Introduction to Macroeconomics: Math App - Lecture 009

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Economics for Management Studies
Iris Au

30 January 2013 CHAPTER 23: FISCAL POLICY AND AGGREGATED SUPPLY TO DEMAND MODEL SUPPLEMENTARY C Full-Employment Level of Output and Output Gaps Full-employment level of output (Y ) is when the economy FE is operating at its full potential, when the economy is at its full employment. Full Unemployment is when good and productive workers are able to find jobs easily, young and experienced workers find their first jobs easily, and old workers are not forced out of the labour force if they lose their jobs (no discouraged workers). It is also the level of output that the economy will converge to in the long run. The unemployment rate at Y isFEalled the non-accelerating inflation rate of unemployment (NAIRU) or natural rate of unemployment (NRU). Full employment does not mean that everyone is working because:  The labour market is dynamic (people constantly move in and out of the labour market)  Frictional Unemployment when there is unemployment that results from the turnover in the labour market as workers move between jobs  Structural unemployment when there is a mismatch between the skills or locations of workers and the skill or location requirements of job openings  There are “frictions” in the economy (some industries or regions expand while some industries or regions contract) Our economy is not always producing at full employment (at the long run equilibrium), and when we are not producing at our long run equilibrium we experience either: Recessionary or Deflationary Gap occurs when the equilibrium level of output (Y*) is less than the full-employment level (IE: Y* < Y , the FE current rate of output), when the economy is producing less output than is normally associated with full employment. The economy has lots of unemployed workers and there will be pressure for prices to fall. Inflationary Gap occurs when the equilibrium level of output (Y*) is greater than the full-employment level (IE: Y* > Y ), when the FE economy is producing more output than is normally associated with full employment. The economy overheats and jobs are relatively easy to find. Also, there will be pressure for prices to rise. Endogenous Budget Balance Our extended model (let IM0 = 0, and hold r and E constant): AE = AE + C Y, 0 Y AE 0 C +0I +0G + X + 0 TR 1 C 0 1 0 C = [C (1 – T – TR ) – IM ] Y 1 1 1 1 Y* = AE 0 1 / (1 – C )Y= AE x0M BB = (T 0 TR –0G) + (T + 1R ) Y1 Autonomous part of BB because it is independent of any variable, they are constant. Endogenous part of BB because it will change automatically whenever output changes, even if the government does not change its fiscal policy or do anything about its budget, the part that government does not have control over. The budget balance is endogenous.  Holding all else constant, BB ↑ when Y ↑  Holding all else constant, BB ↓ when Y ↓ A change in G, T , or TR has two effects on the BB, where BB = (T – TR – G) + (T + TR ) Y 0 0 0 0 1 1 Suppose T ↓, TR ↑, or G ↑ (an expansionary fiscal policy): 0 0  (T0– TR –0G) ↓ = BB ↓ (When government collects fewer taxes, gives out more transfers or spend more, holding all else constant, it will reduce the exogenous part of the budget)  The level of AE ↑ when T ↓, T0 ↑, or 0 ↑ = Y ↑ = (T + TR )Y ↑ =1BB ↑ (1he indirect effects aggregated expenditure, when aggregated expenditure goes up then output goes up allowing government to collect more tax and pay out fewer transfers which improves the budget. But what happens to the budget overall depends on how much these two factors change Structural Deficit vs. Cyclical Deficit Given the budget balance changes automatically when Y changes, we need to separate a deficit during a recession from a persistent deficit even the economy is operating at full employment. Structural Deficit is when the government runs a budget deficit when Y = Y , this is bad. Cyclical Deficit is when BB = 0 FE when Y = Y , FEt the government runs occasional budget deficit when Y < Y , this is naturFE and we should not worry about it. Ideally, we should run surpluses during good times (when Y > Y ), and deficits
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