copyright © 2008 pearson addison-wesley. all rights reserved. chapter 22 adding government and...

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

Chapter 22

Adding Government and Trade to the Simple Macro Model

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In this chapter you will learn to

1. Describe the relationship between national income and government purchases and tax revenues.

3. Explain the distinction between the marginal propensity to consume and the marginal propensity to spend.

4. Explain why the presence of government and foreign trade reduces the value of the simple multiplier.

5. Describe the effect of government fiscal policy on the level of national income.

2. Describe the relationship between national income and exports and imports.

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Government Purchases

Net Tax Revenues

Government purchases of goods and services (G) are part of desired aggregate expenditures

- not including transfer payments

Net taxes (T) are total tax revenues net of transfer payments.

Introducing Government

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The Budget Balance

The budget balance is the difference between G and T:

- if G < T: a budget surplus

- if G > T: a budget deficit

We assume net taxes are given by:

T = t Y

where t is the net tax rate.

Introducing Government

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Budget Balance and Saving

Private saving is the amount that household save:

= disposable income – consumption expenditure

Public saving is saving on the part of the government

= T – G

Budget surplus: public saving is positive

Budget deficit: public saving is negative

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State and Local Governments

When measuring the overall contribution of government to desired aggregate expenditure, all levels of government must be included:

- federal, state, and local

- combined purchases of state and local governments are larger than those of the federal government.

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Summary

The presence of government affects our simple model by:

- adding directly to desired AE through G

- collecting tax revenue (T) and make transfer payments

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Introducing Foreign Trade

Net Exports

For imports, we assume:

IM = mY

where m is the marginal propensity to import.

We make two central assumptions:

- U.S. exports are autonomous with respect to U.S. GDP

- U.S. imports rise as U.S. GDP rises

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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.

Introducing Foreign Trade

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Figure 22.1 The Net Export Function

The NX function is drawn holding constant:

• foreign GDP

• domestic and foreign prices

• the exchange rate

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An increase in foreign income leads to more foreign demand for U.S. goods:

- increases X and shifts NX function upward

Shifts in the Net Export Function

A rise in U.S. prices (holding foreign prices constant):

- decreases X

- IM function rotates up as Americans switch toward foreign goods

NX function shifts down and gets steeper

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Figure 22.2 Shifts in the Net Export Function

Illustration of a rise in U.S. prices relative to foreign prices.

This could be caused by:- Δ exchange rate- Δ price levels

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Summary

The presence of foreign trade modifies our basic model by:

- foreign firms and households purchase U.S.-made goods (X)

- all components of domestic expenditure (C, I, and G) include some import content (IM).

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Equilibrium National Income

Desired Consumption and National Income

With taxation, YD is less than Y.

If T = (0.1)Y, then YD = (0.9)Y.

C = 30 + (0.8)(0.9)Y

C = 30 + (0.8)YD

C = 30 + (0.72)Y

The MPC out of national income (0.72) is less than the MPC out of disposable income (0.8).

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The Desired Consumption Function

where b = MPC

From the numerical example above, we can generally write:

C = a + b(1 – t)Y

a = autonomous consumption

t = tax rate

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The AE Function

Recall that the slope of the AE function is the marginal propensity to spend out of national income.

We then expand the AE function:

AE = C + I + G + (X – M)

Summing the four components of desired AE:

AE = a + b(1 – t)Y + I + G + (X – mY)

= [ a + I + G + X ] + [b(1 – t) – m]Y

We call: b(1 - t) - m = z

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Equilibrium National Income

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.

As before, output is assumed to be demand determined in this model:

- equilibrium condition is Y = AE(Y)

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Figure 22.3 The Aggregate Expenditure Function

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Changes in Equilibrium National Income

The Multiplier with Taxes and Imports

Imports and taxes make z smaller:

• z = MPC(1 – t) – m

The simple multiplier is also smaller:

• multiplier = 1/{1 –[ MPC(1 – t) – m]}

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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

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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 adjustment is necessary.

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Figure 22.4 The Objective of Stabilization Policy

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e´1

Y1 Y0

e1

AE1

AE0

e0 •

•

AE =Y

E0

E1

•G

Y Y

AE

For example, suppose z = 0.62 ==> multiplier = 2.63.

G = -$100 million ==> Y = - $263 million.

Consider some G < 0.

Equilibrium national income will fall:

Y = G x simple multiplier

Changes in Government Purchases

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Figure 22.5 The Effect of Changing the 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

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Demand-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

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Equilibrium National Income

Simple multiplier; 1/(1-z)

Closed economy with no government: z = MPC

Open economy with government: z = MPC(1-t) - m

The equilibrium level of national income is that level where desired AE equals actual national income.

The Simple Multiplier

Demand-Determined Output

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2. When firms are price setters they often respond to shocks by changing output (and only later changing their price).

1. When output is below potential, firms can increase output without increasing their costs.

When is this a reasonable assumption?

In the next chapter, we allow a variable price level:- more complicated- more realistic

The model assumes a constant price level so that national income is demand determined.

Demand-Determined Output

Demand-Determined Output