AGGREGATE EXPENDITURE—INCLUDING GOVERNMENT & FOREIGN SECTOR
x We complicate the simple model developed last week and we include government and foreign sector in the model.
x National saving—revisit.
x Consider the effects of a change in aggregate expenditure on national income and budget balance.
Enriching the Model—Including Government & Foreign Sector
The Government Sector
The government enters the model in the following ways:
1) Collecting taxes, T
x The government collects taxes from households and firms to finance its spending.
x In our model taxes are positively related to income, i.e.,
T = T0 + t1Y, where T0 = constant, 1 > t1 > 0
2) Making transfer payments, TR
x Transfer payments refer to payments from the government to individuals that are not in exchange for goods and services.
x Examples include employment insurance (EI), public pension, and etc.
x Transfer payments are inversely related to income, i.e.,
TR = TR0 – tr1Y, where TR0 = constant, 1 > tr1 > 0
3) Spending on final goods and services, G
x It is also called government purchases, and it is the government expenditure on final goods and services.
x In our model, we assume G is an autonomous variable, (i.e., its value is give), i.e., G = constant.
The Foreign Sector
x When an economy trades with foreign countries, this economy is an open economy.
x Before we discuss how the foreign sector enters the model, we need to talk about the exchange rate.
x Question: What is the exchange rate?
x Answer: Exchange rate (E) is the price of a country’s 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$).
o Example: If E = US$ 0.875/C$, then the value of 1 C$ is equivalent to US$ 0.875 (US$ 0.875 per C$).
x Question: What happens when E changes?
o If E increases from US$0.875/C$ to US$0.89/C$, C$ appreciates against US$ because it takes more US$ to exchange 1 C$.
o If E decreases from US$0.875/C$ to US$0.86/C$, C$ depreciates against US$ because it takes fewer US$ to exchange 1 C$.
The foreign sector enters the model in the following ways:
1) Exports, X
x Holding all else constant, X decreases when E increases (C$ appreciates).
o Canadian goods become more expensive to foreigners, foreign demand for Canadian goods decreases.
Suppose a Canadian product sells for C$200 in Canada.
x 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
x 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
x Note: Since the US$ price of the Canadian product rises; Canadian goods become more expensive to Americans. They will buy less
Conclusion: Exports are inversely related to exchange rate:
X = X
0 – x1 (E – ), where X0, x1 & are constants
0 = autonomous exports, x1 is amount that exports will decrease by if E >
2) Imports, IM
x 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 Æ our demand for foreign goods increases.
x 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.
Suppose an American product sells for US$100 in the US.
x 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
x 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
x 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 = IM0 + im1Y + im2 (E – ), where IM0, im1, im2 & are constants
IM0 = autonomous imports, im1 = marginal propensity to import (1 > im1 > 0), im2 is amount that imports increase by if E >