CHAPTER

Chapter 8 The Classical Long-Run Model Part 2

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More Important Stuff •

Leakages = T + S

– Income earned by households that they do

not

spend on the country’s output during a given year •

Injections = I P + G

– Spending on a country’s output from sources other than its households 2

Even More Important Stuff • At equilibrium, total output (Y) will equal total spending Y = C + I P + G We can do the following: Y – C = I P + G (move C to LHS) Y – C – T = I P + G –T (subtract T from each side) S = I P + G –T(Recall : S = Y-C-T) S + T = I P + G • At equilibrium, total leakages are equal to total injections S + T = I P + G 3

Leakages and Injections

By definition, total output equals total income. Leakages: net taxes (T) and saving (S) - reduce consumption spending below total income. Injections: government purchases (G) plus planned investment spending (I p ) - contribute to total spending. When leakages equal injections, total spending equals total output.

4

Big Question

• What guarantees that leakages are injected back into the spending stream?

• Answer: - The loanable funds market where savers maker their funds available to borrowers - The supply and demand for loanable funds.

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The Loanable Funds Market

• Supply of loanable funds i

s equal to household saving

– These funds are loaned out and households receive interest payments on these funds • Supply of loanable funds curve (saving) – shows the level of household saving at various interest rates – slopes upward: quantity of funds saved and supplied to the financial market increases as the interest rate increases.

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Household Supply of Loanable Funds

Interest Rate 5% 3% A Total Supply of Funds (Saving) B As the interest rate rises, saving or the quantity of loanable funds supplied increases.

Remember: As households save more they spend less: As S↑, C↓ 1.5

1.75

S (Trillions of Dollars per Year) 7

The Loanable Funds Market

• Demand for loanable funds is borrowing by business firms and the government • Business demand for loanable funds – is equal to their planned investment spending (

I P

) – level of investment spending firms plan at various interest rates 8

Interest Rate 5% 3% Business Demand for Loanable Funds A 1.0

1.5

B As the interest rate falls, business firms demand more loanable funds for investment projects.

Planned Investment (

I p )

(Business Demand for Funds) I P (Trillions of Dollars per Year) 9

Now the Government

• Government budget deficit, G > T – Excess of government purchases over net taxes (G > T). – In our example, G = $2.0 and T = $1.25. The deficit = $0.75 trillion.

• Government’s demand for loanable funds is equal to its budget deficit – The government must borrow and it pays interest on funds borrowed 10

The Loanable Funds Market

• Government demand for funds curve: – Amount of government borrowing at various interest rates • We assume this is independent of the interest rate • Budget surplus – Excess of net taxes over government purchases (T>G) 11

The Loanable Funds Market

• Total demand for loanable funds curve – Total amount of borrowing at various interest rates.

– Total demand = [

I p

+(G-T)], the sum of desired business investment plus government deficit.

• As the interest rate decreases – Total quantity of funds demanded rises • Quantity of funds demanded by business firms increases • Quantity demanded by the government remains unchanged 12

The Demand for Loanable Funds

Summing business demand for loanable funds at each interest rate … Interest Rate (a) Business Demand for Funds (

I p )

B 5% and the government's demand for loanable funds … gives us the economy's total demand for loanable funds at each interest rate.

Interest Rate (b) 5% Interest Rate Government Demand for Funds (

G-T )

B 5% (c) Total Demand for Funds [ B

I p +(G-T)]

A A A 3% 3% 3% 1.0

1.5

Trillions of dollars per year

0.75

Trillions of dollars per year 1.75

2.25

Trillions of dollars per year 13

Equilibrium in the Loanable Funds Market

• Interest rate will rise or fall until the quantities of funds supplied and demanded are equal • At equilibrium, the market clears.

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Interest Rate

Loanable Funds Market Equilibrium

Total Supply of Funds (Saving) E 5% 1.75

Total Demand for Funds [

I p +(G-T)]

Trillions of Dollars per Year 15

How the Loanable Funds Market Ensures That Total Spending = Total Output

The leakage of net taxes (T) goes to the government and is spent on government purchases (G). If the government is running a budget deficit, it will also borrow part of the leakage of household saving (S) and spend that too. Any household saving left over will be borrowed by business firms and spent on capital. Thus, every dollar of leakages turns into spending by either government or private business firms.

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Say’s law with equations

Loanable funds markets clear  S

funds

supplied

funds

demanded Loanable funds markets clear 

Leakages Injections

Leakages = Injections  Total spending = Total output Say’s Law holds as long as the loanable funds market clears • Total spending equals total output when all leakages are injected back into spending • True even in a more realistic economy 17

Fiscal Policy in the Classical Model:

What happens when things change?

• Fiscal policy is a change in government purchases or net taxes designed to change total spending and total output • Demand-side effects – Effects on total output that result from changes in total spending (demand for G&S) • Classical model conclusion: – Fiscal policy has no demand-side effects!

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Here’ why!

• Increase in G without a change in T: – the government must borrow the additional funds – this will increase in the demand for loanable funds – interest rate increases causing • Decrease in planned investment spending • Decrease in consumption spending as households save more - increase in savings • The result is the increase in government purchases crowds out the spending of households (C) and businesses (I p )because the interest rate increases.

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Example: Crowding Out as a result of a $0.5 Trillion Increase in Government Purchases from $1.75 to $2.25 Trillion Interest Rate 7% B Total Supply of Funds (Saving) G↑ = AH = $0.5 trillion C ↓ = AF = $0.3 trillion I P ↓ = FH = $0.2 trillion 5% A F H C↓ I p + (G 1 -T) I P ↓ I p + (G 2 -T) 1.75

2.05

2.25

Trillions of Dollars per Year

Beginning from equilibrium at point A, an increase in the budget deficit caused by I additional government purchases shifts the demand for funds curve from I p + (G 2 p + (G 1 − T) to − T). At point H, the quantity of funds demanded exceeds the quantity supplied, the interest rate begins to rise. As it rises, households save more, and business firms invest less. In the new equilibrium at point B, both consumption and investment spending have been completely crowded out by the increased government spending.

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Crowding Out

• Crowding out – the decline in one sector’s spending – caused by an increase in some other sector’s spending • Complete crowding out – is a dollar-for-dollar decline in one sector’s spending – caused by an increase in some other sector’s spending • What caused the crowding out????

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An Increase in G - Bottom Line

In the classical model an increase in government purchases (G) • Completely crowds out private sector spending • Total spending remains unchanged • No demand-side effects on total output or total employment 22

Example: A Decrease in Net Taxes • Government cuts net taxes (T) – Why would the gov’t cut taxes?

• To increase total spending.

– Assume: households spend the entire tax cut – Budget deficit increases as T ↓ – Increase in demand for loanable funds [I p +(G-T)] – Interest rate increases causing • Decrease in planned investment spending • Decrease in consumption spending as households save more 23

Crowding Out from a $0.5 Trillion Decrease in Taxes (T) Interest Rate 7% C↓ B Total Supply of Funds (Saving) T ↓ = AH =$0.5 trillion = Initial C ↑ H A F 5% I p + (G-T 1 ) I P ↓ I p + G-T 2 ) 1.75

2.05

2.25

Trillions of Dollars per Year

Beginning at point A, an increase in the budget deficit caused by a tax cut shifts the demand for funds curve from I p + (G − T 1 ) to I p + (G − T 2 ). If the tax cut is entirely spent, consumption initially rises by the distance AH. At the original interest rate of 5 percent, the quantity of funds demanded now exceeds the quantity supplied. This causes the interest rate to rise. As the interest rate rises, we move from A to B along the supply of funds curve. Saving rises (and consumption falls) by the distance AF. The final rise in consumption is FH. We also move along the demand for funds curve from H to B, so investment falls by the distance FH. In the new equilibrium at point B, consumption (which has risen by FH) has completely crowded out investment (which has dropped by FH).

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A Decrease in Net Taxes – Bottom Line

In the classical model, a cut in taxes • Initially increases consumption • But the interest rate increases which crowds out planned investment and consumption.

• Total spending remains unchanged • No demand-side effects on total output or employment 25

The Classical Model and Classical Economist • Government – Needn’t worry about employment • The economy will achieve full employment on its own. • Later in the course we will call this the self correcting mechanism – Needn’t worry about total spending • The economy will generate just enough spending on its own to buy the output that a fully employed labor force produces • Fiscal policy h as no demand-side effects on output or employment 26