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Evaluating political actions

Download the simplest version of the model, FinanceministerBasic.exe.
Just click on the link (run the file rather than saving it) and it will prompt you to install the model to your PC. There is another version of this same model, FinanceministerDynaMo.exe. The only difference (which may be important from you view of matters) is that it graphs the variables all together in one chart and it lets you see more variables than the Basic model does. You might install and use it if you want to see a variable (like the government's budget deficit) that is hidden in the Basic version.

The economic relationships in the model are similar to models constructed by Hansen and Cooley, but lacks any money or a monetary sector. Prof. Uhlig has a rather technical pdf file (pdf-file) describing the model that uses mathematical methods well beyond the level of this course. Prof. Uhlig makes several basic points about the model:

"Following assumptions are made:

1. In the model households are assumed to be identical, that is, every household has the same preferences about leisure and consumption. Moreover, that means that all households can provide the same amounts of capital and labor.

2. In addition, all firms are identical: all jobs are equal, structural change does not occur, hence there is no possible unemployment due to missing/wrong qualification.

3. A closed economy is assumed: external trade and international flow of capital are neglected.

4. Moreover, fully flexible prices and perfect competition is assumed - thus, a perfectly functioning market economy where governmental regulation is not necessary to achieve the efficient solution.

5. Another simplifying assumption is considered in this context: in this model public spending does neither increase productivity nor is it required for purchasing public goods. Public spending, in terms of government purchases, are rather subsidies (e.g. for cultural institutions or security) which raise the households utility but are not productive. Child allowance or social benefits are denoted as »transfers« and are not included in public spending.

6. Evaluating political actions is done by considering the change in households' utility. This utility depends positively on private consumption and government purchases. However, higher labor input in this case impacts utility negatively as increasing employment here does not mean decreasing unemployment. Instead it signifies increasing working hours for the individual household in contrast to the usual perception." (These six points copied from Prof. Uhlig's site.)

There are several other assumptions or characteristics of the model we should bear in mind:

1) This model only shows you deviations away from a growth path similar to the one you saw in the Solow model. You never see the actual "default" growth path, just the deviation away from it.

2) There are two types of government expenditure in the model and three types of government revenues or taxation. The gov. pays interest on its debt to the private sector. The three types of taxation are:
first taxes on capital that is on capital's interest income. Higher taxes on capital reduce the incentive to invest in capital and reduces the capital stock. This will in turn lower the marginal productivity of labor and so reduce work effort.
second taxes on consumption. This stands in for ether sales taxes or VAT taxes.
third there is a wage tax. We might think of it as an income tax, but that would be somewhat misleading as it does not fall on interest payments or income from capital.

3) The government's budget constraint is very important in this model and has been handled in a way you wouldn't expect.

The default setting is for the government's budget to be balanced each year. The wage tax (or income tax) does not appear as a variable you can change. That is because the model changes the wage tax to balance the government's budget. The Gov Deficit to GDP ratio still moves around because the rate at which output grows will be affected by changes you make.

If you change the government budget balance parameter away from 1 towards 0 the model does not change the wage tax so much but instead lets the government run a deficit or surplus. It won't let you set this parameter to 0 because that would cause the GovDebt/GDP ratio to go to infinity which is not sustainable. While that is true one might like to see what happens if the economy temporarily follows a fiscal policy that is unsustainable in the future. Well you are not allowed to here.

I want you to get two things out of the model: first how does an increase in government spending affect growth in the long run and short run, and secondly which of the three taxes seems to be least damaging to growth?

Issue One: How does government spending affect the economy?
Increase government spending (say to around 936) while leaving the gov budget parameter that sometimes appears at the bottom of the screen at one.

Print the output and answer the following questions: How does an increase in government spending affect the economy? Looking at the assumptions of the model given above why is the effect of greater government spending different from what you would expect in a Keynesian model, such as the one you examined in Econ 106?

Issue Two: Which taxes hurt the economy the most.
There are three taxes in the model so if we think about raising one tax and increasing another tax to compensate then we have three parings to examine:
wage vs capital
wage vs consumption
consumption vs capital

Tax scenario one: Lower the tax on capital and let the program increase the tax on wages to keep the governments budget balanced. Does this seem to help or hurt consumption, output, employment? You can also do the opposite to check the results: increase the tax on capital letting the program decrease the tax on wages.
Tax scenario two: Lower the tax on consumption and let the program increase the tax on wages.

Does this seem to help or hurt consumption, output, employment? You can also do the opposite to check the results.

Tax scenario three: Lower the tax on capital to about 25% and increase the consumption tax to about 21%

Does this seem to help or hurt the economy?

Print the output for the scenario that seems to be most beneficial to the economy and answer the following question.

Which of the three taxes is least harmful to the economy and why?

Solution Preview

Please see the attached file.

How does an increase in government spending affect the economy?
The Government consumption increase but GDP as well as the private consumption decline over the period of time. The level of employment in the economy and investment also decline. There is no change in transfers, consumption tax and capital tax however, the wage tax increase. The level of debts in the ...

Solution Summary

Evaluating political actions is achieved.