Econ 302 In-Class Exercise on Presidential Platforms

Course Instructor: Leigh Tesfatsion
Last Updated: 10 December 1996

     Suppose the economy in period 0 is currently in a short-run
equilibrium (Y(0),R(0)) with Y(0) less than Y*(0), with a substantial
government budget deficit, and with relatively slow productivity
growth---that is, with measured total factor productivity growing
slowly relative to historical experience.  What are the current
and future implications of implementing the following presidential
platforms in period 1?


Active government intervention in the private sector economy is
#not required#.  The economy will recover by itself as the price
level adjusts in response to market pressures.


Active government intervention in the private sector economy
should be #minimized#.  Government should #cut# way back on
spending and #cut# way back on taxes.  The Federal Reserve Board
should keep a tight control of the money supply to prevent


The government should #raise# spending on physical and human
capital and #raise# taxes to pay for it.  The increased
government spending should not be permitted to add to the
government budget deficit.


The government should #raise# spending on physical and human
capital, make selective moderate #cuts# in taxes for middle income
families, and #increase# the minimum hourly wage by 90 cents.


The government should #raise# spending on social goods such as
welfare, health, the environment, and education.  The government
should #cut# taxes, particularly taxes on the poor, and #raise#
the minimum wage substantially.

NOTE: In the simplfied HT model, Y* is constant and the **levels**
of M and G are assumed to be controlled by government.  In the real
world, Y* grows over time in response to increases in the capital
stock, the size of the labor force, and improvements in technology;
and government increases G and M over time to accommodate this
growth in Y*.  Consequently, it is changes in the **growth rates**
of G and M that are actually at issue among policy makers, not
not changes in the levels of G and M per se.





     Additional government intervention in the private sector
     economy is not required.  The economy will recover by itself
     as the price level adjusts in response to market pressures.


     The libertarians are hoping that the general price level
P(T) will adjust #down# quickly in response to the negative GDP
gap Y(T)-Y*(T).  This will #increase# the real money supply, and
the excess supply of money will bring down the interest rate, so
that demand=supply equilibrium is reestablished in the money
market.  That is, the LM curve will shift #down# (smaller R for
each Y).  The lower interest rate will then stimulate an increase
in investment and net exports, and hence also in Y.  The decrease
in the general price level should continue until there is no
excess supply or demand in the labor market, i.e., until Y^o =
Y* and the economy is in internal balance.

Potential Problems:

     1.  Does the economy tend to converge naturally to
internal balance, without need of government intervention,
following upon some kind of shock to the economy?

     2.  Even if the economy does exhibit stability in this
sense, how long does it take for internal balance to be

     Regarding these potential problems, the price level might
not be very responsive to GDP gap pressures---e.g., the
coefficient f in the expectations-augmented Phillips curve might
be very small in magnitude due to market imperfections such as
externalities, monopolistic price setting in markets with small
numbers of firms, capital market imperfections, etc.  Thus, for
example, it might take many periods before decreases in the
general price level significantly reduce the size of a negative
GNP gap.  In the meantime, people are unemployed and the high
real interest rate is a discouragement to private investment.
Consequently, the capital stock K(T) might grow only slowly over
time (relative to what it could be doing), which implies in turn
a slow growth rate for potential GDP Y*.

     Also, the behavioral relationships postulated by Hall and
Taylor for consumption and money demand might not accurately
measure the response of consumers to changes in the economic
environment because they do not properly take into account the
extent to which economic agents are forward looking ( i.e.,
anticipators of future events).  For example, forward-looking
consumers might base their period T consumption on their expected
average disposable income over the next several years rather than
on just their current disposable income.  Consequently, if Y stays
below Y* for a lengthy period of time, the level of consumption
predicted by the simple HT consumption function C = a+b[1-t]Y
might be too high because it ignores the fact that consumers are
becoming increasingly pessimistic regarding their future income
prospects, implying that one or both of the behavioral coefficients
a and b in the HT consumption function is decreasing.

     The forward-looking theory of consumption is discussed by
Hall and Taylor in Chapter 10.  Unfortunately, we will not have
time to cover this chapter in Econ 302.



     Active government intervention in the private sector economy
     should be #minimized#.  Government should #cut# way back on
     spending and #cut# way back on taxes.  The Federal Reserve
     Board should keep a tight control of the money supply to
     prevent inflation.


     The basic idea is that government should only do for the
people what people can't do for themselves.  While most political
parties accept this idea, conservatives differ from liberals
with regard to their interpretation of the phrase "what people
cannot do for themselves."

     Except for a few basic functions such as national defense
and the regulation of foreign relations (plus the collection of
minimal taxes to finance these functions), conservatives such as
Gingrich (and to a lesser extent Dole) believe that most things
should be left to the voluntary efforts of private citizens.
They believe that a cut-back in government intervention would
unleash a tide of productive private effort---in particular,
large increases in private investment, including expenditures on
research and development (R and D) that could positively affect
the total factor productivity coefficient A in the aggregate
production function.  These private efforts would thus result in
a higher capital stock and improved technology that would in turn
lead to increases in the potential GDP level Y* over time.  Any
imbalance that might arise between Y and Y* would be corrected
for quickly and automatically by offsetting movements in the
price level and the interest rate.

     On the other hand, conservatives worry about the supposed
propensity of the government to pay for increases in current
expenditures by means of debt financing (i.e., the sale of
government bonds to U.S. private citizens and to ROW) or by
printing press financing (i.e., the sale of government bonds
directly to the central bank---the Fed Reserve in the U.S.---in
return for a deposit account or cash).  Either means of financing
runs up the current government budget deficit:

       [G + F + N]  -  tY   =   DB/P    +    DM/P  ,

and hence reduces government savings:

       S_g  =  tY - [G + F + N] ,

where F = government net transfers to the private sector and N =
interest payments on the current government debt (outstanding
government bonds held by private U.S. citizens and by ROW).
Conservatives point to the identity

       S_p   +    S_g     +     S_r     =     I

to argue that reductions in S_g means that either investment I
will have to be cut or that the reduction in S_g will have to be
made up by increases in private savings S_p or by increases in
ROW savings S_r (borrowing from ROW).  Decreasing I or increasing
S_r are not very attractive options ("mortgaging the future of
our children"), and increasing S_p has proved hard to do.

       In addition, repeated increases in M resulting from a
printing press financing of government expenditures will result
in eventual inflation as Y rises above potential GDP Y*.  An
increase in the expected inflation rate reduces the expected real
earnings on securities such as bonds whose promised payments to
holders are denominated in dollars---for example, $100 per year.
Consequently, the price P_B for such bonds will drop, which
implies that the nominal rate of return on these bonds (e.g.,
$100/P_B) will rise.

     Conservatives therefore argue that the Federal Reserve Board
should only increase M to keep it in line with the growing
transactions needs of a growing economy.  That is, basically the
money supply should not grow any faster than Y*.

Potential Problems:

     In terms of the Hall and Taylor model, a cut-back in G
shifts #down# the IS curve, and a cut in t rotates the IS
curve #upwards# around the R-intercept, offsetting to some extent
the cut-back in G.  These displacements in the IS curve can
result in two possible types of outcomes.

     If the expansionary effects of the decrease in t sufficiently
outweigh the contractionary effects of the cut in G, then Y and R
will both increase.  In this case there will be a reduction in the
current level of unemployment (a reduction in the size of the GDP
gap) but also a reduction in current investment which will result in
a smaller capital stock in the next period.  Consequently, unless
the cut in t results in a large increase in labor supply that
offsets the reduction in the capital stock, potential GDP Y* in the
next period will fall.  If Y actually rises above Y*, there will
also be an increase in the inflation rate.

     On the other hand, if the contractionary effects of the cut
in G outweigh the expansionary effects of the decrease in t,
then both Y and R will decrease.  In this case there will be an
increase in the amount of unemployment in the current period, but
there will also be more private investment and hence a higher
capital stock and potential GDP level Y* in the next period.

     Suppose that a decrease in Y and R result from the decrease in
G and t, so that I increases.  What potential problems could still

     First, there is no guarantee in actuality that the decrease
in R will encourage expenditures on newly produced capital goods
that are the most socially productive from a long-run point of
view.  Also, private firms might respond to the decrease in R by
increasing their borrowing in order to acquire existing real
estate or companies rather than to finance investment in new
capital goods.  Thus, large amounts of increased private
expenditure in reponse to a decrease in R might actually result
in only minimal increases in future potential GDP levels Y*.

     Second, even if expenditures are such that Y* eventually
increases, it does not necessarily follow that the actual GDP
level Y will also increase by this same amount.  The latter
belief rests on the assumption that the economy is essentially
stable, in the sense that Y tends to converge to Y*.  As
discussed for the Libertarian platform, this requires a
well-functioning price adjustment mechanism and appropriate
accommodation by the Fed.  For example, excessive fears of
inflation by the Fed could result in too tight a monetary policy,
which keeps Y restricted below Y*.

     Finally, the Hall and Taylor model includes only a very
simple tax policy parameter---a single income tax rate t.  In
fact, many conservatives are more interested in implementing tax
cuts on "capital gains" (gains made from price appreciation on
financial assets such as stocks and bonds) rather than on income in
general.  Theses conservatives argue that tax savings on capital
gains---because they first accrue to the richer portion of the
population---have a greater chance of being reinvested in the
economy rather than being consumed.

     Liberals counter that this "trickle down" theory of economic
growth, in effect since the early nineteen eighties, has created
an extremely unequal distribution of income in the U.S. over the
past sixteen years that is leading to increased social unrest.
For example, they point to the "excessive" salaries being paid to
chief executive officers (CEOs) of companies relative to the pay
of ordinary workers, and to the angry response of voters when
this situation was brought to their attention by Pat Buchanan in
the 1996 presidential primary election.



     The government should #raise# spending on physical and human
     capital and #raise# taxes to pay for it.  The increased
     spending should not be permitted to add to the government
     budget deficit.


     The U.S. needs to spur productivity growth of both its
physical and human resources.  The experience of the 1980s, in
which a largely deregulated business sector devoted much of its
time paying attention only to short-run profit considerations
(e.g., mergers and acquisitions financed by "junk bonds") at the
expense of R and D aimed at the long-run development of new
products, shows that we cannot rely entirely on the #private#
sector to do this.  The business sectors of our major competitors
(Japan, Germany, Korea, etc.) receive strong government support.
The U.S. business sector cannot hope to compete in this new
global arena without the support of the U.S. government.  The
U.S. needs an "industrial policy" in which government and
business together put together a plan for the long-term
rejuvenation and development of the U.S. economy.

     Tsongas, Rudman, and their supporters therefore advocate
major new government-sponsored spending on the infrastructure of
the U.S. economy, together with human capital investment in
education and job training.  However, they also believe that the
U.S. government must be fiscally prudent in the sense that these
expenditures are paid for now, by raising taxes, rather than
passing the buck to future generations by resorting to bond or
printing press financing.

Potential Problems:

     First, the government may spend unwisely, so that much of
the increase in government expenditures represents consumption
(using up of resources) rather than investment (production of
income-producing assets).

     Even if the increase in government spending is largely
investment in nature, how confident should we be that government
can do better than private industry in picking "winners" and
"losers" to subsidize in the global market place?  Wouldn't the
grand "industrial policy" just end up being a corrupt pork-barrel
policy?  Have bureaucrats ever really proved themselves to be
more far-sighted and efficient than private business?

     Third, do we really want to have an increase in taxes at a
time when most economic commentators are calling the economy
"soft"---i.e., in danger of falling into recession?  What would
this additional tax burden do **now** to financially strapped
American families?  Doesn't this contractionary tax policy risk
sending the economy into a downward spiral?



     The government should #raise# spending on physical and human
     capital, make selective moderate #cuts# in taxes for middle income
     families, and #increase# the minimum hourly wage by 90 cents.


     The rationale for increased involvement of government in
investment expenditure is similar to that of Tsongas/Rudman.
However, Clinton is not as fiscally conservative.  Clinton and
his supporters argue that increased government investment
expenditures will generate a stream of returns that is more than
enough to service both the additional debt (government bonds)
issued to finance the increased investment expenditures #and# any
additional debt that #might# be needed to finance the modest
middle income tax cut.

     That is, they argue that selectively increased #investment#
expenditures by government would #not# be a burden on future

     Suppose, for example, that the economy is in an IS-LM
equilibrium at (Y^o(T),R^o(T)) in period T.  The government
budget constraint for period T takes the form

 G + F + N       =    tY^o(T)     +      DB(T)     +     DM(T).

period T  gov't       period T          period T        period T
 expenditures        tax revenues       bond issue      money issue

Consequently, an increase in G, together with a decrease in t,
would seem to require either:

     a) an increase in DB(T), requiring additional future interest
        plus principal payments that place an increased burden
        on future generations;
     b) an increase in DM(T), leading possibly to a rise in the
        price level and hence to an "inflationary tax" on all future
        dollar earnings.

However, the #overall# change in the tax revenues tY^o(T) resulting
from an increase in G and a decrease in t depends on what precisely
happens to Y^o(T).  If Y^o(T) increases enough to offset the decrease
in t, tax revenues will go up; otherwise tax revenues will fall.
Hence, without further information about the relative magnitudes
of the increase in G and the decrease t, as well as information
concerning the particular nature of the IS-LM relationships
showing how Y^o(T) depends (directly and indirectly) on G and t,
it is unclear whether tax revenues will increase or decrease in
response to an increase in G and a cut in t, and hence what type
of change in DB or DM would be necessary to finance these changes.

     Nevertheless, the stimulus provided by a current increase in
government #investment# expenditures could cause an increase in
future Y* and Y levels and hence in future tax revenues, even if
the short-run effect on tax revenues is negative.  In this sense,
the increase in government expenditures could end up "paying for

     One cannot even pose this issue using the Hall and Taylor model
as is because---as for the U.S. national income accounts prior to
January 1996---all of G is interpreted as consumption spending.

      To see what happens when the investment aspects of G are
explicitly accounted for, suppose the Hall and Taylor model is
modified as followed.  Government expenditure G in any period T
is now the sum of two terms:  a term G_c representing consumption
expenditure; and a term G_i representing investment expenditure
on research and development that leads to an increase in total
factor productivity with a one period lag, as follows:

          A(T+1)  =  A(T)  +  G_i ,

where the production function in any period T relating the GDP
level Y to the employment level N is given by

           Y    =     A(T)          x       F( N, K(T) ).

                    total factor                   period T
                     productivity                  capital stock
                    in period T

As long as G_i is zero, total factor productivity stays constant
over time.  If G now increases in period T due to an increase in
G_i from zero to some positive amount, this results in an
increase in A(T+1) and hence in potential GDP Y*(T+1) in period
T+1 relative to the levels that would otherwise have occurred.
Assuming market pressures keep Y close to Y*, this then leads
ultimately to higher Y levels for the economy, which (for
unchanged t) results in increased tax revenues.  In this sense,
an increase in G could "pay for itself."

Potential Problems:

     The Republicans counter by asking:  How can we be sure that
government investment spending will be truly prudent and
productive?  They argue that, if government picks wrong, the U.S.
risks massive increases in the deficit that will ultimately have
to be financed by imposing additional taxes on future generations.
Moreover, even if government does manage to invest in productive
investments, what evidence do we have that government is #better#
at picking productive investment projects than the private

     What about the increase in the current minimum nominal wage
of $4.25 per hour by 90 cents?  The economy by assumption is
currently at a point where some amount of involuntary unemployment
already exists (Y greater than Y*).  In terms of the labor
market, this could be due to a nominal wage W(T) that is "too
high" relative to market clearing.  The HT model would then
predict that any legislated increase in the minimum nominal wage
to a higher level W_min would either have no effect (because
W_min is below W(T)) or would cause an increase in unemployment
(if W_min is above W(T)).

     In reality, the effects of an increase in the minimum
nominal wage depend on precisely what is going on at the lower
end of the wage scale.  If employers are hiring workers at the
current minimum wage $4.25/hour whose marginal productivity is
just worth this cost, and you now force these employers to raise
the minimum wage so it becomes higher than the marginal product
of these workers, then presumably these workers will lose their
jobs.  But if workers are not being paid their true marginal
product because they have relatively little bargaining power
(weak union, one plant towns, migrant workers, etc.), then
raising the minimum wage may well result in a redistribution of
income from employers to workers without workers losing their

     Many (but by no means all) Democrats believe that a raise in
the minimum wage by 90 cents will not cause any significant
increase in unemployment and will help low-wage workers who are
caught in difficult situations in which they are unable to secure
wages equal to their true marginal product.  On the other hand,
Republicans fear that it will mean a significant increase in
unemployment, especially among teenagers and other young workers
who desperately need work experience to secure an initial
foothold in an ever more competitive workplace.



      The government should #raise# spending on social goods such
      as welfare, health, the environment, and education.  The
      government should #cut# taxes, particularly taxes on the
      poor, and #raise# the minimum wage substantially.

Government Spending on Welfare, Health and Education:

     The crux of the issue for welfare, health, and education is
not whether these are worthy social goods, but who is better
equipped to provide these goods in an efficient cost-effective
way---government or the private sector?

     Many Democrats argue that government should undertake
spending on welfare, health, and education #for the poor#
(particularly children, the disabled and the elderly), a segment
of the population that does not have the resources to help
itself.  They argue that spending on children should be viewed as
human capital investment and spending on the disabled and the
elderly should be viewed as a duty and responsibility that all
civilized societies should assume.  They argue that the private
sector does not adequately provide for such spending due to
various types of market failures.

     For example, future wage earnings are generally not accepted
by private financial institutions as collateral for loans, so
human capital investment in children by parents is tied more to
the parents' current income than to the potential abilities of
the child.  This results in an underinvestment in poor but able

     Republicans (and some Democrats as well) counter that
government spending on welfare, health, and education saps
private initiative, resulting in a dependent citizenry who lose
the habit of self-sufficiency.  They argue that government should
leave childcare to parents and healthcare and insurance to the
private healthcare and insurance industries.   The growth of
government programs such as social security and medicare should
be pared back, because spending on these programs is now out of
control and places too heavy a tax burden on young workers.

Government Spending on the Environment:

     For the environment, there are severe disagreements
concerning not only who should be the ultimate caretaker
---government or the private sector---but also what should be
the proper balance between environmental protection and the
development of environmental resources for economic gain.

     Many Democrats argue that the environment is a public good
in which all future generations have a stake.  The government
---in its fiduciary role as a protector of the interests of
future generations---should take steps to protect this public
good from destructive private development for temporary private
gain.  On the other hand, many (but by no means all) Republicans
argue that environmental regulations have gone too far, placing a
heavy cost burden on private industries that reduces their
productivity and competitiveness.

Cutting Taxes:

     As for cutting taxes, the crux of the issue is whether the
economy can afford to cut taxes in any substantial way in light
of the currently perceived government budget crisis.  Democrats
argue for cuts in taxes on the poor on the basis of fairness
considerations; but Republicans worry that tax dollars returned
to the poor will be used for consumption rather than investment
and hence will contribute to the current deficit without adding
to the productive capacity of the economy.

     In particular, Republicans argue that tax cuts should
instead be directed to those who will use the additional income
for productive purposes; in particular, they argue for a cut in
capital gains taxes (taxes on the dividend income earned from
stock share ownership), arguing that such cuts will encourage
physical capital investment.  Democrats counter that such cuts
are a boondoggle for the already rich, and that there is no
evidence that cuts in capital gains taxes encourage new
#investment# (capital creation) as opposed to simple portfolio
redistributions between bonds and stock shares.

Increasing the Minimum Wage:

     The potential problem associated with an increase in the
minimum wage---an increase in the unemployment rate---has
previously been addressed for the Clinton platform.  Here these
issues are exacerbated because the called for increase in the
minimum wage is more substantial than the increase advocated by
the Clinton Administration.