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Yet if the public sector is sufficiently large, in a butskellite type mixed economy, then its very presence can dampen down the business cycle. If growth slows, for example, and there is an increase in unemployment, then under a welfare state workers will receive unemployment benefit. So although they are not earning the wages that they earned under employment, unemployed workers are still able to consume, albeit at a lower level. Such a transfer payment can be thought of as a negative tax, affecting consumer expenditure in a similar way to a tax cut.
This second type of fiscal policy is referred to as an automatic stabiliser – a fiscal response to a slowdown in economic activity that happens without any active decisions on the part of the government. Governments, of course, have to choose to keep the system in place to facilitate this automatic spending, but they do not have to actively direct the spending from day to day.
The Anti-Waste League, formed by Lord Rothermere, had put up candidates and won three by-elections during 1921.
David Lloyd George, the prime minister, acted by appointing a businessman Sir Eric Geddes to head the new Committee on National Expenditure, which was soon dubbed ‘The Great Axe’. It highlighted waste in all areas of public spending, including details such as there being a ratio of one cleaner for every vehicle in the Army. Between 1921 and 1922 it recommended economies totalling £87 million, about 10 per cent of the country’s entire GDP.
In the case of Greece, during the European financial crisis that started in 2010, the main problem has been trying to service the interest payments on its debt. This problem has been compounded by the lack of confidence in Greek bonds in the world financial markets.
The ‘sound finance’ advice given by policymakers, in the European Commission and beyond, has been for Greece to cut government spending and increase taxes in order to meet its debt interest payments. From the perspective of Keynes, however, the problem with this austerity approach is that the reduction in government spending will, via the multiplier, reduce national income and the ability of the economy to generate tax revenue. In the face of this type of crisis, Keynes would have called for the government to boost income using government infrastructure spending.
If animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die.
We have said that the economy will be in equilibrium when planned saving matches planned investment. So we need to use our diagram to explore this relationship. First, we need to show planned saving. Our diagram already shows planned consumption at each level of income, and of course planned saving is simply the difference between income and planned consumption. Having shown saving, we need to go on to add investment to our model to complete our analysis of equilibrium.
At an income level of £600, households are planning to spend £520 on consumption and to save the remaining £80. But firms are not planning to invest at all! Let’s now incorporate planned investment into our diagram. This will mean two slight changes.
The Keynesian model treats planned investment as an exogenous component of demand, that is, as not dependent on current income. It will therefore appear as a horizontal line on our diagram but, when we add planned investment to planned consumption, the aggregate demand line, which at present shows only planned consumption, will move upwards by the amount of planned investment we introduce.
In our diagram, planned saving is shown by the vertical gap between the consumption function and the 45-degree line. Planned investment is shown by the vertical gap between the consumption function and the aggregate demand function.
Given the assumptions we have made about exogenous consumption, the propensity to consume and the level of exogenously determined investment, these two vertical gaps are equal at an income level of £600, so at this income level planned saving = planned investment. We have therefore illustrated an economy in equilibrium at an income level of £600.
Note that the AD line (C + I) crosses the 45-degree line at an income level of £600. Since at any point on the 45-degree line AD = Y, we can say that at an income level of £600 aggregate demand = income.
Lloyd George’s £300 million programme had three main planks:
Similar public spending programmes were announced throughout the world in response to the economic crisis of 2008. In the USA, President Obama introduced the American Recovery and Reinvestment Act of 2009, which resulted in US$831 billion of government spending on items such as infrastructure, health and education. In the same year, Australia launched a ‘Nation Building and Jobs Plan’, costing AUS$42 billion, on items such as building local community infrastructure and refurbishing schools – estimated to create 90 000 jobs and to boost annual GDP by 1% after two years (Vu and Tanton, 2010, p. 129).
You cannot spend your way out of recession or borrow your way out of debt.
This common sense mantra has been espoused by those on the right of the political spectrum in response to the economic crisis of 2008, such as the Tea Party movement in the USA. The alternative political position is captured in the T-shirt below, worn by supporters of the anti-cuts movement.
Aggregate demand (AD) in the extended model consists of planned consumption (C ) and planned investment (I ), as before, with an additional term (G ) representing planned government spending:
AD = C + I + G
The size of the multiplier depends on the marginal propensity to consume, as explored in the box below. It has a simple formula:
where b is the marginal propensity to consume. In the example in Table 1, the propensity to consume is equal to 1/2. Hence
The eventual doubling of income in the multiplier process is captured in total by this formula for the multiplier.
The Geddes Act, introduced by one of the great Liberal administrations, ironically gave impetus to a burgeoning Labour Party. The number of seats it held rose from 59 in 1918 to 142 in 1922, reflecting a new coalition across class lines. It went on to form its first administration in 1924.
(b) In what way is it unrealistic to suggest, as in this example that the consumption function would start from the origin?
Even with no income, there must be some consumption: households need to consume basic goods so would need to borrow or run down savings balances to finance this consumption. This bare minimum consumption that does not depend on income is known as exogenous consumption. Exogenous consumption is usually symbolised by a.
(b) What is the equation of the aggregate demand function you have derived?
The equation is: AD = 180 + 0.7Y, as there are now two constants: exogenous consumption (100) and planned investment (80).
(b) State by how much AD falls short of the level required to produce the full-employment income of £800.
In this example, aggregate demand at any level of income is calculated using the equation:
AD = 180 + 0.7Y
So, if equilibrium income (Y) were to be £800:
AD = 180 + 0.7 x 800 = 180 + 560 = 740
which would fall short of income by £800 – £740 = £60.
Policy intervention will be needed to give a stimulus that initially raises aggregate demand by £60.
(c) Assume that the required stimulus is going to take the form of policy to increase investment. Use the tool to change investment by the amount you calculated in (b).
(d) Describe what has happened to the equilibrium level of income as a result of the change you made in (c).
The economy is now in equilibrium at an income of £800 which is the full-employment level of income.
(a) What are the different challenges faced by firms in Germany compared to firms in Italy?
The video raises a variety of issues at both the macro and microeconomic level, so your notes may be different from those here.
The video describes the story of a strong German economy with rising exports and falling unemployment compared to a struggling Italian economy. In Italy, the video indicates some of the macro problems related to lack of productivity growth and a lack of investment. A lot of Italian firms are very small so this can be a barrier towards improving production technology and human capital. Being able to increase productivity is one strategy for competing with firms based in countries with lower wages.
As reported above, the official estimate was that 5000 jobs were created by each £1 million of expenditure. Directly and indirectly, how many jobs could have been created by the £72.5 million earmarked for the first year of the Lloyd George road-building programme?
The total impact would have been 362 500 jobs (72.5 × 5000) in the first year – a substantial hole in the more than one million unemployed in 1929, created just by road-building. For Keynes, this was not a Lloyd George fantasy; it was confirmed by the government itself after intensive pressure and analysis.
(b) How do macroeconomic conditions relate to firm performance?
The direct relationship between macro and micro performance is not clear in the video. Dr Nerb emphasises the role of change to Germany’s labour market – increasing flexibility of labour by allowing firms to recruit workers on a temporary basis, which is supposed to encourage reduced unemployment. However, Professor Mazzucato strongly disagrees, suggesting the real change is also due to Germany investing in research and development (R&D) and human capital to make firms perform better.
The aggregate demand model can also be used to illustrate what might happen under an increase in government spending, as shown in Figure 15. Let government spending increase by £300 million – money that could be spent along the lines of the 2009 Obama Recovery Act or the 1929 Lloyd George three-point plan. This is shown by an upward shift of the intercept of the aggregate demand schedule by £300 million due to an increase in government spending from G0 to G1. It is referred to in modern economics as a fiscal stimulus. Using one of its key fiscal powers – the ability to carry out expenditure – the government is able to boost aggregate demand.
This ‘double your money’ insight can now be explained by breaking down the effect of the stimulus into a series of rounds, as shown in Table 1. In Round 1, the change in income is equal to the fiscal stimulus of £300 million. Round 2 then depends on how much of this income is spent.
(c) What factors determine the success of firms? How are these factors different in Italy and Germany?
Successful firms, whether in Germany or Italy, share similarities: instead of trying to compete directly with low-cost producers, they have differentiated their products, focusing on very high-quality goods requiring specialist expertise. So even though the macroeconomic situation in each country is different, there are similar examples shown for how firms can succeed. In this section, we will investigate some of the ways we can model how firms compete.
Think about the goods and services you use each week – what types of firm produce them? You may also work for a firm. Make a quick list of at least five different firms that you have a connection with, for instance, as a customer, employee, investor or owner. What are the similarities between firms on your list?
Your list may show a bewildering variety of different firms, a mixture of well recognised national names, other local suppliers, and some that may appear to have only a virtual presence.
The diversity of firms in the economy is enormous: from the local corner shop, bakery or other food producers such as dairy farmers, to vast enterprises like Microsoft or Apple producing consumer goods, or GlaxoSmithKline or Pfizer producing pharmaceutical and health care products. Major multi-product firms are bigger on most measures of size than the economies of many whole countries, and also operate from sites across different countries, giving them the term Multi-National Corporations (MNCs). Not all firms produce goods, but some instead provide services, or a mixture of both goods and services. Services firms offer a range of activities, from the professional services, such as tax, legal and financial advice offered by ‘The Big Four’ audit firms (PWC, Ernst & Young, Deloitte and KPMG), or caring and social services provided by a local childminder or nursery.
Some firms are particularly well-known, capturing the attention of the media by developing innovative products to challenge the status quo. In fact, firms like Microsoft, Apple and, more recently, Amazon and Google began as small enterprises before growing to become large corporations known to households internationally. Aside from these high-profile firms with customers all over the world, there are many firms that sell directly to other businesses and provide intermediate goods and services as inputs into other firms’ production processes.
For a multiplier of 3.57 (as in the above example, with initial tax rate 10% and a marginal propensity to consume of 0.8), calculate the multiplier impact on income of an increase in government spending ΔG = £30 million.
This activity allows you to compare the above tax cutting example with a fiscal stimulus based on increased government spending. With a multiplier of 3.57, the final increase in income from the increase in government spending is 3.57 × £30m = £107.1 million. Even without the benefit of an increase in the multiplier, an increase in government spending delivers a higher boost to income than an equivalent tax cut: £7 million more in this example.
After studying this course, you should be able to: