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Lecture 5

Week 5 chapter notes

Economics for Management Studies
Course Code
Iris Au

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Chapter 22 Adding Government and Trade to the Simple Macro
Model Notes
22.1 Introducing Government
x fiscal policy—the use of the government’s tax and spending policies
Government Purchases
x desired government purchases, G, are part of aggregate desired expenditure
x government transfer payments do affect aggregate expenditure but only through effect these transfers have on households’
disposable income
x as GDP rises or falls, level of government’s transfer payments will generally change, but it is not to be assumed that G does not
automatically change just because GDP changes
Net Tax Revenues
x net taxes—total tax revenue minus transfer payments, denoted T
x because transfer payments are smaller than total tax revenues, net tax revenues are positive
x disposable income is therefore substantially less than national income
x net tax rate—increase in net tax revenue generated when national income rises by $1; also called the marginal propensity to tax
x T = tY, where t is the net tax rate
The Budget Balance
x budget balance is difference between total government revenue and total government expenditure; equivalently, it equals net tax
revenue minus government purchases, T – G
x budget surplus—any excess of current revenue over current expenditure
x budget deficit—any shortfall of current revenue below current expenditure
x private saving—saving on the part of households—the part of disposable income that is not spent on current consumption
x public saving—saving on the part of governments, equal to the government budget surplus
x when government has budget surplus, public saving is positive; when government has budget deficit, public saving is negative
Provincial and Municipal Governments
x federal government raises about same amount of tax revenue as do the provincial and municipal governments combined, but
transfers a considerable amount of its revenue to the provinces
x when measuring overall contribution of government to desired aggregate expenditure, all levels of government must be included
1. All levels of government add directly to desired aggregate expenditure through their purchases of goods and services, G.
2. Governments also collect tax revenue and make transfer payments. Net tax revenues are denoted T and are positively related to
national income. Since T does not represent any expenditure on goods and services, it is not included directly in the AE function.
T will enter the AE function indirectly, however, through its effect on disposable income (YD) and consumption. Recall that YD
= Y – T and that desired consumption depends on YD.
22.2 Introducing Foreign Trade
Net Exports
x marginal propensity to import—the increase in import expenditures induced by a $1 increase in national income, denoted by m
x IM = mY, where m is the marginal propensity to import
x NX = X - mY
Shifts in the Net Export Function
x an increase in foreign income, other things being equal, will lead to an increase in the quantity of Canadian goods demanded by
foreign countries—that is, to an increase in Canadian exports
x this change causes the X curve to shift upward and therefore the NX function also to shift upward, parallel to its original position
x a fall in foreign income leads to a reduction in Canadian exports and thus to a parallel downward shift in the NX function
x a rise in Canadian prices relative to those in other countries reduces Canadian net exports at any level of national income; a fall
in Canadian prices increases net exports at any level of national income
1. Foreign firms and households purchase Canadian-made goods. Changes in foreign income and relative prices (including
exchange rates) will affect Canadian exports (X), but it is assumed that X is autonomous with respect to Canadian national
income. When constructing the economy’s AE function we will include X since it represents expenditure on domestic goods.
2. All components of domestic expenditure (C, I, and G) include some import content. Since C is positively related to national
income, imports (IM) are also related positively to national income. When constructing economy’s AE function, which shows
the desired aggregate expenditure on domestic products, subtract IM because these expenditures are on foreign goods.
22.3 Equilibrium National Income
Desired Consumption and National Income
x presence of taxes, marginal propensity to consume out of national income is less than marginal propensity to consume out of YD
The AE Function
x consumption—C = a + bYD Æ C = a + b(1t)Y, autonomous investment—I, autonomous government purchases—G, net tax
revenues—T = tY, autonomous exports—X, imports—IM = mY
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