Policy

00:01 Hello and welcome back to your online presentation of macroeconomics.

00:05 My name is James DeNicco.

00:06 This is the final presentation in the series.

00:09 We'll be talking about policy.

00:12 So first, we're going to look at what is the role of government.

00:15 We're going to look at pareto optimality.

00:17 That's one way to look at the role of government in the economy.

00:20 So when I say the role of government, that's what I mean.

00:22 What's the role of government in the economy? We're going to look at the main tools of fiscal policy, how the government could try to affect the economy through fiscal policy.

00:32 We'll look at accommodative monetary policy or how monetary policy can accommodate or allow fiscal policy to be more effective.

00:40 And we'll also look at structural policy.

00:43 If monetary policy and fiscal policy fail, you can try to change the structure of the economy.

00:49 One way to look at the role of government in the economy is to look through the lens of prey to optimality.

00:55 So what's Pareto optimal? That's an allocation of goods in which there's no way to rearrange those goods to make somebody better off without making somebody worse off.

01:06 So let's do an example here.

01:07 I have a room full of people and I give everybody a slice of pie.

01:11 Is that pareto optimal? It is. There's no way that I can rearrange things to make somebody better off without making somebody worse off.

01:19 If I take pie from somebody and give it to somebody else, I make that somebody else better off. But the person I took the pie from, they're now worse off.

01:27 Now, how about if I have a roomful of people enough slices of pie for everybody, but I give all the slices of pie to one person.

01:36 Is that pareto optimal? The answer still yes.

01:39 Right? It's still yes.

01:40 I can't rearrange things to make somebody better off without making somebody worse off.

01:45 If I take a pie from the person who has everything well and he still has a lot of pies, but he's worse off.

01:50 He's down one pie.

01:52 I made somebody better off, but I made the person with all the pies worse off.

01:56 Pareto Optimality does not care about equality.

02:00 Pareto optimality is about efficiency.

02:03 So one way to look at the role of government are things parade optimal if they're not? If you can rearrange things without making somebody worse off, then there's a role for government.

02:14 Well, that's a very strict view of the role of government, right? It discounts a lot of things.

02:19 All it cares about is efficiency.

02:22 It doesn't care about inequality.

02:24 So if you think the role of government is to try to reduce inequality, Pareto optimality doesn't allow for that.

02:30 It also doesn't allow for value judgements.

02:33 It doesn't allow you to say something's fair or not.

02:35 So sometimes you might make somebody worse off when you make change as a society, if you vote for that and you think that's fair.

02:42 Looking at the role of government as only if things aren't pareto optimal to come in and be able to change things.

02:48 It discounts value judgements.

02:50 It doesn't let societies take moral stances .

02:54 So pareto optimality that's one way to look at the role of government.

02:58 If things aren't pareto optimal, the government can come in and make things better off without making somebody worse off.

03:04 But there are some criticisms of that.

03:07 It does discount inequality and it does discount value judgements.

03:11 So now let's talk about a competitive equilibrium.

03:15 A competitive equilibrium has a very fancy and very complicated definition. So just let me talk about it in my own terms.

03:23 That's when you have your two sides, your two main sides, your households and your firms, and they look at prices and you have demand supply and they come to an equilibrium. So that's your competitive equilibrium with no interference.

03:36 The private market, the private forces come to this supply and demand conclusion. So the first fundamental welfare theorem from Adam Smith.

03:45 Adam Smith of the Wealth of Nations and the Theory of Moral Sentiments, the man who coined the phrase The Invisible Hand, Adam Smith.

03:52 He puts this first fundamental welfare welfare theorem out there.

03:55 It states that under certain conditions, this competitive equilibrium or this unfettered free market conclusion that houses and firms come together and make is going to be pareto optimal under certain circumstances.

04:09 So the government isn't necessary if these certain circumstances are met.

04:14 So if markets are competitive and full equilibrium, if markets are complete, there's no externalities and there's perfect information with no distortions of incentives, then our competitive equilibrium will be pareto optimal.

04:27 And he says there's no role for government if there's a violation of any of those three.

04:32 That leaves the role for government to come in and crack the competitive equilibrium because it's not pareto optimal.

04:39 All right. So now let's violate that first condition.

04:42 Let's have a market that isn't perfectly competitive at full equilibrium.

04:46 Let's have a monopoly.

04:48 On monopoly violates that that condition.

04:51 So when monopoly is going to set a price higher and they're going to produce it a quantity lower than is efficient, which is achieved with a perfectly competitive market. Full equilibrium.

05:02 So this is your standard monopoly graph from a microeconomics class.

05:07 So what results is this dead weight loss where there's still people that value the product above the cost of producing the product to the firm? But those people aren't purchasing because the price is too high, because of the way the monopoly sets its price and its quantity.

05:23 So there's a role for government there possibly to come in and find a way to optimality improvement.

05:30 Now, when they take away the monopoly that's going to hurt that firm, it's going to hurt their market share.

05:35 It's definitely going to benefit the consumer, lower prices and an increased quantity. So more people will be able to buy that good at a lower price.

05:44 It hurts the firm, but the gains in efficiency for overall society might be enough that you can compensate that monopoly for its losses so that it's not worse off.

05:55 If you can do that, you can improve the economy for everybody else.

05:59 You can improve the overall welfare with lower prices and increased quantity. You can make the economy more efficient.

06:07 If those efficiency gains are enough to offset the losses of the monopoly, well, the government can come in and take some of those gains and give them some of the monopoly so that they're not worse off.

06:18 So that can be an example, an example of where the government can step in and make a pareto optimality improvement.

06:26 So that's the first condition.

06:28 Okay, now let's violate the second condition.

06:31 Let's say there's an externality out there.

06:33 So what's an externality? It's the uncompensated impact of one person's actions on the well being of an innocent bystander.

06:42 So let's take the well-known example of pollution.

06:45 So a firm is producing and they're dumping their waste in the river.

06:49 Well, they're polluting because it's less costly than getting rid of that waste in the proper manner. They're degrading the environment.

06:56 Well, they're reticent to correct that because it's costly for them to fix it.

07:01 Well, that might leave a role for the government.

07:03 The government can come in and say, yes, short term, this is costly, but we're going to force you to fix this problem.

07:09 You need to stop polluting.

07:12 That's obviously going to make us all better off because we're going to have a better environment. It might cost the firm in the short term, but the gains in the long term might offset those short term costs because now we're going to have sustainability.

07:27 The firm can continue to use the water in the air and the land.

07:31 If they degrade it to a point where it's not usable anymore, then the firm is hurt as well. But they might be short sighted.

07:38 They're short sighted because they get all the profit and they share the cost.

07:43 They're also hurt by polluting and degrading the environment, but that cost is shared with everybody.

07:50 Well, they're the ones that reap the profits.

07:52 So in the short term, yes, it might be costly.

07:55 The government comes in and makes them fix that.

07:57 They have to dispose of their waste properly.

07:59 In the short term, it's costly, but in the long run, the sustainability of your environment, the better water, the better land, the better air might allow that company to continue on for a longer period of time and its workers might be healthier as well. So pollution with externalities, that's another role for the government to step in and perhaps create a pareto optimality improvement.

08:22 All right. Also, we could violate that third assumption.

08:25 Say there's not perfect information and there's a distortion of incentives that can leave a role for government.

08:31 So an instance like that, we can look at our monopoly, where now they're being compensated for their losses so that we can have these efficiency gains.

08:39 Well, now they might have reason to distort the truth.

08:43 There is a distortion of incentives here.

08:46 Their incentive is not to be truthful so that they can increase their compensation. In that case, again, the competitive equilibrium will not be pareto optimal and it can leave a role for government.

08:57 So violating those conditions.

09:00 That leaves a role for government because our competitive equilibrium is not pareto optimal. Now what are the levers of policy? What are the tools of policy? So there's three main tools that the fiscal authorities can use.

09:15 So the fiscal authority that comes from our legislature and our executive branch, they can increase government spending.

09:22 They can cut corporate taxes or they can cut income taxes.

09:27 We're talking about expansionary fiscal policy here.

09:30 Contractionary. Contractionary fiscal policy would be exactly opposite.

09:34 That would be decreasing government spending, increasing corporate taxes or increasing income taxes.

09:40 We're going to go through the mechanics of these three tools.

09:44 The first one we're going to look at is an increase in government spending.

09:47 The government wants to expand the economy so they spend some money without changing taxes.

09:53 What are the mechanics of that? What's going to happen? Well, first, we're going to go from point A and aggregate demand is going to shift the point be it's going to drive up the prices, but it's going to increase short run output above the long run potential output.

10:07 It's going to be the increase in government spending drives up aggregate demand. However, if we remember back to our savings and investment presentation, when you increase government spending without changing taxes, there could be a crowding out effect.

10:22 So let's take a look at that.

10:24 The impact of the government spending might not be everything.

10:27 It could be because of this crowding out effect.

10:30 When the government spends money but doesn't change their taxes, that decreases national savings.

10:36 So here in this graph on the left, our savings and investment graph, we'll see.

10:40 Saving supply is going to shift to the left.

10:43 That drives up the real interest rate, which is the opportunity cost of investment. As the opportunity cost of investment goes up, firms are going to invest less. We move to the left along that investment demand curve.

10:57 If we go to our aggregate supply and demand curve on the right, what we're going to see is that movement from A to C is a decrease in private investment.

11:06 That is, that crowding out of private investment.

11:09 That's in the short run.

11:10 In the short run, it's not as big of a deal.

11:12 You might still get some expansion from increasing government spending.

11:16 However, the decrease in investment might have some long run effects.

11:21 So if we take a look at some of those long run effects, we know from our growth presentations that one of the keys to growth is physical capital.

11:30 The increase in physical capital comes from investment.

11:34 If we decrease our investment in the long run, we might be affecting the potential growth of our economy.

11:41 We might slow the growth of our economy here.

11:44 You represent that with a leftward shift in the long run aggregate supply curve.

11:49 So we're going to be moving from point C to D because capital is going to go down because investment's going to decrease.

11:57 So the long run effects of the crowding out are much more disastrous or much more consequential, I guess you might say.

12:04 Then the short run effects, it can have a long run effect of dampening the potential output of the economy.

12:11 So that's the positive and negative sides of increasing government spending.

12:15 So whenever you talk about government spending, you need to talk about government multipliers. So the government multiplier effect, that's the additional shifts in aggregate demand that result when fiscal policy changes income and thereby changes consumer spending.

12:30 So it's going to depend on what we call our marginal propensity to consume.

12:34 So that's the fraction of extra income that people are going to be willing to consume with rather than save.

12:41 So the idea is the government spends some money, people receive that money and then they consume with a fraction of it.

12:48 Then somebody else receives that money and they consume with a fraction of it.

12:52 If you look down here at my example, the government say spends $20 Billion and there's a marginal propensity to consume of 80%.

13:02 So the government spends $20.

13:04 Billion people receive that.

13:06 They they consume 80% of that.

13:08 So there's an additional increase in consumption for aggregate demand of $16 Billion. Somebody receives that $16 Billion, they consume with 80% of it. They spend 80% of it on consumption.

13:21 So there's another increase in aggregate aggregate demand of $12 billion or $12.8 Billion.

13:27 Somebody receives that money and they use 80% of it for consumption.

13:32 So there's another increase in aggregate demand by an increase in consumption of $10.24 Billion.

13:38 It's cyclical. It goes around in a circle, so you just don't get the increase in aggregate demand of the $20 Billion of the government spend.

13:46 But you get these additional increases because people use that money to consume. So the government spends $20 Billion.

13:54 The increase in aggregate demand might actually be bigger than $20 Billion.

13:58 The way we figure out our government multiplier, if you keep going through the cycle over and over and over, what it turns into is the.

14:06 Multiplier equals one over one minus the propensity to consume.

14:10 Here it's one over one -0.8 or five.

14:14 So if the government spends $20 Billion, it's actually going to be an increase in aggregate demand of $100 Billion.

14:23 All right. So now let's take a look at the second tool of fiscal policy, corporate tax cuts. So, again, this is all expansionary fiscal policy.

14:31 If you want contractionary fiscal policy, you just reverse everything I'm saying.

14:35 So here you cut taxes on corporations.

14:38 What that allows them to do is increase their investment.

14:42 As they increase their investment, you're going to see a rightward shift in the aggregate demand curve.

14:48 If we look over here, the aggregate demand curve, again, equals consumption plus investment plus government spending plus net exports.

14:55 So if you cut corporate taxes and they invest, investment goes up and aggregate demand goes up in the short run, we see a shift from A to B.

15:05 Now, in the long run, we're not going to have that crowding out effect.

15:08 That crowding out effect comes because private investment is crowded out by government spending.

15:14 When real interest rates go up here, investment is what's increasing.

15:19 So there's going to be a different long run effect.

15:22 If we take a look here, we see the long run effect.

15:24 We're going to shift from point B to point C.

15:27 We know again from economic from the economic growth presentation that one of the factors in long term growth is an increase in physical capital.

15:36 Well, that's what corporations are doing.

15:39 They're investing more they're purchasing more physical capital.

15:42 So we're going to see the long run aggregate supply and the short run aggregate supply shift to the right.

15:48 So we're going to go from beginning here.

15:50 A in the short run, aggregate demand shifts to the right to point.

15:53 B Now the long run potential is going to shift from point A to point C.

15:59 So with these corporate taxes, it results in a higher long run potential.

16:04 So now let's take a look at the third tool of expansionary fiscal policy income tax cuts. Well, that one really depends on who you ask.

16:12 Some people think it looks more like government spending, that national savings are going to decrease because you decrease taxes and leave government spending alone and you'll have that increase in real interest rates and the crowding out effect.

16:25 Other people think that if you let people keep more of their own money, they'll go out there and they'll be entrepreneurs, they'll start businesses and they'll invest and they'll increase physical capital.

16:35 And then the result will look like the corporate tax cut.

16:38 So it really depends on who you ask there.

16:41 And depending on which is right, then the mechanics of the other tools of expansionary fiscal policy would apply.

16:49 So there's also a tax multiplier.

16:51 And so it's the same type of idea.

16:53 You let people keep their money and so they're going to consume.

16:57 Somebody receives that money and then they consume a certain portion of it.

17:00 And a lot of it's going to depend on the marginal propensity to consume.

17:04 Well, we can also go ahead and calculate our tax multiplier.

17:08 Now, that's going to equal our marginal propensity to consume over one minus our marginal propensity to consume here.

17:15 If we have a marginal propensity to consume or an MPC of 0.8, then our tax multiplier is four.

17:22 It's smaller than the government multiplier because the government multiplier has that initial injection.

17:27 They spend that money and there's increase in aggregate demand here.

17:31 You don't have that. You're saying you can keep more of your money so you don't have that first injection of cash or injection of money into the economy.

17:40 So what you're going to see is a smaller multiplier of four.

17:43 So there's a $20 Billion income tax cut.

17:47 The resulting increase in aggregate demand will be four times 20 or $80 Billion. So there's also what we call accommodating monetary policy, and that can fix some of this crowding out effect.

17:58 So say the government wants to spend money, they want to use expansionary fiscal policy by increasing government spending.

18:05 Well, you worry about the crowding out effect, but you can go ahead and have your central bank conduct accommodative monetary policy to try to keep those real interest rates low.

18:15 So here, let's say they purchase bonds, expansionary monetary policy, they pull bonds out and inject money into the economy.

18:23 Well, what that's going to do is it's going to increase savings.

18:27 The banks and people will have more money.

18:29 So there's more savings that'll drive down the real interest rate.

18:33 So if you conduct government spending with expansionary monetary policy, that can alleviate some of those concerns of the crowding out effect.

18:43 So now let's take a look at the difference between increasing government spending with accommodative monetary policy and without.

18:50 So we have a graphic illustration here.

18:52 What I'm trying to show you is that the increase in aggregate demand can be more effective because we can alleviate some of that that crowding out effect if we have accommodative monetary policy to keep the real interest rates low. We see here this further line that would be with our accommodative monetary policy. Without it, we might have some crowding out effect so we won't get the full impact of that expansionary policy with the increases in government spending. So if all else fails, if the monetary policy fails, if the fiscal policy fails, you can go ahead and try to effect structural policy. So structural policies aimed at changing the fabric or the fundamental makeup of the economy, you can look at things like price controls or the tax code, the public sector, enterprises, regulations, social safety nets, job training, all these different areas.

19:47 You can have your legislature and your executive branch.

19:50 You can have people go and try to affect this structural change to try to expand your economy if all else fails.

19:57 So what have we learned here? Let's do a recap.

20:01 In our final presentation in our macroeconomic series, we talked about policy. We understand the role of government according to Pareto Optimality.

20:09 We understand there's criticisms of that.

20:12 We know the mechanics of the three tools of fiscal policy focusing on government spending, changes in corporate taxes and changes in income taxes.

20:23 We know how monetary policy can accommodate fiscal policy, and we know different areas where policies can affect structural change.

20:31 So that's your presentation on policy.

20:34 That's the presentation series on macroeconomics.

20:37 Thank you very much.