chapter 22: adding government and trade to the simple macro model copyright © 2014 pearson canada...
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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.
Copyright © 2014 Pearson Canada Inc. 3Chapter 22, Slide
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
Copyright © 2014 Pearson Canada Inc. 6Chapter 22, Slide
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.
7Copyright © 2014 Pearson Canada Inc. Chapter 22, Slide
Fig. 22-1 The Net Export Function
The NX function is drawn holding constant:
• foreign GDP
• domestic and foreign prices
• the exchange rate
8Copyright © 2014 Pearson Canada Inc. Chapter 22, Slide
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
9Copyright © 2014 Pearson Canada Inc. Chapter 22, Slide
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
10Copyright © 2014 Pearson Canada Inc. Chapter 22, Slide
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.
12Copyright © 2014 Pearson Canada Inc. Chapter 22, Slide
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.
13Copyright © 2014 Pearson Canada Inc. Chapter 22, Slide
Fig. 22-3 The Aggregate Expenditure Function
14Copyright © 2014 Pearson Canada Inc. Chapter 22, Slide
Adding government and foreign trade does not change the logic of the equilibrium!
15Copyright © 2014 Pearson Canada Inc.
MyEconLab
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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
17Copyright © 2014 Pearson Canada Inc. Chapter 22, Slide
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.
18Copyright © 2014 Pearson Canada Inc. Chapter 22, Slide
Consider some G < 0.
Equilibrium national income will fall:
Y = G x simple multiplier
19Copyright © 2014 Pearson Canada Inc.
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
20Copyright © 2014 Pearson Canada Inc. Chapter 22, Slide
21Copyright © 2014 Pearson Canada Inc.
MyEconLab
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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.
Copyright © 2014 Pearson Canada Inc. 22Chapter 22, Slide
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
23Copyright © 2014 Pearson Canada Inc. Chapter 22, Slide