This is a paper analyzes Biden’s infrastructure plan using two schools of thought: Classical economics and the Keynesian model. This is part of a final in ECO 205 Macroeconomics at Davidson College with Dr. Gouri Suresh
Biden’s infrastructure plan would increase government spending significantly on infrastructure projects such as highways, bridges, transportation systems, electric grids, and the internet (FACT SHEET: The American Jobs Plan 2021). Unemployment is still a major problem with 9.8 million people still unemployed in April 2021 (U.S. Bureau of Labor Statistics 2021). Will Biden’s plan increase employment? What will the effect of Biden’s tax and government spending program have on output? How effective will the American’s Job Plan be according to classical and Keynesian theory?
Expansionary fiscal policy will have no effect on output or employment. In equations (1) and (2) below, government spending is not a factor in aggregate demand or aggregate supply and plays no role in determining equilibrium output and price. No change in output means no change in employment.
- Aggregate Demand (implicit): MV=PY
- Aggregate Supply: Y=Y such that the labor market clears (no relationship between price and output aka a vertical aggregate supply)
Government spending would not affect the labor market or production, but it will have an effect on the loanable funds market that will affect output in the next period. Government spending without raising taxes significantly (Figure 1) and without increasing the money supply will come from borrowing. As shown in Graph 1, when the government starts selling bonds the demand for loanable funds increases which shifts the I + (G-T) curve will shift right by G which will lead to a simultaneous increase in equilibrium savigngs (S0S1). Thus, government spending will increase interest rates (r0r1). The increase in interest incentives people to save and to reduce consumption. Savings increases by the exact same amount as consumption decreases. The crowding out of consumption (y) increases to (y+s). Similarly, high borrowing cost makes fewer private projects feasible, so investment declines; the crowding out of the investment (x) increases to (x+I). The crowding out of consumption, the counter effect of increased savings (3) as well as the decrease in investment (4), leaves output at the same level.
- Y=C+ S + T or C=S
- Y=C+ I + G or G =C +S
Graph 1: Loanable Funds Market
Source: Froyen, Richard T. “Chapter Three: Classical Model: Money Price Output.” In Macroeconomics: Theory and Policies 10th edition, p40. Pearson Education, 2014.
This crowding out of investment will decrease output in future periods. However, there might be a simultaneous increase in confidence in the future as vaccination restores confidence in the economy investment will shift out. When the investment is realized in future periods, the production in the future shifts up (5). However, capital in the future period depends on investment in the current period (6). As shown in the graph below, with crowding out on investment in the current period the future production function would be higher than if there was no deficit spending.
- Kt+1 =It+Kt-dKt
Graph 2: Crowding Out of Investment Effect on Future Output and Employment.
Source: Gouri Suresh, Shyam. “The Classical Model” Davidson College, p22. 2021.
If government spending is funded through a money supply increase, then aggregate demand would shift up and right. However, without a change in aggregate supply, the will shift will cause prices to rise proportionately to the increase in the money supply. Because the velocity of money is constant, there would be no effect on output, thus only leading to an increase in the price level. MV=PY → 2MV=2PY.
With no effect on Y, an increase in government spending will not increase tax revenue (Figure 1). Thus, to balance the government budget constraint below, there will be an increase in seignorage (M) or in borrowing (D). If the former, then government spending will only cause inflation. In the case of the latter, the government deficit will grow to an enormous amount.
- G + Tr +rD = t1Y +t2rD +M +D
Source: Gouri Suresh, Shyam. “Odds and Ends” Davidson College, p7. 2021.
Figure 1: Tax Revenue and Government Expenditure
Source: Fed Fred. https://fred.stlouisfed.org/series/W068RCQ027SBEA#0
However, the analysis above does not take into account the effect of the investment in infrastructure. If spending from the government goes into infrastructure as Biden proposes then it may have a positive effect on total factor productivity. As shown in Graph 3, future TFP will increase (At+1iAt+10) and shift the production up. If the projects proposed reduces costs for business and increases the number of product workers produce per hour, then the output may rise.
Graph 3: Future Output if Government Spending Effectively Increases TFP
Biden suggests that the government debt will be paid down by the increased taxes on corporations. Eventually, the bond market will be in equilibrium when T=G, and no crowding out of investment or consumption. However, when the 28% distortionary tax is imposed on firms, they may choose to pay out less in nominal wages (w0 → w1) because a portion of revenues that would go towards wages will go towards taxes instead. As shown in the graphs below, at lower nominal wages, workers will work less lowering equilibrium employment and output. The result is leftward in the AS curve, raising prices further lowering real wages.
Graph 4: Tax Effect on Output and Employment
Whether Biden’s American Job Plan is effective at increasing employment and output depends tremendously on whether the infrastructure projects increase total factor productivity, and how bad the tax burden will affect employment.
Expansionary Fiscal Policy in a recession will have a positive effect on output and employment. Increased government spending will shift the IS curve upward and right leading to an increase in equilibrium output. This shifts the AD curve to the right. This shift will increase output and therefore employment.
- AD: Y=1i-b+i0C1C2a-bT+Id-i0C0C2+i0MsC2+G
Source: Gouri Suresh, Shyam. “The Keynesian Model pIII” Davidson College, p4. 2021.
Graphs 1: Expansionary Fiscal Policy Effect in the IS-LM schedule
Graph 2: Expansionary Fiscal Policy Effect in the AS-AD schedule
Source: Froyen, Richard T. “Chapter Seven: The Keynesian System: Aggregate Supply and Demand.” In Macroeconomics: Theory and Policies 10th edition, p146. Pearson Education, 2014.
The increased government spending will not only lead to people being directly hired by the government for projects but also will lead to the firms selling supplies and servers to the government to hire more. Thus, the IS shifts to the right by more than G. If $2.7 trillion is used to produce highways and whatnot, the Government Spending multiplier will lead to an increase in output greater than $2.7 trillion. In addition, Biden created tax penalties for hiring outside the US, therefore the multiplier effect will contribute to output growth in the US.
- YG = 11-b+i0C1C2
However, the increase in IS will not only cause an increase in equilibrium output but also to equilibrium interest rates. At higher interest rates, there will be some crowding out of investment and consumption. The severity of crowding out depends on the slope of the LM and IS curve.
- LM: r = c0c2-Msc2+c1c2y
Source: Gouri Suresh, Shyam. “The Keynesian Model pII” Davidson College, p19. 2021.
The slop of the LM depends on c1 and c2 — how sensitive money demand is to income and interest rates respectively. As demonstrated in the graph below, interest rates are very low, and despite the increase in GDP, the interest rate has remained very low indicating that c2 is likely very high, and money demand is hypersensitive to changes in interest rates. The US economy is likely in a liquidity trap. The LM curve is very flat — nearly horizontal and speculative demand for money dominates (Figure 2). Taditional expansionary monetary policy likely has little potential to increase output or employment because interest rates are at the zero lower bound (Gouri Suresh, Shyam. “The Keynesian Model pII” Davidson College, p28. 2021).
Figure 2: Interest Rates and Real GDP over the 2021 Recession.
Source: Fed Fred https://fred.stlouisfed.org/series/DFF#0
Because the LM is so flat, expansionary fiscal policy is much more effective. If interest rates do not rise significantly, then government spending will likely have the full multiplier effect.
Graph 3: Expansionary Fiscal Policy in the IS-LM in a Liquidity Trap.
As shown in Graph 4, Raising taxes in the next period will shift the S+T curve upward. This will have a negative effect on the equilibrium output. However, if the government spending in previous periods sufficiently shifts the AD curve to the right (AD: recovery) then the economy could move into a boom (AD: post-recovery). Once employment recovers, counter-cyclical contractionary fiscal policy may optimally mitigate any inflationary pressure (AD: post-recovery + tax). In their proposal, Biden estimates that the 28% corporate tax will bring in $2 trillion in revenue in the next 15 years (FACT SHEET: The American Jobs Plan 2021). Also important to note is that the tax multiplier (4) is smaller than the government spending multiplier (2) so a raise in taxes will likely lower GDP by less than the government spending increased GDP (Froyen, p.65 see citation of Graph 4).
- YG = -b1-b+i0C1C2
Graph 4: Increase in Taxes in the Alternative Keynesian Cross
Source: Froyen, Richard T. “Chapter Four: The Keynesian System: The Role of Aggregate Demand.” In Macroeconomics: Theory and Policies 10th edition, p65. Pearson Education, 2014.
Graph 5: Contractionary Tax Policy Post-Recovery in the AD-AS schedule
Lastly, Biden’s plan to employ many Americans directly and through the multiplier is an important immediate step. Although employment will eventually rise to a long-term optimal amount, people may lose their employability in the meantime and may detrimentally shift the long-term Philips curve and the long-run aggregate supply.
Graph 6: Phillips Curve in a Recession With Hysteresis
Source: Gouri Suresh, Shyam. “Quiz 7 solutions” Davidson College, p2. 2021.
How effective The American Job Plan depends on how efficient the infrastructure project will be in creating long-term growth without putting the country at risk of debt-pilling. If spending is used efficiently and coupled with private investment then the investment will be most effective. The increased creation of jobs from government projects will lead to a short-term increase in employment — if these projects sufficiently stimulate demand in the private sector as is incentives by tax credits in many types of infrastructure projects then employment has the potential to stay at an optimal level post-recovery.
“FACT SHEET: The American Jobs Plan.” The White House: Briefing Room, May 31, 2021. https://www.whitehouse.gov/briefing-room/statements-releases/2021/03/31/fact-sheet-the-american-jobs-plan/
Froyen, Richard T. Macroeconomics: Theory and Policies 10th edition. Pearson Education, 2014.
Gouri Suresh, Shyam. “Odds and Ends.” Davidson College, p7. 2021.
Gouri Suresh, Shyam. “Quiz 7 solutions.” Davidson College, p2. 2021
Gouri Suresh, Shyam. “The Classical Model.” Davidson College, p22. 2021.
Gouri Suresh, Shyam. “The Keynesian Model pII.” Davidson College, p19, 28. 2021.
Gouri Suresh, Shyam. “The Keynesian Model pIII.” Davidson College, p4. 2021.
Board of Governors of the Federal Reserve System (US), Effective Federal Funds Rate [FEDFUNDS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/FEDFUNDS, May 10, 2021.
U.S. Bureau of Economic Analysis, Government total expenditures [W068RCQ027SBEA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/W068RCQ027SBEA, May 10, 2021.
U.S. Census Bureau, National Totals of State and Local Tax Revenue: Total Taxes for the United States [QTAXTOTALQTAXCAT1USYES], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/QTAXTOTALQTAXCAT1USYES, May 10, 2021.
U.S. Bureau of Economic Analysis, Real Gross Domestic Product [GDPC1], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GDPC1, May 6, 2021.
U.S. Bureau of Labor Statistics, Unemployment Level [UNEMPLOY], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/UNEMPLOY, May 10, 2021.