Chapter 22. Adding Government and Trade to the Simple Macro Model. In this chapter you will learn to. Introducing Government. Government Purchases

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1 Chapter 22 Adding Government and Trade to the Simple Macro Model In this chapter you will learn to 1. Describe the relationship between national income and government purchases and tax revenues. 2. Describe the relationship between national income and exports and imports. 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 Introducing 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

2 Introducing Government We assume net taxes are given by: T = t Y where t is the net tax rate. 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 22-4 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 22-5 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

3 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 22-7 Introducing Foreign Trade Net Exports 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 For imports, we assume: IM = my where m is the marginal propensity to import Introducing Foreign Trade 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

4 Figure 22.1 The Net Export Function The NX function is drawn holding constant: foreign GDP domestic and foreign prices the exchange rate Shifts in the Net Export Function An increase in foreign income leads to more foreign demand for U.S. goods: - increases X and shifts NX function upward 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 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

5 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) Equilibrium 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 The MPC out of national income (0.72) is less than the MPC out of disposable income (0.8) The Desired Consumption Function From the numerical example above, we can generally write: C = a + b(1 t)y where b = MPC t = tax rate a = autonomous consumption

6 The AE Function We then expand the AE function: AE = C + I + G + (X M) Recall that the slope of the AE function is the marginal propensity to spend out of national income. 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 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 Figure 22.3 The Aggregate Expenditure Function

7 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]} 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 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

8 Figure 22.4 The Objective of Stabilization Policy Changes in Government Purchases Consider some ΔG < 0. AE e 0 AE =Y E 0 AE 0 Equilibrium national income will fall: e 1 ΔG AE 1 ΔY = ΔG x simple multiplier e 1 E 1 Y 1 Y 0 ΔY For example, suppose z = 0.62 ==> multiplier = ΔG = -$100 million ==> ΔY = - $263 million. Y 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

9 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 Demand-Determined Output Equilibrium National Income The equilibrium level of national income is that level where desired AE equals actual national income. The Simple Multiplier Simple multiplier; 1/(1-z) Closed economy with no government: z = MPC Open economy with government: z = MPC(1-t) - m Demand-Determined Output Demand-Determined Output The model assumes a constant price level so that national income is demand determined. 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