The media does a horrible job of informing the public about economic issues. This is so because the public, for the most part, is unaware of basic macroeconomic models from which economic policies are derived. Phrases such as ‘government spending’ are mentioned without any explicit explanation of where such spending fits into the big picture. So instead of being able to form sound judgments about these things, people end up relying on vague and misunderstood principles that were haphazardly pulled from the ideasphere or handed down from parents. I’m referring to principles such as “Never raise taxes,” or “Government spending is never a good thing.” I’m yet to hear or read a good justification for these principles out of any mouth not informed of macroeconomic models. Let’s try to mitigate this.
Models such as the Classical model and the Keynesian model are good segues into more advanced economic theory, and are actually largely relevant in current debates. With brevity, we'll look at a Keynesian model and a few of its implications. Nota bene: this is by no measure a complete look at the Keynesian model. In fact, it is a brief clip from the simple Keynesian model. However, this is definitely sufficient for our purposes and the inferences for policy it provides are still sound.
The distinctive implication of the Keynesian model is that government spending can be a good thing - assuming that an economy in equilibrium is a part of the good. Before we look at this, we need to learn a little bit about some economic variables, the components we'll be using in our analysis and the symbols we'll see in our equations.
The big one is GDP, which is represented with Y. GDP (gross domestic product) is a measure of all currently produced final goods and services. It's the output of a nation. Currently produced because we're not concerned with the goods and services from 1899. Final goods and services because there are goods which are intermediate, as in they are used to produce other goods (such as the corn dedicated to feeding cows.) Counting these goods would be counting twice. In the Keynesian model, economists makes some assumptions which allow Y to be equated with over economics concepts. In our case, you'll need to know that Y can be equated with national income, the sum of all earnings from current production. GDP has some components.
Consumption, the spending people do every day, is the major component. This includes goods like food, cars, TVs, and haircuts. We represent consumption with, quite surprisingly, C.
Another component is investment, which may be broken down into subcomponents. Investment largely refers to business fixed investment, the purchase of capital goods (stuff like factories and machinery.) Investment also refers to construction investment, and that's the purchase and building of new homes. Lastely, there is business inventory. These subcomponents won't be crucial for our discussion, but they are good to know of. Investment is represented with I.
Our third component of GDP, and the focus of this post, is government spending. This type of spending refers to the purchases the government makes of goods and services. In other words, this component is very similar to consumption, except individuals aren't making the purchases - the government is. One thing to note, however, is that not all government spending goes into this component. Payments such as Social Security checks are not included. Government spending is represented by G.
Our final component is net exports. We say net exports because this entails actual exports minus imports. Exports refers to the foreign demand for goods and services. Imports refers to demand for the goods and services of other nations. Thus, we subtract imports in our analysis. Exports is represent by X, imports by Z. Now we can finally begin to look at the Keynesian model.
First thing first, look at all of the variables we just defined. If you're astute, or just a good reader, you'll notice that C, I, G, X, and Z are all components of Y. We can write this as
1. Y = C + I + G + X -Z
For now, however, we'll drop the X and Z and focus on a closed economy. Thus,
2. Y = C + I + G
Our second equation here tells that every unit increase in any of the components yields a unit increase in output. Simple enough, right? Definitely. However, things do become a bit more complicated. In the Keynesian model, consumption can be described by a function.
3. C = a + bYD
Uh oh, more variables! To understand this you first need to understand what disposable income is, the concept represented by YD. As mentioned before, GDP can be equated with national income, given certain assumptions. Well, disposable income is just whatever income is left after taxes. So,
4. YD = bY – bT
where T represents taxes. We can plug this into our third equation to get
5. C = a + bY – bT
But what do a and b mean? a is the amount of consumption that will still occur even if disposable income is equal to zero; it’s assumed to have a positive value. b gives the increase in consumer expenditure per unit increase in disposable income. The thought here is that the propensity to consume will increase as disposable income increases, but each additional unit of disposable income will not be followed by a unit increase in consumption (individuals also have the option to save their money.) This completes all speak of variables that will be necessary to discuss government spending. Our equation is as follows.
6. Y = a + bY – bT + I + G
And with some simple algebra we ultimately come to our final equation.
7. Y – bY = a – bT + I + G
8. (1 – b) Y = a – bT + I + G
9. Y = (1 / 1 – b) (a – bT + I + G)
Now our focus is on the right hand side of the equation, specifically on bT, I, and G. An assumption made in the Keynesian model is that I, business investment, is unstable. The reasons why aren’t necessary for this discussion. Just know that it was believed I would arbitrarily increase and decrease. Obviously, this could put the economy into disequilibrium. Thus, enter T and G. Let’s say that I decreases, so output decreases with it. The politician has two options to counteract this change: either increase government spending or cut taxes. This is where the value of government spending comes in. In many cases, increasing government spending may be preferable because of b, which has a value less than one. Given b, any unit change in taxes will have less of an effect than a unit change in government spending! This is not to say that cutting taxes will never be preferable, but if you accept the assumptions made by the Keynesians, then increases in government spending can be sound.
This type of reasoning could justify the bailout packages from Bush and Obama. The economy went into recession - output decreased. In order to increase output, Y, the government started spending money. Very simple. Or, at least, very simple in this discussion. Of course, one shouldn’t just expect the economy to come out of a recession with an increase in G. Rather, we should look to see what happens afterwards. If an increase in G leads to an increase in output, then we have some evidence supporting the Keynesian model. If not, then we have problems.
There you have it: a justification for an increase in government spending. The only problem is that economists aren’t certain which macroeconomic model is correct, so we must take any inferences derived from these models with a grain of salt. Check back in the future, and I’ll post some material explaining more of the Keynesian model and other models, too. Knowing these models, even if it’s just the basics of them, gives you a sound base for judging political policies, sound-bytes in the media, and claims made by your ultra-conservative/liberal dad.