of 42 copyright © 2008 pearson education canada 1 chapter 22 adding government and trade to the...

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Copyright © 2008 Pearson Education Canada

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Chapter 22

Adding Government and Trade to the Simple Macro Model

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In this chapter you will learn

1. how government purchases and tax revenues are related to national income.

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

2. how exports and imports are related to national income.

4. why the presence of government and foreign trade reduces the value of the simple multiplier.

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

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Government Purchases

Net Tax Revenues

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

- not including transfer payments (CPP, EI, OAS, GIS, Social Assistance, subsidies, grants, etc.)

Net taxes (T) are total tax revenues net of transfer payments (CPP, EI, OAS, GIS, Social Assistance, subsidies, grants, etc.)

22.1 INTRODUCING GOVERNMENT

MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

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The Budget Balance

The budget balance is the difference between G and T.*

- if G < T: a budget surplus

- if G > T: a budget deficit

*(ignoring debt-service payments)

We assume net taxes are given by:

T = tY

where t is the net tax rate.

Implies that all taxes are related to the level of income.


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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.

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Government Expenditure Function

Desired government expenditure is treated as autonomous – completely unrelated to the current level of Y

We can write G = G

Were G is determined by – what governments do! the budget process!

election cycles!

Mostly just the provision of ‘goods and services’ (general government, health, education public safety, transportation, etc.)


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Government Expenditure Function (what does it look like?)

Desired Government Expenditures

G

Actual National Income

Y

G

0

200

150

100

G’

G’’

Shift up implies a Government spending increases

Shift down implies Government spending cuts


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Government Net Tax Function

Desired Net Taxes

T

Actual National IncomeY0

200

150

100

T = tY

-150

-100

Governments set the tax rate (t) but Y determines the total taxes paid (T)

Y0

T1 = tY1

T0 = tY0

Y1

Recall Net taxes (T = Tx less transfers)MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

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Changes in Taxes (the tax rate t)

Desired Net Taxes

T

Actual National IncomeY

T = tY

0

200

100

T’’ = t’’Y

Net tax increases

Net tax decrease

-150

-100

T’ = t’Y

Note: t’ > t > t’’

Y0

T0’’

T0

T0’


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T - G

Pu

blic

Sa

ving

0300 600 900


The slope of the public saving function is equal to the net tax rate.

Y G T = 0.1 x Y T-G150 51 15 -36300 51 30 -21525 51 52.5 1.5600 51 60 9900 51 90 39

The Public Saving Function

As national income rises, the budget surplus (public saving) increases.

Public Saving is defined as T – G

Net tax revenue which the government does not spend


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Copyright © 2005 Pearson Education Canada Inc.

Summary

1. All levels of government add directly to aggregate expenditure.

2. Governments also collect taxes and make transfer payments.

3. Government purchases and taxation, taken together, imply the public saving function, T-G.


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22.2 INTRODUCING FOREIGN TRADE

Net Exports We make two central assumptions:

2) Canada’s imports rise as Canadian GDP rises

For imports, we assume: IM = mY

where m is the marginal propensity to import.

1) Canada’s exports are autonomous with respect to Canadian GDP

The export function is simply X = X

What determines the value of is X? A number of things including FOREIGN NATIONAL INCOMES


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Export Function (what does it look like?)

Desired Exports

X


Y

X

0

200

150

100

X’

X’’

Shift up implies Exports increases

Shift down implies Exports decrease


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Import function (what does it look like?)

Desired Imports

M

Actual National IncomeY0

200

150

100

M = mY

Y0

M1 = mY1

M0 = mY0

Y1


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Changes in Imports (the marginal propensity to import m)

Desired Imports

M

Actual National IncomeY

M = m Y

0

200

100

M’’ = m’’Y

Increase in imports

Decrease in imports

M’ = m’Y

Note: m’ > m > m’’

Y0

T0’’

T0

T0’


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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.

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The NX function is drawn holding constant:

• foreign GDP

• domestic and foreign prices

• the exchange rate

72

48

24

0 300 600 900

96IM = 0.1Y

X = 72

72

48

24

0 300 600 900

-24

Y X IM = 0.1 x Y NX0 72 0 72

300 72 30 42600 72 60 12720 72 72 0900 72 90 -18

Imp

ort

s an

d E

xpor

tsN

et E

xpor

tsNX = 72 - 0.1Y

Y

Y

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net exports, (NX = X – IM)

is also referred to as the Balance of Trade

if then we have

NX = X – IM > 0 a trade surplus

NX = X – IM = 0 a trade balance

NX = X – IM < 0 a trade deficit


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

- increases X and shifts NX function upward

Shifts in the Net Export Function

2. A rise in Canadian prices (holding foreign prices constant) or an appreciation of the Canadian dollar :

- decreases X

- IM function rotates up as Canadians switch toward foreign goods

NX function shifts down and gets steeper


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IM´

X

(X - IM)

X´

IM

(X - IM)´

Illustration of a rise in Canadian prices relative to foreign prices or an appreciation of the Canadian dollar.

This could be caused by:- Δ exchange rate (appreciation)-Δ price levels (increase relative to foreign prices)

Imp

ort

s an

d E

xpor

tsN

et E

xpor

ts




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Foreign Income - An increase in foreign income results in an increase

Canadian exports - NX function shifts up. (and the reverse)

Shifts in the Net Export Function - Summary

Relative International Prices - A rise in Canadian prices relative to foreign prices reduces Canadian exports (X shifts down). The IM function also rotates up since Canadians now spend a higher fraction of income on foreign goods. The NX (=X-IM) function shifts down and also

gets steeper. (and the reverse)

Other considerations: Barriers to trade – tariffs, quotas, regulations, etc.

Taste – trade promotion, ‘buy Canadian’Mad cow disease, lead paint on toys, etc.


Appreciation of the Canadian dollar - A rise in the value of the Canadian dollar reduces Canadian exports (X shifts down). The IM function also rotates up since Canadians now spend a higher fraction of income on foreign goods. The NX (=X-IM) function shifts down and also gets steeper. (and the reverse)

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Recall the exchange rate is the number of Canadian $’s required to purchase one unit if foreign currency (1.06 Cdn $’s = 1 US $)If the value of the Canadian $ changes such that it requires fewer

Canadian $’s to buy one unit of foreign currency, then we say that the Canadian $ has appreciated in value. (a fall in the exchange rate)

Jan. 2002 Sep. 2007 1.60 Cdn $’s = 1 US $ 1.06 Cdn $’s = 1 US $

OR

If the value of the Canadian $ changes such that it requires more Canadian $’s to buy one unit of foreign currency, then we say that the Canadian $ has depreciated in value. (a rise in the exchange rate)

Jan 1997 Jan 2002 1.35 Cdn $’s = 1 US $ 1.60 Cdn $’s = 1 US $

A fall (rise) in the exchange rate implies an appreciation (depreciation) in the value of the Canadian $


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We can look at appreciation and depreciation from the Foreigner’s perspective

If the value of the Canadian $ changes such that it requires more foreign currency to buy one Canadian $, then we say that the Canadian $ has appreciated in value. (a fall in the exchange rate)

Jan. 2002 Sep. 2007 0.63 US $’s = 1 Cdn $ 0.94 US $’s = 1 Cdn $

OR

If the value of the Canadian $ changes such that it requires less foreign currency to buy one Canadian $, then we say that the Canadian $ has depreciated in value. (a rise in the exchange rate)

Jan 1997 Jan. 2007 0.74 US $’s = 1 Cdn $ 0.63 US $’s = 1 Cdn $

A fall (rise) in the exchange rate implies an appreciation (depreciation) in the value of the Canadian $


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22.3 EQUILIBRIUM NATIONAL INCOME

Desired Consumption and National IncomeWith taxation, YD is less than Y.

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

C = 30 + (0.8)(0.9)Y

C = 30 + (0.8)YD

C = 30 + (0.72)Y

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

C = a + bYD where YD = Y - tY so that

C = a + b(Y-tY) or C = a + b(1-t)Y


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The simple consumption function with taxes is written as:

If t increase then the slope of the consumption function, b(1-t), decreases.

Y

a Slope = b(1-t’)

C

Note this will cause the slope of the AE line to decrease also.

Slope = b(1-t)


C = a + b(1-t)Y

where t’ > t

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The AE Function – total desired expenditure on Canadian goods and services from all sources

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

AE = C + I + G + NX


AE

Y

40o line (AE=Y)

AE = C + I + G + NX

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The slope of the AE function

IF C = a +bYD where YD = Y – tY

I = I G = G X = X and M = mY where NX = X - M

Then AE = C + I + G + NX

= a + bYD + I + G + (X - M)

= a + b(Y – tY) + I + G + (X - mY)

= a + [b(1 – t) -m]Y+ I + G + X recall b is the MPC

AE = C + I + G + NX

In this model, we get:

z = MPC(1 - t) - m

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


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Equilibrium National Income

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.

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

equilibrium condition is Y = AE(Y)

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

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An alternative (but equivalent) approach to determining the 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.

www.myeconlab.com

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22.4 CHANGES IN EQUILIBRIUM NATIONAL INCOME

The Multiplier with Taxes and Imports

Recall multiplier is equal to 1/(1-z)

Imports and taxes make z smaller

the simple multiplier is also smaller

z = MPC(1 - t) – m

In our complete model, the multiplier is

1 / (1- [MPC(1 - t) – m])


Using realistic values of taxation and imports for Canada, the evidence shows that the value of the multiplier is closer to 1 than 2.

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Y1 Y0

e1

AE1e0 •

AE =Y

E0

E1

Y Y

AE

For example, suppose MPC = 0.9 , t = 0.3 and m = 0.4

Then z = 0.9 (1 - 0.3) – 0.4 = 0.23 and the multiplier is

1 / (1-z) or 1 / (1 - 0.23) = 1.30

AE

The value of z is determined by:

z = MPC(1-t) - m

z = AE / Y - slope of the AE curve

z increases as MPC increases and decreases as t and m increase. Try different values for MPC, t, m and recalculate the multiplier.How does the picture change?


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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

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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.

Fiscal policy represents an attempt on the part of the government to keep actual output as close as is possible to potential output. (lots of problems with this but lets do the theory anyway)

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

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e´1

Y1 Y0

e1

AE1

AE0

e0 •

•

AE =Y

E0

E1

•G

Y Y

AE

For example, suppose z = 0.62 ==> multiplier = 2.63.

G = -$100 million ==> Y = - $263 million.

Consider a decrease in government expenditures (G < 0).

Equilibrium national income will fall:

Y = G x simple multiplier


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AE0

Y0 Y1

AE1

•

•

E1

E0

e0

e2

AE=Y

The government may also 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

AE

Y

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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.

www.myeconlab.com

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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.

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e´1

Y1 Y0

e1

AE1

AE0

e0 •

•

AE =Y

E0

E1

•

AE

Y Y

AE

We say the economy is demand driven.

Recall: desired AE = C + I + G + NX

The level of desired spending (the position of the AE curve) determines the level of equilibrium national income, Y.

Any change in the AE curve (shift or change in slope) implies a different level of equilibrium Y


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

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

When is this a reasonable assumption?

In the next chapter, we allow a variable price level:- more complicated- more realistic

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of 42 copyright © 2008 pearson education canada 1 chapter 22 adding government and trade to the...

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