The Effects of Macroeconomic Policy with a Disparity in Price Elasticity Between Private‐ and Public‐ Sector Demands
| DOI | http://doi.org/10.1111/sjpe.12201 |
| Date | 01 November 2019 |
| Published date | 01 November 2019 |
| Author | Yasuko Ishiguro |
THE EFFECTS OF MACROECONOMIC
POLICY WITH A DISPARITY IN PRICE
ELASTICITY BETWEEN PRIVATE- AND
PUBLIC-SECTOR DEMANDS*
Yasuko Ishiguro**
ABSTRACT
We introduce a disparity in price elasticity between government demand and
consumption demand into a simple money-in-the-utility-function model. This
extension demonstrates that the effect of fiscal policies on production may be
positive, negative, or neutral depending on the disparity in price elasticity
between sectors. Because the effect of an increase in nominal money supply with
constant nominal government expenditure is the opposite to that of a fiscal pol-
icy, a fiscal policy financed by seigniorage can have positive, negative, or no
effects depending on parameter values. Moreover, the effect of simultaneous
implementation of expansionary–contractionary policies depends on how they
are combined.
II
NTRODUCTION
Fiscal and monetary policies are some of the main points of interest of
macroeconomics. Cash-in-advance and money-in-the-utility-function (MIU)
models have recently been built for theoretical macroeconomic analyses with
money. In classical models, the CES or Cobb–Douglas utility function is
often used. Owing to the weak separability of these utility functions,
demand shocks have no scope to affect output under flexible pricing. In clas-
sical theories, only supply-side shocks, such as productivity shocks, can
affect output levels. Therefore, in a neo-classical analysis, an imperfection in
money markets has been introduced to consider the effectiveness of aggre-
gate demand policies on output levels. On the contrary, Keynesian-type
models use similar utility functions with price rigidity to examine the effects
of aggregate demand policies.
1
In the conventional literature, the assumption
of price rigidity or the imperfection in money markets is made to show that
*This work was supported in part by a Grants in-Aid for scientific research (C) (No.25380311)
from the Japan Society for the Promotion for Science.
**University of Hyogo
1
Under the assumption of price rigidity, New Keynesian studies indicate that a fiscal policy
or tax increase is followed by labour supply changes because of the income or assets effect.
The heterogeneity of goods or households with liquidity constraints under the price rigidity
condition also leads to policy effectiveness.
Scottish Journal of Political Economy, DOI: 10.1111/sjpe.12201, Vol. 66, No. 5, November 2019
©2018 Scottish Economic Society.
631
demand shocks affect output. However, a few analyses focus on the mecha-
nism of demand shocks affecting production through price distortion in
monopolistic competition instead of an imperfection in money markets or
price rigidity.
2
Firms or labour unions have the initiative in determining the level of pro-
duction or real wage rates when competition is imperfect. For example,
when firms have monopoly power because of an imperfection in a goods
market, the price and quantity of production are dependent on the value of
the market’s price elasticity. When price elasticity is low, firms have an
incentive to produce less and set higher prices. When the price elasticity of
goods is identical between buyers, firms do not care who buys but are con-
cerned about demand size. However, if price elasticity is not identical across
demand sectors, such as consumption and government spending, the demand
share also becomes important for firms because reactions to price changes
differ between consumers and governments. When the demand share with
low price elasticity is high, the price elasticity of the whole market is low,
giving firms significant monopoly power. In this case, the firm sets its price
high and production volume low. However, if the demand share with high
price elasticity is large, the whole market price elasticity is high. Then, a
more competitive market condition creates a low price and high production
level. Generally, the demand for goods by the public sector tends not to
respond flexibly to price changes because the goods and services provided by
the public sector meet basic social welfare needs. Consider the case of pro-
viding child-care services fulfilling the legal requirements. Because a child-
care centre has to satisfy the safety standard required legally, it cannot
easily substitute materials according to changes in prices. Another case is
vaccination preventing infectious diseases. It is challenging to stop vaccinat-
ing, even though prices rise. However, households can substitute cheaper
goods for expensive ones or even stop spending when prices are high. Fur-
thermore, as the government must follow regulations and laws, procedures
for changing government purchasing schedules are complicated. Then, the
demand for goods by the public sector appears to be less price sensitive
than in the private sector. Therefore, the equilibrium output level depends
on the share of government demand out of total demand. Dixon (1990),
Dixon and Rankin (1994), and Jacobsen and Schultz (1994) conducted anal-
yses in which fluctuations in price elasticity due to a change in demand
share affect production.
3
These analyses show that increases in government
expenditure negatively affect production when the price elasticity of govern-
ment demand is lower than that of private demand because the price
2
One of the few analyses to consider other mechanisms is the series of studies by Otaki
(2007, 2009), Otaki and Tamai (2011), which shows that an expansionary fiscal policy
financed by seigniorage can increase consumption, producing ex post price rigidity via
dynamic optimization.
3
Gali (1994, 1995) argued that private investment reflects fluctuations in price elasticity in
the market which affects the dynamics of capital accumulation, indicating multiple steady
states and equilibrium paths.
632 YASUKO ISHIGURO
Scottish Journal of Political Economy
©2018 Scottish Economic Society
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