phần 3 pptx

The first way is to suppose that all output y isproduced by the private sector and that the government sector purchases theoutput it desires g from the private sector.. In this case, one

FIGURE 2.12 General Equilibrium

2.B SCHUMPETER’S PROCESS OF CREATIVE DESTRUCTION 53

Creative destruction is not a steady process While the forces of creativedestruction are always present in a capitalist system, the process often occurs

in intense bursts - "discrete rushes," as Schumpeter termed them, "which areseparated from each other by spans of comparative quiet." Historically, we ex-perienced a period of intense creative destruction in the late 19th and early 20thcenturies, and we are now living in the midst of another At the turn of the lastcentury, the industrial revolution had transformed agricultural economies andwas radically changing most people’s lives New industrial powers–the UnitedStates and Germany–were developing to challenge the established economies ofEngland and France Today, the ongoing revolution in technology and commu-nications is creating new industries and transforming or eliminating old ones.New economies are emerging that provide new markets as well as new sources

of competition Corporate restructuring and privatization of government-ownedenterprises are widespread

Usually, one can only see what is being destroyed by this process; it is muchmore difficult to understand what is replacing it For example, it was easy

to see carriage and buggy whip manufacturers going out of business with theadvent of the automobile, but much harder to visualize the mega-industry thatwould emerge to replace them Similarly, as manufacturing declined in the U.S.during the latter part of the 20th century, the displacement of factory workerswas evident long before the creation of jobs in the service sector that reemployedthem

Although the process of creative destruction can create tremendous tunities for investors, it is often difficult to discern them early on, when themaximum benefit can be gained However, in our search for value, this is ex-actly what we strive to do for our clients

oppor-On a global level, those countries where capitalism and the forces of creativedestruction are permitted to flourish create more attractive opportunities for in-vestors than less dynamic economies Of course, the United States continues to

be the prime example of relatively unfettered capitalism at work, and the U.S.economy has been better able not only to withstand, but to thrive amid thecurrent forces of creative destruction–hence the sustained strong performance

of the U.S stock market in the 1990s However, there are other countries thatare also benefiting from the forces of creative destruction, most notably in Eu-rope Great Britain was the first to dismantle the government programs thathad hindered its economic growth As the rest of Europe follows suit, albeiteach country at its own speed, creative destruction will be at work restructur-ing old inefficient economies into more vibrant, growing ones In particular,Ireland, Italy, Portugal, and Spain, which have less rigid economic systems thanFrance and Germany, are learning to compete effectively in the global economy.The introduction of the euro and the emergence of Pan-Europeanism are alsoexpanding markets for companies able to compete effectively in this new envi-ronment, and the "creative destruction" of national currencies has given birth tothe Euro A few Latin American countries, most notably Argentina and Chile,are becoming free-market economies And in Asia, where we recently witnessedthe destruction of the old status quo, opportunities are beginning to emerge forinnovative companies

At the root of the creative destruction process are individual companies.They are the agents of change that develop new products, new technology, newproduction or distribution methods, new markets and new types of organizationthat will revolutionize the economy Companies that change the business modelfor their industry or develop a new paradigm significantly alter the competitivelandscape As Schumpeter says, "competition which commands a decisive cost

or quality advantage strikes not at the margins of the profits and the outputs

of the existing firms but at their foundations and their very lives."

We want to own companies that benefit from creative destruction Goodbusinesses that are constantly adapting to their changing environment and es-tablish a decided competitive advantage will generate strong returns for theirshareholders over a long period of time We search industries throughout theworld to find those companies that are transforming the terms of competition

in their field The forces of creative destruction in capitalism are not only theengine of economic growth; they also generate unparalleled investment oppor-tunities for astute investors

1 From Joseph A Schumpeter, History of Economic Analysis, edited from

a manuscript by Elizabeth Boody Schumpeter (New York: Oxford versity Press, 1963)

Assume that the government sector ‘demands’ g units of output, where g isexogenous There are two ways of viewing the production of output destinedfor the government sector The first way is to suppose that all output y isproduced by the private sector and that the government sector purchases theoutput it desires g from the private sector The second way is to suppose that thegovernment produces the output it needs by employing workers (public sectorworkers) If the government has access to the same technology as the privatesector, then either approach will yield identical results.

Before proceeding further, we need to ask the question: What is g used for?

In reality, government purchases are directed toward a wide variety of uses,including: bureaucratic services, in-kind transfers (e.g., school lunch programs,health-care services), military expenditures, and outright theft (politicians lining

55

their own pockets) For some types of expenditures (e.g., those expendituresthat are distributed free of charge to the general population), it would makesense to think of households viewing g as a close substitute for goods and servicesthat they might otherwise purchase from the private sector In this case, onecould model preferences as:

In this case, output that is purchased from the private sector and output that issupplied by the government are viewed as perfect substitutes by the household(e.g., as is likely the case with school lunch programs) If the school lunches sup-plied by the government do not exactly correspond to the lunches that parentswould pack for their kids on their own, then might instead specify u(c + λg, l),with λ ≤ 1 According to this specification, one unit of government supplied out-put is equivalent to λ units of privately purchased output as far as the household

is concerned

Alternatively, government expenditures may be allocated toward uses that

do not have very close substitutes in the way of market goods; e.g., military penditures or a national space program In this case, one might more reasonablymodel preferences as:

where λ ≥ 0 and v is an increasing and concave function According to thisspecification, households may value a national space program not for materialreasons but for ‘psychic’ reasons (e.g., national pride) On the other hand, ifhouseholds do not value such expenditures at all (e.g., if g is used to build aking’s castle, or used to finance an unpopular war), then one could specify λ = 0

In what follows, we will adopt the latter specification of preferences (3.2) forthe case in which λ = 0 As it turns out, the model’s predictions for economicbehavior will continue to hold even for the case in which λ > 0 (the only thingthat would change is the prediction for economic welfare) On the other hand,the model’s predictions concerning behavior will generally differ if we adopt thespecification (3.1)

As it turns out, in our model, the government fiscal policy will have no effect

on the equilibrium wage or profits; i.e., (w∗, d∗) = (z, 0) In general, this result

3.2 GOVERNMENT PURCHASES 57

will not hold, but does so here because of the linearity that we have assumed

in the production function But the implications of the fiscal policy on outputand employment are not affected by this simplification and so we proceed withthis simple specification

In order to see how individuals are affected by the fiscal policy, we have torestate their choice problem If individuals must pay a lump-sum tax τ, thentheir budget constraint is now given by: c = wn − τ Substituting the time-constraint n + l = 1 into the budget constraint allows us to rewrite the budgetconstraint as: c = w − wl − τ If the private sector derives no direct utility from

g, then the choice problem of individuals is given by:

Choose (c, l) in order to maximize u(c, l)subject to: c = w − wl − τ and 0 ≤ l ≤ 1

The solution to this choice problem is a pair of demand functions: cD(w, τ ) and

lD(w, τ ) Once the demand for leisure is known, one can compute the supply oflabor nS(w, τ ) = 1 − lD(w, τ )

Since the choice problem of the business sector is unaffected, we know thatthe equilibrium wage and dividend payment will equal (w∗, d∗) = (z, 0) As well,the government budget constraint (3.3) will have to be satisfied in equilibrium.The model we studied in Chapter 2 is just a special case of the model de-veloped here (i.e., in the earlier model, we were assuming g = 0) Figure 3.1displays the general equilibrium of the economy when g = 0 (point A) When

g = 0, the equilibrium budget constraint corresponds to the production ities frontier Suppose now that the government embarks on an ‘expansionary’fiscal policy by increasing spending to some positive level g > 0 Because thegovernment spending program requires a tax on individuals, their budget con-straint moves downward in a parallel manner If consumption and leisure arenormal goods (a reasonable assumption), then the new general equilibrium isgiven by point B in Figure 3.1 Notice that the income-expenditure identity

possibil-y = c + g is alwapossibil-ys satisfied in this econompossibil-y

The model predicts that an expansionary fiscal policy financed by a lump-sumtax induces an increase in output and employment However, the policy alsoinduces a decline in consumer spending The basic force at work here is a purewealth effect (there is no substitution effect here because the real wage remainsunchanged) In particular, because the after-tax wealth of individuals declines,they demand less consumption and leisure (assuming that both consumptionand leisure are normal goods) The decline in the demand for leisure impliesthat the supply of labor rises Because firms simply hire all the labor that issupplied in our model, aggregate employment expands, which is what leads to

an expansion in real GDP

Note that while this expansionary fiscal policy causes GDP to rise, it makesour average (model) person worse off (the indifference curve falls to a lowerlevel) There is an important lesson here: be careful not to confuse GDP witheconomic welfare

3.2 GOVERNMENT PURCHASES 59

3.2.2 Distortionary Taxation

Now, some of you may be asking whether we needed to go through all the trouble

of developing a model to tell us that an increase in g leads to an increase in y.After all, we know from the income-expenditure identity that y ≡ c + g Does

it not simply follow from this relationship (which must always hold true) that

an increase in g must necessarily lead to an increase in y? The answer is no

To demonstrate this claim, let us reconsider the effects of an expansionaryfiscal policy when government spending is financed with a distortionary tax

A distortionary tax is (as the name suggests) a tax that distorts individualdecisions, since the amount of tax that is paid depends on the level of individualeconomic activity A primary example of a distortionary tax is an income tax(the amount of tax paid depends on how much income is generated) In reality,most taxes are distortionary in nature

With an income tax, the individual budget constraint becomes: c = (1 −

τ )wn, where 0 ≤ τ ≤ 1 now denotes the income-tax rate Substituting the constraint n + l = 1 into the budget constraint allows us to rewrite the budgetconstraint as: c = (1 − τ)w − (1 − τ)wl Note that the direct effect of the incometax is to reduce the slope of the individual budget constraint; i.e., the slope isnow given by the after-tax wage rate −(1 − τ )w We know that when the slope

time-of the budget constraint changes, there will generally be both a substitution andwealth effect at work

Again, the choice problem of the business sector remains unchanged so that(w∗, d∗) = (z, 0) In equilibrium, the government’s budget constraint must besatisfied; i.e., the fiscal authority must choose a τ = τ∗> 0 that satisfies:

Figure 3.2 depicts the original equilibrium when g = 0 (point A) and thenew equilibrium where g > 0 (point B) The position of point B assumes thatthe substitution effect dominates the wealth effect (which is certainly plausi-ble) Observe now that the effect of an expansionary fiscal policy is to cause adecline in both output and employment The economic intuition of this result

is straightforward The increase in government purchases requires an increase

in the income-tax rate, which reduces the after-tax wage rate of individuals.The tax now has two effects Because individuals are poorer, they reduce theirdemand for both consumption and leisure, so that labor supply increases (this

is the wealth effect) On the other hand, the tax also reduces the price of leisure(increases the price of consumption), so that individuals substitute out of con-sumption into leisure, thereby reducing labor supply (this is the substitutioneffect) If the substitution effect on labor supply is stronger than the wealtheffect, then the net effect is for employment (and hence output) to fall

Observe that it is still true for this economy that y = c + g What has pened here, however, is that the increase in g is more than offset by the resultingdecline in c So while the income-expenditure identity holds true, it is clear thatone can not rely simply on this relation to make predictive statements This isbecause the income-expenditure identity is not a theory (recall the discussion

hap-in Chapter 1)

In economies like Canada and the United States, government purchases over thelast few decades have averaged in the neighborhood of 20% of GDP; see Figure1.2 Most of these purchases are allocated toward what one might label ‘pub-lic’ goods (output designated for mass consumption), such public parks, publicinfrastructure (roads, bridges, etc.), public health and education, and nationaldefense It is interesting to note, however, that these types of government pur-chases constitute a relatively small fraction of total government spending In

3.3 GOVERNMENT AND REDISTRIBUTION 61

Canada, for example, total government spending is very close to 50% of GDP (as

it is in many European countries) Much, if not most, of this additional spending

is in the form of transfer payments to individuals (e.g., unemployment ance, welfare, pensions, grants, personal and business subsidies, etc.).1 Sincethe benefits of such transfers are typically concentrated among specific groupsand since the costs are borne by the general public, such transfers necessarilyinvolve some amount of redistribution A cynic might argue that governmentsare primarily in the business of robbing Peter to pay Paul.2 An apologist mightargue that government is (or should be) more like Robin Hood (redressing pastinjustices) In any case, there is no question that redistribution, for better orworse, appears to be a primary function of government The question we wish toaddress here is: What are the macroeconomic consequences of policies designed

insur-to redistribute income?

In the present context, the government’s budget constraint is as follows:

Purchases + Transfers = Taxes

The sum (Taxes - Transfers) is referred to as Net Taxes Thus, in our lation of the government budget constraints (3.3) and (3.4), the expenditureside referred to purchases and the revenue side referred to net taxes Totalgovernment spending here is defined as purchases plus transfers

formu-To begin, let us recall our benchmark allocation (y∗, l∗), which satisfies

M RS(y∗, l∗) = z and y∗ = z(1 − l∗) Consider now a government policy thatgrants each person a lump-sum transfer equal to a units of output The gov-ernment finances this transfer with an income tax τ (which we will take as theexogenous policy parameter) For simplicity, assume that all households areidentical and that g = 0 The household’s budget constraint becomes:

redistribute income (and not create additional value).

(Ontario) which proclaimed: “Come to Joe Kool’s where we screw the other guy and pass the savings on to you!”

In other words, as with the benchmark allocation (y∗, l∗), the household’s choice(y0, l0) must lie on the PPF However, the allocation that arises under theredistribution scheme does not correspond to the benchmark allocation; i.e.,

Thus, our theory predicts that economies with ‘generous’ transfer programs(and high average tax rates to finance such programs) should exhibit relativelylow levels of real GDP and employment The intuition is simple First, thelump-sum transfers reduce labor supply via a pure wealth effect (people do nothave to work as hard to acquire output) Second, the income tax distorts therelative price of output and leisure In particular, since the after-tax wage falls,the relative price of leisure falls so that individuals substitute out of consumptionand into leisure Both of these forces work to reduce GDP and employment

In the context of our example above that features a ‘representative’ hold, we see that such a government policy also leads to a reduction in welfare

house-3.3 GOVERNMENT AND REDISTRIBUTION 63

However, in a more realistic model that featured different types of households(e.g., high-skilled versus low-skilled), we would find that some households wouldbenefit while others would lose The model’s predictions concerning the effect

on GDP and aggregate employment, however, would remain intact Note thatwhen households differ, it becomes very difficult for us to make any definitivestatement about whether such a redistribution program improves ‘social’ wel-fare The notion of ‘social’ welfare is ultimately in the eyes of the beholder

3.4 Problems

1 Suppose that preferences are such that M RS = c/l and that the vidual’s budget constraint is given by c = w − wl − τ (a lump sum tax).Derive this person’s labor supply function nS(w, τ ) and explain (provideeconomic intuition) how it depends on τ

indi-2 Periods of war often entail huge increases in government military ing financed with government bonds (in the context of our model, youcan think of bond-financing as representing a type of lump-sum tax); seeFigure 3.2 for the case of the United States during World War II Are thepatterns of economic activity in Figure 3.2 consistent with our theory?Explain Hint: draw ‘trend’ lines through the data in the diagrams below

39 40 41 42 43 44 45 46 47

Gross Domestic Product Private Consumption

Government Spending Employment

3 Suppose that preferences are such that M RS = (c/l)1/2 and that theindividual faces a budget constraint c = (1 − τ )w(1 − l) Derive this indi-vidual’s labor supply function and explain how it depends on τ Contrast

sup-5 Figure 3.3 displays the allocation that would result under a policy thatdistributes a lump-sum transfer financed by an income tax The textasserted that the new allocation (B) must lie to the right of the bench-mark allocation (A) Prove that this must be the case Hint: Show that

an allocation that lies to the left of (A) must necessarily entail crossingindifference curves