Week4 Lecture

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

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Description
1 ECMA06 – Aggregate Expenditure (with government and foreign sector) Aggregate Expenditure – with Government & Foreign Sector Outline • Extend the simple model developed last week by including government and foreign sector in the model. • National saving in an open economy. • Consider the effects of a change in aggregate expenditure on national income and budget balance. www.notesolution.com 2 Enriching the Model – Including Government and Foreign Sector The Government Sector The government enters the model in the following ways: 1) Collecting taxes, T • The government collects taxes from households and firms to finance its spending. • Assumption: Taxes are positively related to income. • Tax function: T = T +0t Y,1 where T = 0utonomous taxes t1= tax rate & 1 > t > 1. www.notesolution.com 3 ECMA06 – Aggregate Expenditure (with government and foreign sector) 2) Making transfer payments, TR • Transfer payments refer to payments from the government to individuals that are not in exchange for goods and services. • Examples include employment insurances (EI), public pension, and etc. • Assumption: Transfer payments are inversely related to income. • Transfer payments function: TR = TR – t0 Y, 1here TR = auton0mous transfer tr1= benefit reduction rate & 1 > tr > 0 1 3) Spending on final goods and services, G • It is also called government purchases, and it is the government expenditure on final goods and services. • Assumption: G is an autonomous variable, (i.e., its value is given), i.e., G = constant. www.notesolution.com 4 The Foreign Sector • When an economy trades with foreign countries, this economy is an open economy. Exchange Rate • Exchange rate (E) is the price of a country’s currency in terms of another currency. • In our class, exchange rate measures the value of C$ in foreign currency (i.e., the # of foreign currency needed to exchange 1 C$). • Example: If E = US$ 0.875/C$, then the value of 1 C$ is equivalent to US$ 0.875 (US$ 0.875 per C$). • Question: What happens when E changes? • Answer: ⇒ If E ↑, then C$ appreciates against the US$ because it takes more US$ to exchange 1 C$. ⇒ If E ↓, then C$ depreciates against the US$ because it takes fewer US$ to exchange 1 C$. www.notesolution.com 5 ECMA06 – Aggregate Expenditure (with government and foreign sector) www.notesolution.com 6 The foreign sector enters the model in the following ways: 1) Exports, X • Assumption: Exports depend on the exchange rate only. ⇒ When E ↑(i.e., C$ appreciates), X ↓because Canadian goods become more expensive to foreigners, foreign demand for Canadian goods ↓ . • Exports are inversely related to exchange rate. • Exports function: X = X –0x (E1– ), where X = 0utonomous exports x & are constants 1 www.notesolution.com 7 ECMA06 – Aggregate Expenditure (with government and foreign sector) 2)Imports, IM • Assumption: Imports depend on income and exchange rate. ⇒ Holding all else constant, IM ↑when Y ↑because when Y ↑ , we consume more goods including imported goods ⇒our demand for foreign goods ↑ . ⇒ Holding all else constant, IM ↑ when E ↑ (C$ appreciates) because foreign goods become less expensive to us, our demand for foreign goods ↑ . • Imports are positively related to both income and exchange rate. • Imports function: IM = IM + 0m Y +1im (E – 2, where IM = 0utonomous imports im 1 = marginal propensity of imports im 2 are constants www.notesolution.com 8 A More Complicated Model Suppose the model consists of the following functions: C = 20 + DI T = (2/7)Y – 20 TR = 220 – (1/7)Y I = 100 – 5(r – 0.0r = 0.05 G = 250 X = 120 – 3(E – 0.85); E = 0.85 (US$ 0.85 per C$) IM = Y + 2.5(E – 0.85); E = 0.85 Note: We have a much more complicated model, but for now we keep it by holding the interest rate (r) and the exchange rate(E) constant. Note: *When T = TR = 0, DI= Y= Y = the marginal propensity to spend out of GDP (= Y) ** When ≠ 0 and ≠R 0, D≠ Y ⇒ ≠ c ≠ MPC. Now = the marginal Y propensity to spend out of DI. www.notesolution.com 9 ECMA06 – Aggregate Expenditure (with government and foreign sector) Solving for Equilibrium • To solve for the equilibrium, we try to get the AE equation: AE = AE + c Y, 0 Y where c Y marginal propensity to consume out of Y • Steps: 1) Get the consumption function as a function of GDP (Y) 2) Get the AE function by setting AE = C + I + G + X – IM 3) Solve for Y by equating AE = Y. Step 1: Get C = C(Y) C = 20 + (7/8)DI, where DI = Y – T + TR • Get DI: • Get C = C(Y): www.notesolution.com 10 Step 2: Get the AE Function AE = C + I + G + X – IM • Holding r = 0.05 ⇒I = 100 – 5(0.05 – 0.05) = 100 • Holding E = 0.85 ⇒X = 120 – 3(0.85 – 0.85) = 120 ⇒IM = Y + 2.5(0.85 – 0.85) = Y Step 3: Solve for Y Equilibrium is given by Y = AE. www.notesolution.com 11 ECMA06 – Aggregate Expenditure (with government and foreign sector) Checking Our Answer (only if asked for) • We can check our results by finding values for all the variables and check whether they add up to the equilibrium level of Y. T: T = (2/7)Y – 20 = (2/7)1120 – 20 = TR: TR = 220–(1/7)Y = 220–(1/7)1120 = DI:DI = Y – T + TR = C: C = 20 + DI = I: I = 100 G: G = 250 (given) X: X = 120 IM: IM = Y = • Now, we can check our results: Y = C + I + G + X – IM www.notesolution.com 12 National Saving in an Open Economy • For an open economy: Y = C + I + G + X – IM Lessons: • For an open economy, national saving MUST equal to the sum of (domestic) investment and net exports, i.e., NS = I + NX. • An open economy can save in 2 ways: 1) Undertaking investment. 2) Running a trade surplus (accumulate foreign wealth) www.notesolution.com 13 ECMA06 – Aggregate Expenditure (with government and foreign sector) • From last week lecture: NS = S + S . p SG= Y – T + TR – C = DI – C S = T – TR – G • (Continued from our numerical example on p7) What is the level of private saving? S = DI – C = • What is the level of public saving? G ⇒ If S < 0, then the government runs a budget deficit. G ⇒ If S > 0, then the government runs a budget surplus. ⇒ If S = 0, then the government runs a balanced budget. S = T – TR – G = • What is the level of national saving? www.notesolution.com 14 • What happens to net exports? ⇒ If NX < 0, then the country has a trade deficit. ⇒ If NX > 0, then the country has a trade surplus. NX = X – IM = • Check: Recall, NS = I + NX • Note: In this example, the country haseficits – the simultaneous occurrence of budget deficit and trade deficit. • Over the past few years, the Americans have had very large trade deficits and very large budget deficits. This is no accident! www.notesolution.com 15 ECMA06 – Aggregate Expenditure (with government and foreign sector) Effect of a Change in AE on Y • We will consider what happens when we change one of the parameters of the model. • Return to our extended model (hold r & E constant): Generic form Numerical example C = C +0c DI1 C = 20 + DI T = T +0t Y1 T = – 20 + (2/7)Y TR = TR – t0 Y 1 TR = 220 – (1/7)Y I = I0 I = 100 G G = 250 X = X 0 X = 120 IM = im Y 1 I
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