Chapter 22
Adding Government and
Trade to the Simple
Macro Model
1

Introducing Government
Government is and important variable in the economy. Fiscal Policy:
• government expenditures or purchases

• taxation

2

Government Spending
• G is part of desired AE
Transfer payments: e.g. pensions
• not government purchases

• only a flow of funds from gov’t to HH
• affects disposable income and HH spending

Tax Revenues
Net taxes, T:
• total tax revenue minus total transfer payments
3

Tax rates are autonomous policy variables, but revenues vary with GDP:

T = tY where t = marginal propensity to tax.
Note: t includes all taxes, so when Y rises by $1, tax revenues rise by t x $1.

4

The Budget Balance: [ T – G ]
G is autonomous
Tax rates are induced
• [ T – G ] revenue minus expenditures

If T > G - budget surplus
If T < G - budget deficit
As Y increases, T rises
• tax revenues rise
• transfers payments fall
5

Provincial and Municipal Governments
• G includes all levels of government in desired AE in public saving [ In Canada – combined purchases of provincial and municipal governments is larger than federal government.]

6

The Net Export Function
Exports: X
• autonomous wrt Canadian national income.
Imports: IM = mY
• rise as national income increases

• not autonomous
• induced or depends on GDP
Marginal propensity to import :
• change in imports caused by a $1 change in GDP
• m / Y
• MPM = m = 20/100 = 0.2

7

Net export function:

NX = X – IM

• Falls as national income rises
• X constant
• IM increase as GDP [ Y ] increases

8

If X > IM :
• Foreigners buy more C$
• To buy exports
• Canada accumulates more foreign currency
• Uses foreign currency to buy foreign income-earning assets • Similar to investment ( I )
• Produces future income for Canadians

9

Y

X

IM

X - IM

0

60

0

60

100

60

20

40

200

60

40

20

300

60

60

0

400

60

80

-20

X,IM

IM

60

0

X

Y

300

NX function holds constant:
• foreign national income

NX
60

• domestic and foreign prices
• exchange rate
If any of these change, NX changes: 0

Y
300
NX
10

If IM > X:
• Canadians sell more C$
• Buy more imports than foreigners
• Canada’s trading partners accumulate C$

• C$ used to buy Canadian assets
• Liability for Canada

• Income will flow to foreigners

11

Shifts in the Net Export Function
Foreign income:
If foreign incomes increase
• ceteris paribus, Canadian exports [ X ] increase
• shifts up NX function
NX

0

Y
NX0

NX1
12

Domestic and foreign prices:
A rise in Canadian prices relative to foreign prices:
• reduces Canadian exports
• X function shifts down
• Imports increase - cheaper

• IM function rotates up
• NX function shifts down and gets steeper

13

X, IM

Canadian prices rise relative to foreign prices

IM1
IM0

• X fall
• IM rise
• NX fall

X0
X1
Y
NX

Y

NX1

NX0
14

Exchange rates cause relative prices to change.

Appreciation of Canadian dollar:
• increases Canadian prices relative to foreign prices

Depreciation of Canadian dollar:
• decreases Canadian prices relative to foreign prices

15

Equilibrium GDP
• where desired aggregate expenditure (AE) equals national income (Y)
• AE = Y
Include:
• government ( T - G )
• net exports ( NX = X - IM )

Adjust consumption:
• with government, national income (Y) is not the same as disposable income (Yd)
Yd = Y - T
16

With taxes:
• disposable income (Yd) < national income (Y)

Suppose T = 0.1Y. (Taxes = 10% of Y)

Then, Yd = Y – 0.1Y = 0.9Y (Disposable income = 90% of Y)
Consumption function (out of Yd):

C = 10 + 0.8Yd
C = 10 + (0.8)(0.9Y)
C = 10 + 0.72Y
17

With income taxes:
• MPC out of national income (0.72)
• is less than the MPC out of disposable income (0.8)
• MPCY < MPCYd

18

Generally: or C = a + b (Yd)
C = a + b (Y - T)

Since T = tY or C = a + b (Y - tY)
C = a + b[(1 - t)Y]

In last example, C = 10 + 0.8 (1 – 0.1)Y

= 10 + 0.8 (0.9) Y
C = 10 + 0.72Y
19

AE = C + I + G + X – IM
C = a + b Yd
I
G
T = tY
X
IM = mY

= a + b(1 - t)Y

AE = C + I + G