# MGEA06H3 Lecture Notes - Exchange Rate, Kolmogorov Space, Consumption Function

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29 Jan 2013
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ECMA06 Aggregate Expenditure (with government and foreign sector)
1
Aggregate Expenditure (continued) with Government &
Foreign Sector
Outline
Extend the simple AE model by including government and
foreign sector in the model.
Discuss national saving in an open economy.
Consider the effects of a change in aggregate expenditure on
national income and budget balance.
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ECMA06 Aggregate Expenditure (with government and foreign sector)
2
Enriching the Model Including Government and Foreign
Sector
The Government Sector & The Budget Balance
The government enters the model in the 3 ways:
1) Spending on final goods and services, G
It is the government expenditure on final goods and
services.
Assumption: G is an autonomous variable, (i.e., its value is
given).
2) Collecting taxes, T
Assumption: Taxes are positively related to income because
the government collects taxes from households and firms to
finance its spending.
Tax function:
T = T0 + t1Y, where T0 = autonomous taxes
t1 = tax rate & 1 > t1 > 0.
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ECMA06 Aggregate Expenditure (with government and foreign sector)
3
3) Making transfer payments, TR
Assumption: Transfer payments are inversely related to
income.
They are payments from the government to individuals that
are NOT in exchange for goods and services.
Examples include employment insurances (EI), public
pension, and etc.
Transfer payments function:
TR = TR0 tr1Y, where TR0 = autonomous transfer
tr1 = benefit reduction rate &
1 > tr1 > 0
Budget Balance & Public Saving
Budget balance (BB) = T TR G = SG
If SG < 0, then the government runs a budget deficit.
If SG > 0, then the government runs a budget surplus.
If SG = 0, then the government runs a balanced budget.
Note: The budget balance and public saving (SG) are two sides
of the same coin.
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