Topic 4: Aggregate Expenditure (Including Government & Foreign Sector) - Knowledge Summary and Exam Analysis

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Department
Economics for Management Studies
Course
MGEA06H3
Professor
Iris Au
Semester
Winter

Description
Knowledge Summary: Topic 4: Part A – Aggregate Expenditure (Including Government & Foreign Sector) The Government Sector The government play a role in the AE model in the following ways: 1) Collecting Taxes, T • The government collects taxes from households and firms to finance its spending • Taxes are positively related to income o T = T o t 1 where T o constant, and 1> t1> 0 2) Making transfer payments, TR • Transfer payments refer to payments from the government to individuals that are not in exchange for goods and services (e.g. Employment insurances, public pension, etc.) • Transfer payments are inversely related to income o TR = TR o tr 1 where TR o constant, and 1 > t1 > 0 3) Spending on final goods and services, G • Government expenditure on final goods and services o G = constant The Foreign Sector • When an economy trades with foreign countries, this economy is an open economy • Exchange rate (E) is the price of a country’s currency in terms of another currency o In this course, we quote exchange rate as the # of foreign currency needed to exchange 1 C$ o Example: If E = US$ 0.875/C$, the value of 1 C$ is equivalent to US$0.875 o If E increases, it means that C$ appreciates against the US$ because it takes more US$ to exchange 1 C$ o If E decrease, it means that C$ depreciates against the US$ because it takes fewer US$ to exchange 1 C$ The foreign sector enters the model in the following ways: 1) Exports, 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 dereases o Exports are inversely related to exchange rate o X = X o x 1E – E*) where X o x1& E* are constants 2) Imports, IM • 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 • 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 o Imports are positively related to both income and exchange rate o IM = IM 0 im Y 1 im (E 2 E*) where Im ,oim ,1im ,2and E* are constants How to solve for equilibrium in the AE model? Step 1: Get the consumption function as a function of GDP(Y) Step 2: Get the AE function by setting AE = C + I +G + X – IM Step 3: Solve for Y by equating AE = Y National Saving – Revisit • With no government and foreign sector in the AE model, national saving (NS) = investment (I) • With an open economy and a government, NS = I + NX o Y = C + I + G +X – IM o Y – C – G = I + X – IM o NS = I + NX • For public saving, S G o If S < 0, then the government runs a budget deficit o If S > 0, then the government runs a budget surplus G o If S = 0, then the government runs a balanced budget • For net exports, NX o If NX < 0, then the country has a trade deficit o If NX > 0, then the country has a trade surplus Note: • Twin deficits = simultaneous occurrence of budget deficit and trade deficit Topic 4: Part B – Effect of a change in AE on Y In generic form (If IM o 0 and we hold r & E constant) • AE = (C +o DI1 + I + o + X – imoY 1 • AE = C +oc [Y1– (T + o Y) 1 (TR – troY)] 1 I + Go+ X – im o 1 • AE = (C +oI +oG + X + coTR –1c To) + 1co(1 – t1– tr 1 – i1 ]Y 1 • Y* = (C o I +oG + X + coTR –1c To)/{11–o[c (1 – t1– tr )1– im1]} 1 It is good to remember this equation because it allows you to know if a change in one of the variables will cause an increase or decrease in Y In general form, the multiplier (M) in the AE model is: • AE = AE + o Y Y where AE = o + Io+ G o X + c TRo– c1T o 1 o C Y c (1 – t 1 tr 1 – im 1 • Y* = AE xo1/(1 – C ) Y • Multiplier (M) = dY*/dAE = 1o(1 – C ) = Y/{1 – [c (1 –1t – tr1) – 1m ]} 1 In general form, the budget balance (BB) in the AE model is: • BB = T – TR – G, where T = T +ot Y1 TR = TR –otr Y1 • BB = (T +ot Y1 – (TR + or Y)1– G • BB = (T –oTR – Go + (t + tr1)Y 1 Therefore, change in budget balance (also known as public saving, S ) G • ∆BB = [∆T oro–∆TR or –∆Go + (t + tr ) ∆1 1 Topic 3&4 – Final Past Paper Answers 2006 Final Q7 – Q12: G 7) S = T – TR – G = (3/24)(624) – [39 – (1/24)(624)] – 70 = 78 – 13 – 70 = -5 Answer is H P 8) S = (Y – T + TR) – C = (624 – 78 + 13) – [36 + (10/13)(624)] = 43 Answer is M 9) New Y = [36 +(10/13)Y] + 40 + 85 + [94 – (2/13)Y] Y = 255 + 8/13Y Y = 663 Answer is K G 10) New S = T – TR – G = (3/24)(663) – [39 – (1/24)(663)] – 85 = -13.5 G Therefore, ∆S = -8.5 Answer Is K 11) New Y = (12/13)[Y – (3/24Y – 13) + (39 – 1/24Y)] + 40 + 70 + [94 – (2/13)Y] Y = (12/13)(20/24Y + 52) + 40 + 70 + 94 – 2/13Y Y = 20/26Y + 48 + 40 + 70 + 94 – 2/13Y Y = 252 + 16/26Y Y = 655.2 Therefore, ∆Y = 31.2 Answer is J G 12) New S = T – TR – G = [(3/24)(655.2) – 13] – [39 – (1/24)(655.2)] – 70 = -12.8 G Therefore, ∆S = -7.8
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