1. GDP in an Open Economy with Government Chapter 17
LIPSEY & CHRYSTAL
ECONOMICS 12e

2. Learning Outcomes
Government consumption contributes to aggregate spending in the same way as any other component of autonomous spending.
Taxes affect private consumption via their effect on disposable income.
Net exports are negatively related to domestic income.

3. Learning Outcomes
A necessary condition for GDP to be in equilibrium is that desired aggregate domestic spending is equal to national output.
The size of the multiplier is negatively related to the income tax rate and the marginal propensity to import.

4. GDP IN OPEN ECONOMY WITH GOVERNMENT
Government Spending and Taxes
Government consumption is part of autonomous aggregate spending.
Taxes minus transfer payments are called net taxes and affect aggregate spending indirectly.
Taxes reduce disposable income, whereas transfers increased disposable income.

5. GDP IN OPEN ECONOMY WITH GOVERNMENT
Government Spending and Taxes
Disposable income, in turn, determines desired private consumption, according to the consumption function.
The budget balance is defined as government revenues minus government spending.
When this difference is positive, the budget is in surplus; when it is negative, the budget is in deficit.

6. GDP IN OPEN ECONOMY WITH GOVERNMENT
When the budget is in surplus, there is positive public saving, because the government is spending less on the national product than the amount of income that it is withdrawing from the circular flow of income and spending.
When the government budget is in deficit, public saving is negative.

7. GDP IN OPEN ECONOMY WITH GOVERNMENT
Net Exports
Since desired imports increase as national income increases, desired net exports decrease as national income [GDP] increases, other things being equal.
Hence the net export function is negatively sloped [net exports fall as GDP rises].

8. GDP IN OPEN ECONOMY WITH GOVERNMENT
Equilibrium GDP
GDP is in equilibrium when desired aggregate expenditure, C + I + G [X - IM], equals national output.
The sum of investment and net exports is called national asset formation because investment is the increase in the domestic capital stock and net exports result in investment in foreign assets.
At the equilibrium level of GDP, desired national saving, S + T - G, is equal to national asset formation, I + X - IM.

9. GDP IN OPEN ECONOMY WITH GOVERNMENT
Changes in Aggregate Spending
The size of the multiplier is negatively related to the income tax rate.
A shift in exogenous spending 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 or by a change in official interest rate.

10. The budget surplus function (£million)

11. Budget Surplus Function
Price Saving [£m]
1000
2000
3000
4000
5000
6000
National Income [GDP][£m]

12. Budget Surplus Function
Price Saving [£m]
T - G
-170
1000
2000
3000
4000
5000
6000
National Income [GDP][£m]

13. The budget surplus function
The budget surplus is negative at low levels of GDP and becomes positive at high levels of GDP.
Tax revenue increases with GDP while government spending is assumed not to vary with GDP.
The slope of the budget surplus function is 0.1 when the income tax rate is assumed to be 10%.

14. The net export function (£million)

15. [i]. Export and Import Functions Real National Income [GDP] [£m]
IM = 0.25Y
Imports and Exports [£m]
540
X = 540
1000
2000
3000
Real National Income [GDP] [£m]

16. Real National Income [GDP] [£m]
Export and Import Functions
[ii]. Net Export Function
540
Net Exports [£m]
2160
(X - IM) = Y
1000
2000
3000
Real National Income [GDP] [£m]

17. The net export function
Net exports, defined as exports minus imports, are negatively related to GDP.
Exports are assumed to be constant at £540 million while imports are 0.25 of National income.
So the net export function is given by: Y

18. The aggregate spending function (£million)

19. An Aggregate Spending Curve and Equilibrium GDP
AE = Y AE
Desired Expenditure [£m] E0
2000
1060
450
1000
2000
3000
4000
5000
Real National Income [GDP] [£m]

20. Aggregate expenditure
The aggregate expenditure function is the sum of desired consumption, investment, government spending, and net exports.
Equilibrium GDP occurs at E0 where the desired aggregate expenditure line intersects the 450 line.
Only when GDP is £2000 will desired spending equal national output.

21. The Effect of Change in Government Spending
AE = Y
AE1
AE0
Desired Expenditure [£m]
45o Y0 Y0
Real National Income [GDP] [£m]

22. The Effect of Change in Government Spending
A change in government spending changes GDP by shifting the AE line parallel to its initial position.
The initial level of AE is at AE0 and GDP is Y0 with desired expenditures 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 in government spending times the multiplier.

23. UK borrowing as a % of GDP (1972 to 2005)

24. UK fiscal stance as a % of UK GDP

25. Exports and imports as a % of UK GDP