GDP in an Open Economy with GovernmentChapter 17

LIPSEY & CHRYSTAL

ECONOMICS 12e

Learning Outcomes

• Government consumption contributes to aggregate spending in the same way as any other component of autonomous spending.

• Taxes affect private consumption via their effect on disposable income.

• Net exports are negatively related to domestic income.

Learning Outcomes

• A necessary condition for GDP to be in equilibrium is that desired aggregate domestic spending is equal to national output.

• The size of the multiplier is negatively related to the income tax rate and the marginal propensity to import.

GDP IN OPEN ECONOMY WITH GOVERNMENT

Government Spending and Taxes• Government consumption is part of autonomous

aggregate spending. • Taxes minus transfer payments are called net taxes and

affect aggregate spending indirectly. • Taxes reduce disposable income, whereas transfers

increased disposable income.

GDP IN OPEN ECONOMY WITH GOVERNMENT

Government Spending and Taxes• Disposable income, in turn, determines desired private

consumption, according to the consumption function.• The budget balance is defined as government revenues

minus government spending. • When this difference is positive, the budget is in surplus;

when it is negative, the budget is in deficit.

GDP IN OPEN ECONOMY WITH GOVERNMENT

• When the budget is in surplus, there is positive public saving, because the government is spending less on the national product than the amount of income that it is withdrawing from the circular flow of income and spending.

• When the government budget is in deficit, public saving is negative.

GDP IN OPEN ECONOMY WITH GOVERNMENT

Net Exports • Since desired imports increase as national income

increases, desired net exports decrease as national income [GDP] increases, other things being equal.

• Hence the net export function is negatively sloped [net exports fall as GDP rises].

Equilibrium GDP• GDP is in equilibrium when desired aggregate

expenditure, C + I + G [X - IM], equals national output. • The sum of investment and net exports is called national

asset formation because investment is the increase in the domestic capital stock and net exports result in investment in foreign assets.

• At the equilibrium level of GDP, desired national saving, S + T - G, is equal to national asset formation, I + X - IM.

GDP IN OPEN ECONOMY WITH GOVERNMENT

Changes in Aggregate Spending• The size of the multiplier is negatively related to the

income tax rate.• A shift in exogenous spending changes GDP by the value

of the shift times the simple multiplier. • A shift in aggregate spending can be brought about by

fiscal policy changes or by a change in official interest rate.

GDP IN OPEN ECONOMY WITH GOVERNMENT

The budget surplus function (£million)

0National Income [GDP][£m]

1000 2000 3000 4000 5000 6000

0

Budget Surplus Function

Pri

ce S

avin

g [£

m]

National Income [GDP][£m]

1000 2000 3000 4000 5000 6000

Pri

ce S

avin

g [£

m]

T - G

0

0

-170

Budget Surplus Function

The budget surplus function

• The budget surplus is negative at low levels of GDP and becomes positive at high levels of GDP.

• Tax revenue increases with GDP while government spending is assumed not to vary with GDP.

• The slope of the budget surplus function is 0.1 when the income tax rate is assumed to be 10%.

The net export function (£million)

1000 2000 3000

X = 540

540

Imp

orts

an

d E

xpor

ts [

£m]

Export and Import Functions

IM = 0.25Y

0Real National Income [GDP] [£m]

[i]. Export and Import Functions

Export and Import Functions

1000 2000 3000

Net

Exp

orts

[£m

]

Real National Income [GDP] [£m]

[ii]. Net Export Function

(X - IM) = 540 - 0.25Y0

540

2160

The net export function

• Net exports, defined as exports minus imports, are negatively related to GDP.

• Exports are assumed to be constant at £540 million while imports are 0.25 of National income.

• So the net export function is given by: 540-0.25Y

The aggregate spending function (£million)

AE

1060

1000 2000 3000 4000 5000Real National Income [GDP] [£m]

An Aggregate Spending Curve and Equilibrium GDPD

esir

ed E

xpen

dit

ure

[£m

]

0

450

AE = Y

E0

2000

Aggregate expenditure

• The aggregate expenditure function is the sum of desired consumption, investment, government spending, and net exports.

• Equilibrium GDP occurs at E0 where the desired aggregate expenditure line intersects the 450 line.

• Only when GDP is £2000 will desired spending equal national output.

AE0

Real National Income [GDP] [£m]0

AE = Y

45o

AE1

Y0 Y0

Des

ired

Exp

end

itu

re [

£m]

The Effect of Change in Government Spending

• A change in government spending changes GDP by shifting the AE line parallel to its initial position.

• The initial level of AE is at AE0 and GDP is Y0 with desired expenditures at e0.

• An increase in government spending raises AE to AE1.

• GDP rises to Y1 at which level desired expenditures are e1.

• The increase in GDP from Y0 to Y1 is equal to the increase in government spending times the multiplier.

The Effect of Change in Government Spending

UK borrowing as a % of GDP (1972 to 2005)

UK fiscal stance as a % of UK GDP

Exports and imports as a % of UK GDP