lecturer: dr. priscilla twumasi baffour, department of economics contact information ... ·...

College of Education

School of Continuing and Distance Education2014/2015 – 2016/2017

Lecturer: Dr. Priscilla Twumasi Baffour, Department of Economics Contact Information: [email protected]

Session Overview

• In sessions three and four, we discussed national incomedetermination in an economy which does not partake in anyform of external trade. In this session we shall introduceinternational trade components (exports and imports) thatmakes an economy open and discuss its implications onequilibrium output using both the aggregate expenditure andinjections- leakages approach. The session further explainsthe multiplier and effects of changes in autonomousspending. The session concludes by introducing the conceptof the balanced budget multiplier.

Priscilla T. Baffour Slide 2

Session Outline

The multiplier concept

Relaxing the Temporal Assumptions

• Opening the Economy to the Foreign Sector

Equilibrium GDP

Determination of Equilibrium GDP

Aggregate Spending approach

Injections-Leakages Approach

Changes in aggregate spending

The balanced budget


Learning Outcome

• After completing this session, you should be able to;

• Derive the multiplier

• Explain the rationale behind the multiplier

• Discuss the determinants of exports and imports

• Identify the effect of net exports on the multiplier

• Determine equilibrium national income in an open economy

• Illustrate the impact of changes in autonomous spending onnational income

• Explain the balanced budget multiplier concept

Priscilla T. Baffour, PhD. Department of Economics

Reading List

• Read Chapter 15 of John Sloman; Economics, 8thEdition (2011), Pearson

• Session Slides

• Watch video on session 5 ……………………..

• Any Other Economics text books available to students


The Multiplier

• The multiplier is the ratio of a change in equilibrium income to theinitial change in autonomous spending (autonomous consumption,investment or government expenditure).

• The multiplier is greater than unity, this is because an initial change inautonomous spending causes a spending chain reaction whichalthough of dwindling importance at each successive stage will resultin a multiple change in real output on income.

• Thus a change in autonomous spending sets off further changes inconsumption demand, aggregate demand and real output or income


Intuition behind the Multiplier

• Suppose there is a positive AD shock (Increase in governmentspending for example). This causes sales, expected sales, andoutput to rise. Higher output raises employment and income.Higher income causes higher consumption, which raises AD evenmore and the cycle continues.

• Thus, the effect on output is larger than the size of the originaldemand shock. One could say that the multiplier process“magnifies” the effect of any initial demand shock.

• It is important to note that the multiplier works in bothdirections. If the initial shock is negative, it will also bemagnified.


The Multiplier Cont.

• The multiplier under simple closed economy dependson the marginal propensity to consume (MPC).

– In this case, it is the reciprocal of the MPS.

• Diagrams below illustrate how the multiplier works inan economy in response to a change in any of theautonomous spending components.

• Here an increase in injection (which can begovernment expenditure or investment) results in anincrease in output from Y1 to Y2


O Y

AE Y = AE

AE1= C + I

Y1

Keynesian Cross: Increase in Investment


O Y

Y

AE1

Y1

AE2

Y2

a

c

AE

b

Multiplier:

(c-a) / (b-a)

Keynesian Cross: Increase in Injections (J)


Open Economy: Inclusion of the Foreign Sector

By relaxing the earlier assumption of a closed economy, two important conceptsare introduced which are exports and imports.

EXPORTS (X)

• Exports contribute to aggregate spending in the same way as any othercomponents of autonomous spending (i.e. C0 , I0 and G0)

– Export spending by the foreign sector is autonomous of national Income

(i.e. X = X0). That is, exports do not depend on domestic income.

IMPORTS (IM)

• Imports are made up of an autonomous and income induced component(because it depends on domestic national income) .

(i.e. IM = M0 + mY)

where M0 is autonomous imports; m is marginal propensity to import;

mY is income induced imports


• Export expenditure by the foreign sector depends on;

– national income in foreign economies

– other countries’ circular flow of incomes

– exchange rate

• We can therefore reasonably conclude that Exports are independent

of domestic national Income hence they are autonomous

The Factors that Influence Exports (X)


• An economy’s expenditure on imports depend on

– national income (the higher the domestic income, the higher the

demand for all goods including imports)

– exchange rates

• Therefore we can reasonably conclude that Imports is made up of

two components

– Autonomous Imports (depends on the exchange rate)

– Income-Induced Imports (depends on national Income)

The Factors that Influence Imports (IM)


Net Exports or External Balance (NX=X-IM)

• The external balance or net exports or trade balance is the value of exports minus the value of imports

NX = X – IM

• Net Exports can be negative, positive or zero

– If X > IM the NX > 0 : Trade Surplus

– If X < IM the NX < 0 : Trade Deficit

– If X = IM the NX = 0 : Trade Balance

• Net exports are negatively related to domestic national income (Y)

NX = X – IM = X0 – (M0 + mY)

NX = X0 – M0 - mY


• GDP is in equilibrium when desired aggregate expenditure equalsnational output.

AE = C + I + G [X - IM]

• The sum of investment and net exports is called national assetformation because investment is the increase in the domestic capitalstock and net exports result in investment in foreign assets.

• At the equilibrium level of GDP, desired national saving (S + T – G), isequal to national asset formation (I + X – IM)

S + T – G = I + X – IM

• At the equilibrium level of GDP, Injections is also equal to Leakages or Withdrawals

I + G + X = S + T + IM

Equilibrium GDP: Open Economy


Algebra : Aggregate Spending Approach

AE = C + I + G + [X - IM] ……….1

C = C0 + C1YD …………2

YD = Y – T……………3

T = T0 + tY…………4

I = I0………5

G = G0………..6

X = X0…………

IM = M0 + mY…………….(7)

EQUILIBRIUM GDP: OPEN ECONOMY


Solving equations 1 to 7 under the equilibrium condition that

AE = Y

Will yield the following equilibrium GDP

𝑌𝑒 =1

1 − 𝑐1 1 − 𝑡 +𝑚[𝐶0 + 𝐼0 + 𝐺0 + 𝑋0 −𝑀0 − 𝑐1𝑇0]

If A0=𝐶0 + 𝐼0 + 𝐺0 + 𝑋0 −𝑀0 then

𝑌𝑒 =1

1 − 𝑐1 1 − 𝑡 +𝑚[𝐴0]

EQUILIBRIUM GDP: OPEN ECONOMY WITH GOVERNMENT


INJECTIONS- LEAKAGES APPROACH

AE = C + I + G + [X - IM]

Y = C + S + T.

At equilibrium, AE = AD = Y.

C + I + G + [X - IM] = C + S + T.

I + G + [X - IM] = C - C + S + T.

I + G + [X - IM] = S + T.

I + G + X = S + T + IM

Where injections = I+G+X and Leakages = S+T+IM

Recall that,

YD = Y – T T = T0 + tY

I = I0 G = G0

X = X0 IM = M0 + My

S = - C0 + (1 - c1)YD

Priscilla T. BaffourSlide 18


IO+ GO + XO = -co + (1 - c1)YD+ TO +tY + MO + mY

co + IO+ GO + XO - MO - TO = (1 - c1)YD +tY + mY

co + IO+ GO + XO - MO - TO = (1 - c1)(Y-T) +tY + mY

co + IO+ GO + XO - MO - TO = (1 - c1)(Y- (TO +tY))+tY +mY

co + IO+ GO + XO - MO - TO = Y - TO - c1Y+ c1TO – c1tY + mY

co - c1TO + IO+ GO + XO - MO = Y - c1Y– c1tY + mY

co - c1TO + IO+ GO + XO - MO = Y (1- c1– c1t + m)

co - c1TO + IO+ GO + XO - MO = Y (1- c1(1- t) + m)

Y = (1/(1- c1(1- t) + m)) (co - c1TO + IO+ GO + XO - MO)



• (1/(1- c1(1- t) + m)) is the multiplier in an open economy.

• (co - c1TO + IO+ GO + XO - MO ) is the autonomous spending.


AE0

Real National Income [GDP] [ȼm]0

AE = Y

45o

AE1

Y0Y1

Des

ired

Ex

pen

dit

ure

[ȼ

m]

The Effect of a Change (Increase) in Government Spending

E0

E1

• A change (increase) in government spending changes GDP by shiftingthe AE line parallel to its initial position.

• The initial level of AE is at AE0 and GDP is Y0 with desiredexpenditures 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 ingovernment spending times the multiplier.

The Effect of a Change in Government Spending

• A shift in exogenous spending (A0) 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 (i.e. changes in G0 or T )

or by a change in official interest rate (monetary

Policy).

• Will later on look at how the change in official

interest rates affect aggregate spending when we

introduce money and money market into the

analysis.

Changes in Aggregate Spending

INCLUSION OF GOVRNMENT SECTOR : Some Important Observations

Government Budget Balance

• The budget balance is defined as government revenues minusgovernment spending.

Budget Balance = T - G

Budget Balance can be negative, positive or zero

If T > G the BB > 0 : Budget Surplus or Fiscal Surplus or positive public savings

If T < G the BB < 0 : Budget Deficit or Fiscal Deficit or negative public savings

If T= G the BB = 0 : Balanced Budget

Government Spending and Taxes

• Changes in Government Spending is more powerful in impacting on output than changes in Taxes.

• When there is a change in Taxes its impact on equilibrium output is dampened and this is irrespective of the type of taxes are used;

• if direct taxes (i.e. the tax rate ) are changed, its presence reduces the size of the multiplier and therefore change in equilibrium output given Autonomous spending

• If indirect taxes are used (i.e. Autonomous taxes) its effect is dampened by the MPC before it affects national output given the multiplier

• Government spending on the other hand has its full impact on equilibrium output given the multiplier.

lecturer: dr. priscilla twumasi baffour, department of economics contact information ... ·...

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