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Econ 208

Econ 208. Marek Kapicka Lecture 5 The Effects of Gov’t Spending. Announcements. Read Woodford, “Simple analytics..”, pages 1-9 (on the web) PS2 will be posted today. B1) The Effects of Government Spending Equilibrium Conditions. The equilibrium condition (*) Fiscal multiplier with and.

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Econ 208

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  1. Econ 208 MarekKapicka Lecture 5 The Effects of Gov’t Spending

  2. Announcements • ReadWoodford, “Simple analytics..”, pages 1-9 (on the web) • PS2 will be posted today

  3. B1) The Effects of Government SpendingEquilibrium Conditions • The equilibrium condition (*) • Fiscal multiplier with and

  4. B1) The Effects of Government SpendingEquilibrium Conditions

  5. B1) The Effects of Government SpendingHow big is the multiplier? • Rewrite, using : • is somewhere between 2 to 5 • is around 0.6 • is around 0.2 • The fiscal multiplier is around 0.19 to 0.34. Very small!

  6. B1) The Effects of Government Spending Extension #1: Productive government spending • Assume now that government spending is productive: • Where measures the efficiency of government spending • Typically we would have • Total production of the economy:

  7. B1) The Effects of Government SpendingExtension #1: Productive government spending • Planning problem: subject to • Obtain

  8. B1) The Effects of Government SpendingExtension #1: Productive government spending • Putting together • The multiplier is now larger, but is still smaller than one

  9. B2) The Effects of Government Spending Extension#2: Monopolistic Competition • Suppose that instead of competitive markets, there is monopolistic competition • There is a final good producer that demands the intermediate goods • There are many small identical,monopolistic firms producing intermediate goods where is markup

  10. B2) The Effects of Government Spending Extension#2: Monopolistic Competition • Since is constant, the frictionless economy with monopolistic producers behaves similarly as the competitive economy • The fiscal multiplier is exactly the same • Note that the level of production is inefficiently low

  11. B2) The Effects of Government Spending Frictions • Larger increase in would be possible if rises more than • Introduces a ‘’labor wedge’’ into the equilibrium condition: • Before we had . • If then the fiscal multiplier is larger

  12. B2) The Effects of Government Spending Frictions • How to justify increasing ? Assume sticky prices: some producers cannot change their nominal price • How much the labor wedge changes depends on • How sticky prices are • What the monetary policy does

  13. B2) The Effects of Government Spending Frictions • Suppose that there is a nominal price of the final good . Each producer charges a nominal price for its product • Before we had and, in equilibrium, . • Suppose that before an increase in government spending there is • Suppose that a fraction cannot change the output price

  14. B2) The Effects of Government Spending Frictions • In equilibrium, obtain • Corresponds to • If an increase in triggers an increase in the price level then increases with • A response of monetary policy matters!

  15. Results from a world with frictions – a summary • If prices are sticky and the monetary policy reacts to increased government spending by producing some inflation, the fiscal multiplier is larger

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