Chapter 22 - adding government and trade to the simple macro model
Adding gov't to the model allows us to study fiscal policy. Fiscal policy is defined by its plans for taxes and spending. It is the use of tax and spending
policies to achieve gov't objectives.
• Desired gov't purchases: represented by the letter G. Is a part of the aggregate desired expenditure.
• When the gov't buys office supplies, fuel for the Canadian forces, hires a bureaucrat, it is adding directly to the demands for the economy's current
output of goods and services.
• Transfer payments are not a part of aggregate expenditure.
• THEREFORE, gov't transfer payments affect AE (aggregate expenditure) but only through the effect these transfers have on households'
• We view any change in G as a result of a gov't policy decision.
Net tax revenues
• Taxes reduces disposable income. Transfer payments raise disposable income.
• Net taxes are defined as total tax revenue received by the gov't minus total transfer payments made by the gov't, and it is denoted T. For the
remainder of this note, taxes mean net taxes.
• Net taxes is the total tax revenue minus transfer payments.
• Net tax revenues are positive, because transfer payments are smaller than total tax revenues.
• As national income rises, the tax system with given tax rates will yield more revenue (net of transfers). For example, when income rises, people will
pay more income tax in total even though the tax rates are unchanged. In addition, when income rises, the gov't generally reduces its transfers to
• We will use the following simple form for gov't net tax revenues: T=tY.
• t: is the net tax rate or the marginal propensity to tax -- the increase in net tax revenue generated when national income increases by $1.
Remember that Y means income.
• **recall that Yd = Y - T, desired consumption depends on Yd (disposable income).
The budget balance
• the budget balance is the difference between total gov't revenue and total gov't expenditure. Equivalently, it equals et tax revenue minus gov't
• When net revenues exceed purchases, the gov't has a budget surplus. When purchases exceed net revenues, the gov't has a budget deficit. When
the balances are equal - the gov't has a balanced budget.
• When the gov't runs a deficit, they have to borrow money for spending. They do this by issuing bonds (gov't debt) or treasury bills. When the gov't
has a surplus, it uses the excess revenue to buy back outstanding gov't debt.
*when measuring the overall contribution of gov't to desired aggregate expenditure, all levels of gov't must be included*
• Exports depend on spending decisions made by foreign households and firms that purchase Canadian products. Exports won't change as a result
of changes in canadian national income. Therefore, we treat exports as autonomous expenditure.
• Imports depends on spending decisions of canadian households and firms. • As consumption rises, imports will also increase. If consumption rises, so does national income. IM = mY. Where m is the marginal propensity to
import, the amount that desired imports rise when national income rises by $1.
• The simple model equation for net exports is: NX = X - mY.
• Imports are positively related to Y and net exports are negatively related to national income (Y). The negative relationship is called the net export
function. LOOK ON PAGE 550 FOR THE GRAPHS.
• On page 550: net exports fall as national income rises. Slope of import function is equal to the marginal propensity to import (m). Slope of the net
export function is the negative of the marginal propensity to import (m).
Shifts in the Net Export Function
• The net export function is drawn under the assumption that everything affecting net exports, except domestic national income, remains constant.
The two major factors that must be held constant are foreign national income and international relative prices. A change in either factor will shift the
• Anything affecting exports will shift the net export function parallel to itself, upward if exports increase and downward if exports decrease. Anything
affecting the proportion of income that canadian consumers want to spend on imports will change the slope of the net export function.
• 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. This change will cause the X curve to shift upward, therefore the NX curve will also shift upward, parallel
to its original position. A fall in foreign income will shift it downwards. ON PAGE 551, THE GRAPH.
• Changes in the prices of canadian goods relative to those of foreign goods will change the imports and exports, therefore changing the net export
function. Increase in prices will cause foreigners to see that canadian goods are more expensive relative to the goods produced in their own
country. As a result the value of the canadian exports will fall. The X curve will shift downwards. Then the Canadians will see that the imports from
foreign countries are cheaper, so they will spend more on foreign goods instead of canadian goods. Therefore, the Canadians will spend a higher
fraction of national income on imports -- the IM curve will then have a steeper slope. The combination of these two effects lead the NX curve to shift
downwards and have a steeper slope.
• A fall in canadian prices relative to foreign prices would have the opposite effect, shifting the X function up and the IM function down, and thus
shifting the NX function up.
• SUMMARY: a rise in canadian prices relative to those in other countries recues canadian net exports at any level of national income. A fall in
canadian prices increases net exports at any level of national income.
• On page 551, currency exchange causes changes in the NX curve also.
Equilibrium national income is the level of income at which desired AE = actual national income.
Desired consumption and national income
• When net taxes (taxes net of transfers) are positive, disposable income (Yd) is less than national income (Y). We take several steps to determine
eat relationship between consumption and national income in the presence of taxes.
o First, assume that the net tax rate (t) is 10%, so that net tax revenues are 10% of national income. T= (0.1)Y.
o Second, disposable income must therefore be 90% of national income Yd = Y-T=(0.9)Y. Diff equations.
o The consumption function we used last chapter is given as: C = 30 + (0.8)Yd. Which tells us that the MPC out of disposable income is
o We can now substitute (0.9)Y for Yd in the consumption function. By doing so we get C = 30+(0.8)(0.9)Y C= 30 + (0.72)Y.
o We can therefore express desired consumption as a function of Yd or as a different function of Y. In this example, 0.72 is equal to the
MPC times (1-t), where t is the net tax rate. So, 0.8 is the marginal propensity to consume out of disposable income, 0.72 is the marginal
propensity to consume out of national income.
• In the presence of taxes, the marginal propensity to consume out of national income is less than the marginal propensity to consume out of
disposable income. The AE function
• AE's components were consumption and investment. Now we add gov't purchases and net exports.
o C = a+bYd. consumption. (like the y=mx+b, the equation of the graph)
o Investments I
o Gov't purchases G
o Net tax revenues T = tY
o Exports X
o Imports IM = mY
• AE = [a + I + G + X] + [b(1-t) - m]Y. The first brackets represents the autonomous expenditure, and the second set represents induced expenditure.
• The first bracket brings together all the autonomous parts of expenditure. The second set brings together all the parts of expenditure that change