Chapter 22 Adding Government and Trade to Simple Macro Model.docx

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Chapter 22 Adding Government and Trade to Simple
Macro Model
22.1 Introducing Government
Government Purchases
Purchases of goods and services (G) it is adding directly to demand for economy’s current
output of goods and services
Transfer payments also affects desired AE but only through the effect these transfers have on
household’s income
Only G is part of desired aggregate expenditures, not including transfer payments
Assume G is autonomous with respect to YD
Net Tax Revenue
Net Taxes (T) are total tax revenue net of transfer payments
We assume net taxes are given by: T = tY
o T = net tax rate
As Y rises, a tax system with given tax rates will yield more revenue (net of transfers)
Assume that tax rate is an autonomous policy variable
With t we represent a complex tax and transfer structure
Budget Balance
Budget balance is difference between G and T (G does not include debt-service payments)
o If G < T: a budget surplus
Government uses excess revenue to buy back outstanding government debt
o If G > T: a budget deficit
The government must borrow excess of spending over revenues. It does this by
issuing additional government debt (bonds or treasury bills)
All levels of government add directly to desired AE through their purchases of goods and
services (G)
G will be treated as an autonomous expenditure in our model
Net tax revenues (T) is positively related to YD
T will enter AE function indirectly, through its effect on disposable income (YD). Recall: YD = Y T
22.2 Introducing Foreign Trade
Net Exports
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We make two central assumptions
o Canada’s exports are autonomous with respect to Canadian GDP (it depends on foreign
households and firms)
o Canada’s imports rise as Canadian GDP rises (rises consumption and also imports)
For imports, we assume:
o IM = mY
o m = marginal propensity to import
Thus, net exports are given by: NX = X mY
Ceteris paribus, changes in domestic GDP lead to changes in net exports
o As Y rises, NX falls
o As Y falls, NX rises
NX function is drawn holding the following constant:
o Foreign GDP
If foreign GDP increases, our exports will go up (imports is unaffected)
o Domestic and foreign prices
If domestic prices become relatively more expensive, exports will go down and
imports will go up (net export decreases) import function becomes steeper
(slope changes)
o The exchange rate
If there is a depreciation of Canadian dollar, export increases and import
22.3 Equilibrium National Income
Desired Consumption and National Income
Assume that t=10%. So that T = (0.1)Y
YD must be 90% of Y: YD = Y-T = (0.9) Y
Consumption function: C = 30 + 0.8YD
C = 30 + (0.8)(0.9)Y
C = 30 + (0.72)Y
MPC out of national income (0.72) is less than MPC out of disposable income (0.8)
Provincial and Municipal Government
When measuring overall contribution of government to desired aggregate expenditure, all level
of government must be included
o Particularly important in Canada
The AE Function
We then expand the AE function: AE = C + I + G + NX
Consumption: C= a + bYD = a + b(1-t)Y
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