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? SIMPLIFIED LIBERTARIAN PLATFORM 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. SIMPLIFIED GINGRICH/DOLE CONSERVATIVE REPUBLICAN PLATFORM 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. SIMPLIFIED TSONGAS/RUDMAN BIPARTISAN PLATFORM 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. SIMPLIFIED CLINTON PLATFORM 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. SIMPLIFIED JERRY BROWN/RALPH NADER PLATFORM 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. ---------------------------------------------------------------- ---------------------------------------------------------------- SUMMARY OF CLASS DISCUSSION ---------------------------------------------------------------- ---------------------------------------------------------------- SIMPLIFIED LIBERTARIAN PLATFORM 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. Interpretation: 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 reestablished? 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. ------------------------------------------------------------------- ------------------------------------------------------------------- SIMPLIFIED GINGRICH/DOLE CONSERVATIVE REPUBLICAN PLATFORM 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. Interpretation: 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 arise? 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. ---------------------------------------------------------------- ---------------------------------------------------------------- SIMPLIFIED TSONGAS/RUDMAN BIPARTISAN PLATFORM 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. Interpretation: 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? ------------------------------------------------------------------- ------------------------------------------------------------------- SIMPLIFIED CLINTON PLATFORM 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. Interpretation: 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 generations. 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; or 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 itself." 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 sector? 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 jobs. 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. ------------------------------------------------------------------- ------------------------------------------------------------------- SIMPLIFIED JERRY BROWN/RALPH NADER PLATFORM 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 children. 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.