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Intertemporal Model: Applications: Econ302, Fall 2004 Professor Lutz Hendricks

This document summarizes applications of an intertemporal model, including the effects of: 1. A temporary increase in government spending G. Output and employment increase while consumption falls, resulting in a utility loss. 2. A future increase in G. Labor supply and output increase while the real wage and interest rate fall. 3. A permanent increase in G. Both labor supply and output increase while the real wage and interest rate fall. No crowding out occurs. 4. A temporary increase in productivity z. Output, employment, wages and the interest rate initially increase while consumption rises slightly due to income effects.

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Peter Finzell
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74 views18 pages

Intertemporal Model: Applications: Econ302, Fall 2004 Professor Lutz Hendricks

This document summarizes applications of an intertemporal model, including the effects of: 1. A temporary increase in government spending G. Output and employment increase while consumption falls, resulting in a utility loss. 2. A future increase in G. Labor supply and output increase while the real wage and interest rate fall. 3. A permanent increase in G. Both labor supply and output increase while the real wage and interest rate fall. No crowding out occurs. 4. A temporary increase in productivity z. Output, employment, wages and the interest rate initially increase while consumption rises slightly due to income effects.

Uploaded by

Peter Finzell
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Intertemporal Model: Applications

Econ302, Fall 2004 Professor Lutz Hendricks,


August 17, 2004

What this chapter is about

We deepen our understanding of how the model works by studying two applications: 1. Fiscal policy: government expenditure changes. 2. Productivity shocks. The results will tells us something about the sources of business cycle uctuations. .

Fiscal Policy

Goals: Practice how the model works. Determine the eects of government spending. Learn about the dierence between temporary and permanent shocks. Understand how expectations aect current economic activity. .

2.1

Temporary Increase in G

The experiment:
G " but G0 stays unchanged. This must be nanced to satisfy the government budget constraint. Assume that T 0 ".

Important: A policy experiment must specify an entire path of policy variables. The path must satisfy the budget constraint. It does not make sense to ask: what are the eects of a change in G alone? .

2.1.1

Eect of G on Output Supply

Recall how Y s was derived:

G only aects labor supply: G " ) N s ". Y s curve shifts right.

The eect should be small for a temporary change in W ). .

G (small

2.1.2

Eect of G on Output Demand

Y d = C d + I d + G.

No change in I d: rm s target K 0 stays the same.


C d #: income eect due to lower W .

Most likely Y d " because the income eect is small for a temporary G ". .

2.1.3

Equilibrium eect of higher G

Unambiguously, Y ". Likely: r " (because shift of Y s is small). .

2.1.4

Labor Market Eects of higher G

No change in N d (M PN schedule). Direct eect on N s: positive (we already saw that). Indirect eect on N s: higher r above).
) higher N s (see

2.1.5

Summary: Eects of G

Current period: Output increases. Consumption and leisure fall ! utility loss for households. Investment falls. Next period: Taxes must rise to nance higher government debt. K 0 is lower ! Y is lower. Policy implication: Using scal policy to pull an economy out of recession comes at a cost. .

2.2

Future Increase in G

Key point: Expectations of future shocks aect today s equilibrium. Experiment: G0 rises, nanced by higher T 0.

2.2.1

Labor market

Labor supply: rises (for xed w; r) b/c of lower W . Labor demand: no change. Labor market clearing: N " and w #.
Real Wage Ns

w*

Nd N* Employment

10

2.2.2

Goods market

Output supply: rises b/c of lower higher supply. C d falls b/c of lower W (not by much b/c change in G0 is not permanent). I d: no change in target capital stock. Output demand curve shifts left.
r Ys

Yd Y

Total eect: Y "; r #. This is not exactly right: I d will shift because rms expect a change in w0 and therefore in N 0! .

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2.3

Permanent Increase in G
G. This is nanced

Experiment: G and G0 increase by by T 0.

This is the "sum" of the previous two experiments. Therefore, the total eects are:
G " # " " G0 " # # G and G0 "" ## " ?

Ns Nd Cd Id G Yd

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2.3.1

What happens to aggregate demand?

Direct eect: G ". Indirect eect: C d # because of lower W . Permanent income hypothesis suggests: C d should fall by the change in the present value of taxes. Then: Y d curve unaected by scal policy. Surprise result: Permanent scal stimulus raises GDP not through aggregate demand, but through labor supply!

13

2.3.2

What happens to labor supply?

Direct eect: Lower W increases N s. Indirect eect: lower r reduces labor supply (higher W ).

How do we know labor supply does not fall overall? If it did, output supply would decrease. This is not a circular argument. The shift of N s for xed r is the shift in the Y s curve. The second shift (change in r) is a movement along Y s. .

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2.3.3

Summary: Eects of permanent G "

Goods market: GDP rises due to higher supply. Interest rate falls ) I "; C " (movement along Y d). Note: No crowding out, in contrast to temporary G ". Labor market: Higher labor supply ) higher N and lower w. Note: Doing more of the same (raise G for 2 periods instead of 1) does not simply magnify the eects of G. .

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Productivity Shocks

3.1

Temporary increase in z

Labor demand rises: higher M PN . Labor supply: no direct eect. w change is move along the N s curve. Result: For xed r, higher N and higher w. Y s curve shifts right.

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3.1.1

Goods market

I d: no change in target K 0. G: no change. C d: rises because of income eect, but not by much for a transitory z ". (The book omits this.)

Therefore, Y d curve shifts right.


r Ys

Yd Y

Total eect: Y "; r #. .

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Indirect eect on the labor market: r # shifts N s left.

But this eect is empirically small, so that N rises. .

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3.1.2

Business cycle implications

With productivity shocks: consumption, investment, employment, wages, interest rates should be pro-cyclical. This is true in the data. This is the key idea of Real Business Cycle theory, which we study later.

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