chapter 22: adding government and trade to the simple macro model copyright © 2014 pearson canada...

Chapter 22: Adding Government

and Trade to the Simple Macro Model

Copyright © 2014 Pearson Canada Inc.

Chapter Outline/Learning Objectives

Section Learning ObjectivesAfter studying this chapter, you will be able to

22.1 Introducing Government

1. understand how government purchases and tax revenues relate to national income.

22.2 Introducing Foreign Trade

2. understand how exports and imports relate to national income.

22.3 Equilibrium National Income

3. distinguish between the marginal propensity to consume and the marginal propensity to spend.

22.4 Changes in Equilibrium National Income

4. explain why the introduction of government and foreign trade in the macro model reduces the value of the simple multiplier.

5. explain how government can use fiscal policy to influence the level of national income.

22.5 Demand-Determined Output

6. understand that output is demand determined in our simple macro model.

Copyright © 2014 Pearson Canada Inc. 2Chapter 22, Slide

22.1 Introducing Government

Government Purchases

Government purchases of goods and services (G) are part of desired aggregate expenditures

• not including transfer payments

Net Tax Revenues

Net taxes (T) are total tax revenues net of transfer payments.


We assume net taxes are given by:

T = tY

where t is the net tax rate.

The Budget Balance

The budget balance is the difference between G and T (ignoring debt-service payments).

• if G < T: a budget surplus

• if G > T: a budget deficit4Copyright © 2014 Pearson Canada Inc. Chapter 22, Slide

Provincial and Municipal Governments

When measuring the overall contribution of government to desired aggregate expenditure, all levels of government must be included:

• particularly important in Canada

• combined purchases of provincial and municipal governments are larger than those of the federal government

5Copyright © 2014 Pearson Canada Inc. Chapter 22, Slide

22.2 Introducing Foreign Trade

Net Exports

We make two central assumptions:

• Canada's exports are autonomous with respect to Canadian GDP.

• Canada's imports rise as Canadian GDP rises.

For imports, we assume:

IM = mY

where m is the marginal propensity to import


Thus, net exports are given by:

NX = X – mY

Ceteris paribus, changes in domestic GDP lead to changes in net exports:

• as Y rises, NX falls

• as Y falls, NX rises

The relationship between Y and NX is shown by the net export function.


Fig. 22-1 The Net Export Function

The NX function is drawn holding constant:

• foreign GDP

• domestic and foreign prices

• the exchange rate


Shifts in the Net Export Function

1. An increase in foreign income leads to more foreign demand for Canadian goods:

• increases X and shifts NX function upward

2. A rise in Canadian prices (holding foreign prices constant):

• decreases X

• IM function rotates up as Canadians switch toward foreign goods

NX function shifts down and gets steeper


Fig. 22-2 The Net Export Function and a Change in International Relative Prices

Illustration of a rise in Canadian prices relative to foreign prices.

This could be caused by:

• Δ exchange rate

• Δ price levels


22.3 Equilibrium National Income

Desired Consumption and National Income

With taxation, YD is less than Y.

If T = (0.1)Y, then YD = (0.9)Y.

C = 30 + (0.8)YD

C = 30 + (0.8)(0.9)Y

C = 30 + (0.72)Y

Copyright © 2014 Pearson Canada Inc. 11

The MPC out of national income (0.72) is less than the MPC out of disposable income (0.8).

Chapter 22, Slide

The AE Function

We then expand the AE function:

AE = C + I + G + NX

Recall that the slope of the AE function is the marginal propensity to spend out of national income—we call this z.

In this model, we get:

z = MPC(1 – t) – m

Clearly, t > 0 and m > 0 lead to a lower value of z.


Equilibrium National Income

As before, output is assumed to be demand determined in this model:

equilibrium condition is Y = AE(Y)

In words, equilibrium Y occurs where desired aggregate expenditure equals actual national income.

Whenever AE is not equal to Y, there are unintended changes in inventories and firms have an incentive to change production.


Fig. 22-3 The Aggregate Expenditure Function


Adding government and foreign trade does not change the logic of the equilibrium!

15Copyright © 2014 Pearson Canada Inc.

MyEconLab

www.myeconlab.co

m

An alternative (but equivalent) approach to determining the equilibrium level of national income is based on the relationship between national saving and the accumulation of national assets. For more details, look for The Saving-Investment Approach to Equilibrium in an Open Economy with Government in the Additional Topics section of this book's MyEconLab.

Chapter 22, Slide

22.4 Changes in Equilibrium National Income

The Multiplier with Taxes and Imports

Imports and taxes make z smaller

the simple multiplier is also smaller

z = MPC(1 – t) – m

Copyright © 2014 Pearson Canada Inc. 16

APPLYING ECONOMIC CONCEPTS 22-1

How Large is Canada’s Simple Multiplier?

Chapter 22, Slide

Net Exports

As with other elements of AE:

• if NX function shifts upward, equilibrium Y rises

• if NX function shifts downward, equilibrium Y falls

Exports are autonomous with respect to domestic GDP, but they depend on:

• foreign income

• domestic and foreign prices

• exchange rate

• tastes


Fiscal Policy

Fiscal policy is the use of the government's spending and tax policies.

Any policy that attempts to stabilize Y at or near Y* is called stabilization policy.

It is often clear in which direction fiscal policy could be adjusted, but less clear how much is necessary.


Consider some G < 0.

Equilibrium national income will fall:

Y = G x simple multiplier


For example, suppose z = 0.25 ==> multiplier = 1.30.

G = –$100 million ==> Y = – $130 million.

e´1

Y1 Y0

e1

AE1

AE0

e0 •

•

AE =Y

E0

E1

• G

Y Y

AE

Chapter 22, Slide

Fig. 22-4 The Effect of Changing the Net Tax Rate

The government may attempt to change national income by changing the net tax rate.

• a lower t causes the AE function to become steeper

• a higher t causes the AE function to become flatter



MyEconLab

www.myeconlab.co

m

Governments can also combine an increase in government purchases with an increase in tax revenues in such a way that the budget is left unchanged. How do such balanced budget changes affect the level of national income? To see more details on this type of fiscal policy, look for What is the Balanced Budget Multiplier? in the Additional Topics section of this book's MyEconLab.

Chapter 22, Slide

22.5 Demand-Determined Output

Our simple macro model (Chapters 21 and 22) is based on three central concepts:

• equilibrium national income

• the simple multiplier

• demand-determined output

The second and third are closely connected to our assumption of a constant price level.


When is this a reasonable assumption?

1. When output is below potential, firms can increase output without increasing their costs.

2. When firms are price setters they often respond to shocks by changing output (and only later changing their price).

In the next chapter, we allow a variable price level:

• more complicated

• more realistic


chapter 22: adding government and trade to the simple macro model copyright © 2014 pearson canada...

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