Lecture notes from week 4

6 Pages
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Department
Economics for Management Studies
Course Code
MGEA06H3
Professor
Iris Au

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AGGREGATE EXPENDITUREINCLUDING GOVERNMENT & FOREIGN SECTOR Outline N We complicate the simple model developed last week and we include government and foreign sector in the model. N National savingrevisit. N Consider the effects of a change in aggregate expenditure on national income and budget balance. Enriching the ModelIncluding Government & Foreign Sector The Government Sector The government enters the model in the following ways: 1) Collecting taxes, T N The government collects taxes from households and firms to finance its spending. N In our model taxes are positively related to income, i.e., T = T0+ t1Y, where T 0 constant, 1 > t1> 0 2) Making transfer payments, TR N Transfer payments refer to payments from the government to individuals that are not in exchange for goods and services. N Examples include employment insurance (EI), public pension, and etc. N Transfer payments are inversely related to income, i.e., TR = TR 0 t1 Y, where TR =0constant, 1 > tr 1 0 3) Spending on final goods and services, G N It is also called government purchases, and it is the government expenditure on final goods and services. N In our model, we assume G is an autonomous variable, (i.e., its value is give), i.e., G = constant. The Foreign Sector N When an economy trades with foreign countries, this economy is an open economy. N Before we discuss how the foreign sector enters the model, we need to talk about the exchange rate. N Question: What is the exchange rate? N Answer: Exchange rate (E) is the price of a countrys currency in terms of another currency. o In our class, exchange rate measures value of C$ in foreign currency (i.e., # of foreign currency needed to exchange 1 C$). o Example: If E = US$ 0.875C$, then the value of 1 C$ is equivalent to US$ 0.875 (US$ 0.875 per C$). N Question: What happens when E changes? N Answer: o If E increases from US$0.875C$ to US$0.89C$, C$ appreciates against US$ because it takes more US$ to exchange 1 C$. o If E decreases from US$0.875C$ to US$0.86C$, C$ depreciates against US$ because it takes fewer US$ to exchange 1 C$. The foreign sector enters the model in the following ways: 1) Exports, X N Holding all else constant, X decreases when E increases (C$ appreciates). o Canadian goods become more expensive to foreigners, foreign demand for Canadian goods decreases. Example Suppose a Canadian product sells for C$200 in Canada. N If E = 0.85 (US$0.85 = C$1), what is the US$ price of that product? US$ price of the product = C$ 200 US$ 0.85 C$ 1 = US$ 170 N If E increases to 0.9 (US$0.9 = C$1), what is the US$ price of that product? US$ price of the product = C$ 200 US$ 0.9 C$ 1 = US$ 180 N Note: Since the US$ price of the Canadian product rises; Canadian goods become more expensive to Americans. They will buy less Canadian goods. Conclusion: Exports are inversely related to exchange rate: X = X 0 x1(E ), where X 0 x1& are constants X 0 autonomous exports, x i1 amount that exports will decrease by if E > 2) Imports, IM N Holding all else constant, IM increases when Y increases. o When Y increases, we consume more goods and services and some of the goods and services we consumed are imported goods our demand for foreign goods increases. N Holding all else constant, IM increases when E increases (C$ appreciates). o Foreign goods become less expensive to us, our demand for foreign goods increases. Example Suppose an American product sells for US$100 in the US. N If E = 0.85 (US$0.85 = C$1), what is the C$ price of that product? C$ price of the product = US$ 100 CS$ 1 US$ 0.85 = C$ 117.65 N If E increases to 0.9 (US$0.9 = C$1), what is the C$ price of that product? C$ price of the product = US$ 100 CS $1 US$ 0.9 = C$ 111.11 N Note: Since C$ price of the US product falls; the US good become less expensive to Canadians. We will buy more American goods. Conclusion: Imports are positively related to both income and exchange rate: IM = IM 0 im Y1+ im (E2 ), where IM , i0 , 1m & 2 are constants IM 0= autonomous imports, im =1marginal propensity to import (1 > im >10), im is2amount that imports increase by if E > www.notesolution.com
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