0. Macroeconomics (ECON 1211) Lecturer: Dr B. M
Macroeconomics (ECON 1211) Lecturer: Dr B. M. Nowbutsing Topic: Aggregate demand, fiscal policy, and foreign trade

1. Some Key Terms Fiscal policy Stabilization policy Budget deficit
the government’s decisions about spending and taxes
Stabilization policy
government actions to try to keep output close to its potential level
Budget deficit
the excess of government outlays over government receipts
National debt
the stock of outstanding government debt
See the introduction to Chapter 22 in the main text.

2. The Government and the Circular Flow
Introduction of Government: Another Agent
AD = C + I + G (assumed that G is autonomous)
YD = Y – NT
If NT = tY (0<t<1); YD = Y (1- t)
C = f (YD), slope of consumption function is lower with taxes.
If autonomous consumption is zero and MPC = 0.8.
Then C = 0.8 YD = 0.8 (1 – t) Y
If tax rate = 0.2, then C = 0.64 Y
This implies MPCT = MPC (1 – t)

3. 3. Government in the Income-Expenditure Model
Direct taxes
affect the slope of the consumption function
and hence the slope of the AD schedule.
Government expenditure affects the position of the AD schedule

4. 4. A Higher Net Tax Rate AD0 AD1 Y1 Y0 An increase in tax rate shift
the consumption function
which in turn shift the AD
curve
Aggregate demand
AD0
Income,
output
45o line Y1
AD1 Y0
thus drecreasing
equilibrium
output from Y0 to Y1.

5. 5. Government Spending AD1 AD0 Y0 Y1 Assume tax rate is zero,
And government spending
Increases.
With a MPC of 0.9,
the multiplier is 10
Income,
output
Aggregate demand
45o line
AD0 Y0
AD1 Y1
A rise in government
expenditure G induce a
rise in output by ten times
that amount

6. 6. The Balanced Budget Multiplier
According to the balanced budget multiplier, an increase in G accompanied by an increase in NT, has an expansionary effect on output
This is because AD increase by the full amount of an increase in G but AD does not fall by the full amount in taxes as C falls by less
If G and T rises by 200, Then AD rises by 200, YD fall by 200
Assuming MPC = 0.75, AD should fall by 150
Ultimately, there is a net increase in AD of 50

7. 7. The Government Budget
The budget deficit equals total government spending
minus total tax revenue; BD = G -NT
If government spending is
independent of income G
G, NT
but net taxes depend on
income,
As noted, the balanced budget multiplier states that an
increase in government spending plus an equal increase
in taxes leads to higher equilibrium output.
Balanced
budget
but in surplus at high levels
then the budget will be in
deficit at low levels of
income
Income, output

8. 8. Investment, Saving and Budget
Without government, planned savings equal to planned investment
With govt. in equilibrium, planned savings equal planned injections, S + NT = G + I
This implies S – I = G – NT
Thus, private sector surplus (S > I) must be matched by a government budget deficit (G > NT)

9. 9. Deficits and the Fiscal Stance
The size of the budget deficit is not a good measure of the government’s fiscal stance for the following reasons
BD can change for reasons other than fiscal policy, e.g. If I falls, Y falls as well as T
For given level of T and G, BD is higher in recession than in boom
Official measures of the deficit treat the whole of the nominal interest paid by the government on the national debt as an item of G

10. 10. Deficits and the Fiscal Stance
The structural budget shows what the budget would have been if output had been at the full-employment level.
The inflation-adjusted budget uses real not nominal interest rates to calculate government spending on debt interest.

11. 11. Automatic Stabilizers & Discretionary Fiscal Policy
Automatic Stabilizers are mechanisms in the economy that reduce the response of GNP to shocks
for example, in a recession:
payments of unemployment benefits rise
and receipts from VAT and income tax fall
Discretionary fiscal policy is decisions about tax rate and levels of government spending

12. 12. Limits on Active Fiscal Policy
Why can’t shocks to aggregate demand
immediately be offset by fiscal policy?
Time lags: it takes time
to diagnose the problem
to take action
for the multiplier process to operate
Uncertainty
the size of the multiplier is not known
aggregate demand is always changing
Induced effects on autonomous demand
changes in fiscal policy may induce offsetting effects in other components of aggregate demand

13. 12. Limits on Active Fiscal Policy (2)
Why doesn’t the government expand fiscal
policy when unemployment is persistently high?
The budget deficit
concern about inflation if the budget deficit grows
Maybe we’re at full employment!
unemployment may be (at least partly) voluntary

14. 13. Foreign Trade and Income Determination
Introducing exports (X) & imports (Z)
It affects AD and multiplier
TRADE BALANCE
the value of net exports (X - Z)
TRADE DEFICIT
when imports exceed exports
TRADE SURPLUS
when exports exceed imports
Equilibrium is now where
Y = C + I + G + X – Z

15. 14. Exports, Imports and the Trade Balance
Assume that exports
are independent of
income,
Exports
but that imports increase
with income
Imports
X, Z
At higher income levels, there is a trade deficit.
At relatively low income,
exports exceed imports – there is a trade surplus.
There is trade balance at income Y*, but there is no
guarantee that this corresponds to full employment. Y*
Income

16. 15. Foreign Trade and the Multiplier
K = 1 / 1 – (MPCT – MPZ) = 1 / 1 – MPCT + MPZ)
The marginal propensity to import
is the fraction of additional income that domestic residents wish to spend on additional imports.
The effect of foreign trade is to reduce the size of the multiplier
the higher the value of the marginal propensity to import, the lower the value of the multiplier.

17. 16. Investment, Savings, the Budget Deficit and Trade Deficit
In equilibrium total injections = total withdrawals
S + NT + Z = I + G + X
S – I = (G – NT) + (X – Z)
Thus, S – I = Budget deficit/Surplus + Trade Deficit/Surplus