Introduction to Macroeconomics: Math App - Lecture 007

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Economics for Management Studies
Iris Au

28 January 2013 CHAPTER 22: ADDING GOVERNMENT AND TRADE TO THE SHORT-RUN MODEL The Government Sector and the Budget Balance The government enters the model in the 3 ways:  Spending on Final Goods and Services (G) it is the government expenditure on final goods and services, we assume G is an autonomous variable (the value is fixed and given). If there is a change in government spending we call it a shock, a change in fiscal policies  Collecting Taxes (T) we assume taxes are positively related to income because the government collects taxes from households and firms to finance its spending o Tax Function: T = T 0 t 1, where T 0 Autonomous taxes, t = T1x rate and 1 > t > 01  Making Transfer Payments (TR) is inversely related to income. They are payments from the government to individuals that are not in exchange for goods and services (IE: Employment insurances, public pension) o Transfer Payment Function: TR – Or Y, 1here TR = AuOonomous transfer, tr = Benef1t reduction rate and 1 > tr 1 0 Budget Balance and Public Saving G BUDGET BALANCE (BB) = T – TR – G = S G If S < 0, then the government runs a budget deficit. If S > 0, then the government runs a budget surplus. G If S = 0, then the government runs a balanced budget. NOTE: The budget balance and public saving (S ) are two sides of the same coin. The Foreign Sector and the Trade Balance When an economy trades with foreign countries, this economy is an open economy. Exchange Rate (E) is the price of a country’s currency in terms of another currency. Exchange rate measures the value of the Canadian dollar in foreign currency, the number of foreign currency needed to exchange 1 Canadian dollar (IE: If E = US$ 0.875/C$, then the value of 1 C$ is equivalent to US$ 0.875 (US$ 0.875 per C$)). If E↑, then the Canadian dollar appreciates against the US dollar because it takes more US dollars to exchange 1 Canadian dollar. If E↓, then the Canadian dollar depreciates against the US dollar because it takes fewer US dollars to exchange 1 Canadian dollar. The foreign sector enters the model in the following ways:  Exports (X) depends on the exchange rate only and is inversely related to exchange rate. When E↑ (the Canadian dollar appreciates), X↓ because Canadian goods become more expensive to foreigners and foreign demand for Canadian goods ↓ o Exports Function: X = X –0x (E1– Ē), where X = 0utonomous exports and x and Ē a1e constants  Imports (IM) are positively related to income and exchange rate. Holding all else constant, we consume more goods including imported goods when Y↑ then IM↑. Holding all else constant, foreign goods become less expensive to us when E↑ (the Canadian dollar appreciates), our demand for foreign goods ↑ then IM↑ o Imports Function: IM = IM + i0 Y + 1m (E – 2), where IM = Auto0omous imports, im = 1 IM/Y = ma
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