Chapter 22: Adding Government and Trade to the Simple Macro Model Copyright © 2014 Pearson Canada Inc.

Chapter Outline/Learning Objectives Section Learning Objectives After studying this chapter, you will be able to 22.1Introducing Government 1.understand how government purchases and tax revenues relate to national income. 22.2Introducing Foreign Trade 2.understand how exports and imports relate to national income. 22.3Equilibrium National Income 3.distinguish between the marginal propensity to consume and the marginal propensity to spend. 22.4Changes 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. 22.5Demand-Determined Output 6.understand that output is demand determined in our simple macro model. Copyright © 2014 Pearson Canada Inc. 2 Chapter 22, Slide

22.1Introducing 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. 3 Chapter 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 deficit 4 Copyright © 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 municipalgovernments are larger than those of the federal government 5 Copyright © 2014 Pearson Canada Inc. Chapter 22, Slide

22.2Introducing 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. 6 Chapter 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. 7 Copyright © 2014 Pearson Canada Inc. Chapter 22, Slide

Fig The Net Export Function The NX function is drawn holding constant: foreign GDP domestic and foreign prices the exchange rate 8 Copyright © 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 9 Copyright © 2014 Pearson Canada Inc. Chapter 22, Slide

Fig 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 10 Copyright © 2014 Pearson Canada Inc. Chapter 22, Slide

22.3Equilibrium National Income Desired Consumption and National Income With taxation, Y D is less than Y. If T = (0.1)Y, then Y D = (0.9)Y. C = 30 + (0.8)Y D 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. 12 Copyright © 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. 13 Copyright © 2014 Pearson Canada Inc. Chapter 22, Slide

Fig The Aggregate Expenditure Function 14 Copyright © 2014 Pearson Canada Inc. Chapter 22, Slide Adding government and foreign trade does not change the logic of the equilibrium!

15 Copyright © 2014 Pearson Canada Inc. MyEconLab 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

22.4Changes 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 17 Copyright © 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. 18 Copyright © 2014 Pearson Canada Inc. Chapter 22, Slide

Consider some  G < 0. Equilibrium national income will fall:  Y =  G x simple multiplier 19 Copyright © 2014 Pearson Canada Inc. For example, suppose z = 0.25 ==> multiplier =  G = –$100 million ==>  Y = – $130 million. e´ 1 Y1Y1 Y0Y0 e1e1 AE 1 AE 0 e0e0 AE =Y E0E0 E1E1 GG  Y Y AE Chapter 22, Slide

Fig. 22-4The 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 20 Copyright © 2014 Pearson Canada Inc. Chapter 22, Slide

21 Copyright © 2014 Pearson Canada Inc. MyEconLab 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

22.5Demand-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. 22 Chapter 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 23 Copyright © 2014 Pearson Canada Inc. Chapter 22, Slide