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Lecture4 PDF

The document discusses the role of government in providing public goods and correcting market failures in the context of intermediate macroeconomics. It outlines the government's budget constraints, the concept of equilibrium, and the competitive equilibrium model, emphasizing the relationship between exogenous and endogenous variables. Additionally, it explores the implications of government spending and changes in total factor productivity (TFP) on consumption, wages, and labor supply.

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13 views37 pages

Lecture4 PDF

The document discusses the role of government in providing public goods and correcting market failures in the context of intermediate macroeconomics. It outlines the government's budget constraints, the concept of equilibrium, and the competitive equilibrium model, emphasizing the relationship between exogenous and endogenous variables. Additionally, it explores the implications of government spending and changes in total factor productivity (TFP) on consumption, wages, and labor supply.

Uploaded by

youcanguessmy234
Copyright
© © All Rights Reserved
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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EF3441: Intermediate Macroeconomics

Prepared by Dr. Tam


Lecture 4
The Government

▶ In our model the government is benevolent: maximizes welfare


of its citizen
▶ Question: why do we need a government?
▶ It provides public goods:
▶ Schools, Police, Fire, Military
▶ Infrastructures
▶ It corrects market failures:
▶ Regulations: financial markets, pollution
The Government: Budget Constraint

▶ Let G be the dollar value of the public goods. In a static


world the budget constraint is:

G =T

▶ When we will look at dynamics we will have

G = T + ∆debt
The Government: Budget Constraint
The Government: Budget Constraint

▶ Static government budget constraint is:

G =T

▶ Taxes T also appear in the household budget constraint:

C = wN + π − T
▶ In the data from where does the government draws revenue?
The Government: Budget Constraint

The impact of government policy on household and firm:


▶ τy : income tax (appears in Househols budget constraint)

C = (1 − τy )wN + π − T

▶ τc : consumption tax (appears in Househols budget constraint)

(1 + τc )C = wN + π − T

▶ τr : tax on revenue (appears in firm profits)

π = (1 − πr )zF (K , N d ) − wN d
Equilibrium

Why do we need an equilibrium concept?


▶ Suppose government consumption (G ) increases by 10%.
What happens to c and ℓ?
▶ Suppose government subsidizes employment? What happens
to wages and GDP?
Equilibrium

Remember
▶ Our consumer is a representative consumer: it represents ALL
of the consumers in Hong Kong
▶ Our firm is a representative firm: it represents ALL of the
firms in Hong Kong
Equilibrium

▶ The idea:
▶ Set some external conditions (exogenous variables)
▶ Determine what happens to all of the other variables of
interests (endogenous variables)
▶ In our static model:
▶ Exogenous variables: (K , G , z)
▶ Endogenous variables: (C , N s , N d , T , Y , w )
Equilibrium

How do we know what is going to happen?


▶ Must be optimal:
▶ everybody (household and firm) must like the decision it has
taken.
▶ Must be feasible:
▶ cannot have more consumption than goods produced.
Competitive Equilibrium: Static

For a set of exogenous variables (K , G , z) A competitive


equilibrium is a set of endogenous variables (C , N s , N d , T , Y , w ),
so that:
▶ The consumer chooses C (consumption) and N S (labor
supply) optimally, taking as given w (wage), T (taxes), π
(dividends)
▶ The firm chooses N d (labor demand) to maximize profits,
taking as given w (wage), K (capital stock), z (productivity)
▶ The markets must be cleared
▶ Labor market: N d = N s
▶ Goods market: Y = C + G
Arrow-Debreu-Mckenie (ADM) Model.
Suggestion: read Chapter 1 in Big Ideas in Macroeconomics: A
Nontechnical View by Kartik Athreya.
Working With the Model
Working With the Model

Derive a relation (production possibility frontier - PPF) so that


given (K , G , z) we can determine all the feasible (C , ℓ) pairs

Y = zF (K , N d )

Since market clear N d = N s :

Y = zF (K , N s )

substitute feasibility of hours of household: N s = h − ℓ

Y = zF (K , h − ℓ)

substitute the goods market clearing: Y = C + G

C = zF (K , h − ℓ) − G
The Production Possibilities Frontier

▶ Some properties of the PPF: C (ℓ) = zF (K , h − ℓ) − G


▶ Equilibrium consumption decreasing in leisure
▶ Decreasing returns - PPF is concave
The Production Possibilities Frontier

▶ The negative slope of the PPF is the marginal rate of


transformation
▶ this implies: Marginal rate of transformation, MRTℓ.c =
marginal product of labor, MPN , so for any (C , ℓ) on the PPF
we can find the wage
Moving Towards the Competitive Equilibrium

▶ To the production possibilities frontier we need to add:


▶ Add the household’s budget constraint C = w (h − ℓ) + π − T
▶ Find the slope: done
▶ Find the intercept
▶ Add indifference curves.
The Competitive Equilibrium (CE)
Competitive Equilibrium: Static

For a set of exogenous variables (K , G , z) A competitive


equilibrium is a set of endogenous variables (C , N s , N d , T , Y , w ),
so that:
▶ The consumer chooses C (consumption) and N S optimally,
taking as given w (wage), T (taxes), π

maxs U(C , h − N s )
C ,N

s.t. C = wN s + π − T
▶ The firm chooses N d (labor demand) to maximize profits,
taking as given w (wage), K (capital stock), z (productivity)

max zF (K , N d ) − wN d
Nd
▶ The markets must be cleared
▶ Goods market: Y = C + G
The Competitive Equilibrium

Algorithm to find a Competitive Equilibrium (graphically):


▶ Find the values of capital (K ), government expenditures (G )
and productivity (z): these are the exogenous variables.
▶ Given exogenous variables determine PPF,
▶ Find point of tangency between PPF and preferences,
▶ Recover endogenous variables (C , N s , N d , T , Y , w ).
▶ Use the constructed equilibrium to determine relationship
between exogenous and endogenous variables.
Key Properties of a Competitive Optimum:

MRSℓ,c = MRTℓ,c = MPN


The Competitive Equilibrium

Algorithm to find a competitive equilibrium (numerically):


1. Find the values of capital (K ), government expenditures (G )
and productivity (z): these are the exogenous variables.
2. Guess a w ,
3. Solve the household’s (utility maximization) problem,
4. Solve the firm’s (profit maximization) problem,
5. Check the good market clearing condition:
▶ If Y = C + G , the guessed w is the equilibrium wage. Stop!
▶ If Y < C + G , guess a lower w , redo 2 − 5.
▶ If Y > C + G , guess a higher w , redo 2 − 5.
It is difficult to solve for the equilibrium wage!
Pareto Optimum (PO)

Definition
The Pareto optimum is the point that a social planner would
choose where the representative consumer is as well off as possible
given the technology for producing consumption goods using labors
as an input.
Write as an optimization problem:

max U(C , h − N)
C ,N

s.t. C = zF (K , N) − T
Pareto Optimum

Key Properties of a Pareto Optimum:


MRSℓ,c = MRTℓ,c = MPN
Example

▶ The representitive household’s preference:


U(c, h − N s ) = β log(c) + (1 − β) log(h − N s ).
▶ The representitive household’s production function:
Y = zK α (N d )1−α .
▶ Government: G = T = 0.
▶ 0 < α, β < 1.
1. Solve for the PO.
2. Write down the algorithm that for the CE.
First Welfare Theorem

Definition
The first fundamental theorem of welfare economics state that,
under certain conditions, a competitive equilibrium is Pareto
optimal.
Not too useful because the CE is much harder to solve than the PO
Second Welfare Theorem

Definition
The second fundamental theorem of welfare economics state that,
under certain conditions, a Pareto optimum is a competitive
equilibrium.

Very useful because the PO is “easy” to solve

▶ We solve the PO,


▶ Use the PO to calculate MPN to back out wage w
(MPN = w ),
▶ We get the CE.
▶ Now, we can use PO to represent CE.
Sources of Social Inefficiencies

▶ Externality and public goods


▶ Distorting taxes
▶ Imperfect competition
▶ Information asymmetry
Examples

We are going to consider the following two exogenous changes:


▶ Changes in government expenditures: G .
▶ Changes in productivity: z.
Government Spending

Suppose the government increases its expenditure: ∆G > 0:


Government Spending

Suppose the government increases its expenditure:


∆G = G2 − G1 > 0
▶ Balanced budget: if G2 > G1 then T2 > T1 . An increase in
government spending means negative income effect on
consumption and leisure;
▶ Reduces household’s disposable income: C2 < C1 and l2 < l1 ;
▶ Increase in equilibrium hours worked: N2 > N1 implies
Y2 > Y1 .
Questions:
▶ what has happened to the real wage?
▶ does GDP increase?
▶ does the household prefer the increase in G?
▶ ∆C vs. ∆G ?
Government Spending

Questions:
▶ what has happened to the real wage?
Decrease. Because N2 > N1 , MPN decreases so is real wage
w.
▶ does GDP increase?
Yes. Because N2 > N1 and Y = zF (K , N).
▶ does the household prefer the increase in G?
No. Because the utility level is lower as showed in the graph.
▶ ∆C vs. ∆G ?
Government Spending

The income-expenditure identity: Y = C + G , so

∆Y = ∆C + ∆G

We know ∆Y > 0 and ∆G > 0, so we get ∆C > −∆G .


That means the private consumption is crowed out by government
purchases, but it is not completely crowded out as a result of the
increase in output.
Government Spending

Suppose the government increases its expenditure: ∆G > 0:


Changes in TFP

Suppose there is an increase in TFP: ∆z > 0


Changes in TFP

Suppose there is an increase in TFP: ∆z > 0


Changes in TFP

Summarizing:
▶ z2 > z1
▶ Wage increases w2 > w1
▶ Consumption increases C1 < C2
▶ Hours worked? depends on income and substitution effects
Separating Income and Substitution Effects

PPF3 is PPF2 adjusting the income of the HH so that it’s


indifferent between new and old equilibrium.
Changes in TFP

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