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
BUDGET BALANCE (BB) = T – TR – G = S
If S < 0, then the government runs a budget deficit.
If S > 0, then the government runs a budget surplus.
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