1 Variable Net Exports Revisited and The Algebra of Income and Expenditure Chapter 25 Appendix © 2006 Thomson/South-Western

2 Exhibit 7: Net Exports and Aggregate Expenditures  Panel (a) In panel (a), net exports, X 2M, equal exports minus imports.  Panel (b) shows what happens when variable net exports are added to the other components of aggregate expenditure  Because variable net exports and real GDP are inversely related, the addition of variable net exports has the effect of flattening out, or reducing the slope of the aggregate expenditure line

3 Net Exports and the Multiplier  Inclusion of variable net exports implies that the formula for the multiplier must be altered to include the marginal propensity to import, MPM  MPM is the fraction of each additional dollar of disposable income that is spent on imported goods  Spending multiplier = 1 / (MPS + MPM)

4 Algebra of Income and Expenditure  Real GDP demanded for a given price level occurs where planned spending equals income  Algebraically this equality can be written as Y = C + I + G + (X – M)

5 Consumption  General form of the consumption function can be written as  C = a + b(Y – NT), or  C = a – bNT + bY  Where  a – bNT is autonomous consumption (the portion of consumption that is independent of the level of income) and  bY is induced consumption, e.g., that portion of consumption generated by the level of income in the economy

6 General Model  Recall that income must equal output, therefore Y = a – bNT + bY + I + G + (X – M)  Which can be rearranged to yield Where a – bNT + I + G + X – M is autonomous spending, and (1 / 1 – b) is the simple multiplier

7 Variable Net Exports  If we now add variable net exports, this equation would become Y = a + b(Y – NT) + I + G + X – m(Y – NT) which yields the following equilibrium equation: