Slides are prepared by Dr. Amy Peng, Ryerson University Chapter Seven Government and International Trade Macroeconomics by Curtis, Irvine, and Begg Canadian Edition, McGraw-Hill Ryerson, 2007

©2007 McGraw-Hill Ryerson Ltd.Chapter 72 Learning Outcomes This chapter explains: The size of the government and international trade sectors of Canadian Economy How the government sector is included in the circular flow How taxes and government expenditure affect equilibrium real GDP The government’s budget function and budget balance Fiscal policy and the government’s budget function and budget balance Automatic stabilizers and discretionary fiscal policy The public debt and the government’s budget balance International trade and its effect on equilibrium income and output Government, international trade, and aggregate demand

©2007 McGraw-Hill Ryerson Ltd.Chapter 7.13 Government and International Trade in Canada Government activity and international trade are both important to Canadian economy.Illustrate…

©2007 McGraw-Hill Ryerson Ltd.Chapter 7.14 The General Government Sector in G7 Countries G7 average Italy France Germany UK Japan US Canada Public Debt ratio Budget Balance Expendi- ture Total Revenue % of GDP Countries

©2007 McGraw-Hill Ryerson Ltd.Chapter 7.15 International Trade in Canada and US (1985 – 2005) ‏ NXImportExportNXImportExport % of GDP United StatesCanada

©2007 McGraw-Hill Ryerson Ltd.Chapter 7.26 Government and Circular Flow Government spending affects aggregate expenditure The management of government revenues and expenditures has implications beyond just adding to aggregate expenditures Fiscal PolicyFiscal Policy is the use of government taxing and spending power to change output and employment

©2007 McGraw-Hill Ryerson Ltd.Chapter 7.27 Government and Circular Flow Budget Balance, surplus (+) or deficit (-) in 2004, Total207.3Total 7.0Other2.7Other 3.6Subsidies and assistance3.6Capital consumption 32.9Interest on public debt6.7Investment income 46.8Indirect taxes 41.1Transfer to provincial and local governments 17.3Contributions to social insurance plans 68.6Transfer to persons4.6 On non-residents 31.2 On corporations 94.4 On persons 46.3Goods and servicesDirect Taxes BillionExpenditureBillionRevenue

©2007 McGraw-Hill Ryerson Ltd.Chapter 7.38 Government Expenditure, Taxes, and Equilibrium Real GDP Adding government expenditure (G) to Aggregate expenditure (AE)‏ AE = C + I + G G = G 0 But taxes and transfer payments affect consumption NT = tYt Net tax, NT = tY, t net tax rate YD = Y – NT = (1-t)Y

©2007 McGraw-Hill Ryerson Ltd.Chapter 7.39 Government Expenditure, Taxes, and Equilibrium Real GDP Assume C = DI T = 15% YD = (1-t)Y So C = (1 – 0.15)Y C = Y Each extra dollar of national income increase DI by $0.85, out of which household spend 68 cents and save 17 cents

©2007 McGraw-Hill Ryerson Ltd.Chapter Net Taxes and Consumption SCYDNTY C = 0.8DI NT = 0 YD = Y C = Y SCYDNTY SCYDNTY C = 0.8DI NT = 0.15 YD = (1-0.15)Y C = Y SCYDNTY

©2007 McGraw-Hill Ryerson Ltd.Chapter Net Taxes and Consumption Function Real Consumption C Real GDP and Income C = Y, t = 0 C = Y, t = ΔC/ΔY = MPC(1-t)‏ = 0.8 x 0.85 What about Multiplier?

©2007 McGraw-Hill Ryerson Ltd.Chapter The Effect of Taxes and Government Spending on Equilibrium Income AEICY (a) No Government Y = AE = C + I C = Y I = 80 Autonomous Expenditure of 100 Multiplier = 5 Y e = AEICY

©2007 McGraw-Hill Ryerson Ltd.Chapter The Effect of Taxes and Government Spending on Equilibrium Income C 80 I G AEYDNTY (b) Tax t = 0.15, G = 0 Y = AE = C + I C = (1-0.15)Y I = 80 Autonomous Expenditure =100 Multiplier = Y e = C 80 I G AEYDNTY

©2007 McGraw-Hill Ryerson Ltd.Chapter The Effect of Taxes and Government Spending on Equilibrium Income G AEICY (c) t = 0, G = 50 Y = AE = C + I + G C = Y I = 80 G = 50 Autonomous Expenditure of 100 Multiplier = 5 Y e = G AEICY

©2007 McGraw-Hill Ryerson Ltd.Chapter The Effect of Taxes and Government Spending on Equilibrium Income C 80 I 5 50 G AEYDNTY (d) Tax t = 0.1, G = 50 Y = AE = C + I + G C = ( )Y I = 80 Autonomous Expenditure = 150 Multiplier = 3.57 Y e = CI 50 G AEYDNTY

©2007 McGraw-Hill Ryerson Ltd.Chapter o 45 o GDP (billions of dollars)‏ AE’ AE Equilibrium GDP output rises by 5 times the rise in G 500 Aggregate expenditures (billions of dollars)‏ Y = AE Government Expenditure, Taxes, and Equilibrium Output 750 G = 50

©2007 McGraw-Hill Ryerson Ltd.Chapter o 45 o GDP (billions of dollars)‏ AE’ AE 500 Aggregate expenditures (billions of dollars)‏ Y = AE Government Expenditure, Taxes, and Equilibrium Output G = 50, t = 0.1 AE increased by 50 (intercept effect)‏ AE increased by 50 (intercept effect)‏ AE becomes flatter (t = 0.1, slope effect)‏ AE becomes flatter (t = 0.1, slope effect)‏

©2007 McGraw-Hill Ryerson Ltd.Chapter The Multiplier Revisited Without Government and Taxes With Tax proportional to Income The Multiplier is smaller

©2007 McGraw-Hill Ryerson Ltd.Chapter The Government’s Budget and Fiscal Policy Government budget –What goods and services the government will buy during the coming year, what transfer payments it will make, and how it will pay for them Government budget balance BB = NT (Net Tax) – G (Government expenditure) BB = tY – G (tY = NT)‏

©2007 McGraw-Hill Ryerson Ltd.Chapter G, NT NT = tY = 0.2Y G (assumed constant)‏ Deficit{ A Government Budget 200 Surplus Balanced

©2007 McGraw-Hill Ryerson Ltd.Chapter Real GDP, Income, and the Government BB BBGNTGDP G =200 NT = tY = 0.2Y BB = NT – G = 0.2Y BBGNTGDP

©2007 McGraw-Hill Ryerson Ltd.Chapter BB BB = 0.2Y A Government Budget Function Real GDP and Income Budget Balance

©2007 McGraw-Hill Ryerson Ltd.Chapter Investment, Saving, and the Budget Leakages = Injections Actual savingsactual net taxes actual government expenditure actual investment expenditureActual savings plus actual net taxes always equal actual government expenditure plus actual investment expenditure S + NT = I + G I – S = NT – G A rise in planned government expenditure must reduce the government’s budget balance

©2007 McGraw-Hill Ryerson Ltd.Chapter Fiscal Policy and Government Budget Balance Fiscal policy is government use of its taxes and spending to affect aggregate expenditure and equilibrium GDP Expansionary fiscal policy eliminates recessionary gaps Restrictive fiscal policy eliminates inflationary gaps Automatic or Built-in Stabilizers

©2007 McGraw-Hill Ryerson Ltd.Chapter Real GDP and income AE 0 o 45 oRecessionaryGap AE 1 Y 0 Y p Aggregate expenditures (billions of dollars)‏ ΔG Expansionary Fiscal Policy

©2007 McGraw-Hill Ryerson Ltd.Chapter Real GDP and income AE 2 o 45 oInflationaryGap AE 3 Y p Y 2 Aggregate expenditures (billions of dollars)‏ Δt Restrictive Fiscal Policy

©2007 McGraw-Hill Ryerson Ltd.Chapter The Structural Budget Balance The structural budget balanceThe structural budget balance is the estimate of what the budget balance would be if the economy were operating at potential output SBB = tY p - G fiscal policy programChanges in the government’s fiscal policy program change the structural budget balance and shift the budget function

©2007 McGraw-Hill Ryerson Ltd.Chapter BB 0 = t 0 Y – G 0 SBB 0 = t 0 Y p – G 0 The Actual and the Structural or Cyclically Adjusted Budget Balance 0 -BB 1 Real GDP and Income Budget Balance -G 0 YpYp +BB 2 SBB 0 Y2Y2 Y1Y1 B A C Structural budget Balance Budget Surplus Budget Deficit

©2007 McGraw-Hill Ryerson Ltd.Chapter Automatic and Discretionary Fiscal Policy Automatic stabilizer –Income taxes and transfers –They are built into the budget program by setting the net tax rate and work automatically –All leakages are automatic stabilizers Discretionary fiscal policies

©2007 McGraw-Hill Ryerson Ltd.Chapter BB 0 = t 0 Y – G 0 Automatic and Discretionary Fiscal Policy 0 -BB 1 Real GDP and Income Budget Balance -G 0 YpYp +BB 2 SBB 0 Y2Y2 Y1Y1 B ACDiscretionary Policy Automatic Stabilization

©2007 McGraw-Hill Ryerson Ltd.Chapter The Public Debt and the Budget Balance Budget balances and outstanding debt are closely related public debt (PD)The outstanding public debt (PD) is the sum of past government budget balances ΔPD = - BB Debt to GDP Ratio

©2007 McGraw-Hill Ryerson Ltd.Chapter Government of Canada Net Debt Ratio % GDP The Government of Canada’s net debt to GDP ratio has declined from a peak of 70.5 percent in 1995 to 41.2 percent in 2005.

©2007 McGraw-Hill Ryerson Ltd.Chapter International Trade and Income Determination Export (X)‏ Import (Z)‏ Net export NX = X – Z Y = AE = C + I + G + X – Z Export expenditure is autonomous Import expenditure rises as national income rises –Slope of the import function is MPZ

©2007 McGraw-Hill Ryerson Ltd.Chapter Exports, Imports, and Net Exports Y X0X0 Z = 0.2Y Exports and Imports Y NX = X Y Net Exports (X-Z)‏ 100

©2007 McGraw-Hill Ryerson Ltd.Chapter Real GDP and income AE 1 =C+I+G+NX o 45 o AE 0 =C+I+G Y e Y e ’ Y 1 Aggregate expenditures (billions of dollars)‏ Slope = ΔAE/ΔY = MPC(1-t) - MPZ Equilibrium Income in an Economy with International Trade NX C 0 +I 0 +G 0 C 0 +I 0 +G 0 +X 0

©2007 McGraw-Hill Ryerson Ltd.Chapter Equilibrium Income in the Open Economy C 80 I 50 G AEYDNTY (a) Equilibrium with No Trade Y = AE = C + I + G C = (1-0.15)Y I = 80, G = 50, NT = 0.15Y Autonomous Expenditure ΔA = 150 Multiplier = Y e =

©2007 McGraw-Hill Ryerson Ltd.Chapter (b) X, Z, and NX X = 100 Z = 0.2Y NX = 100 – 0.2Y NXZXY NXZXY Equilibrium Income in the Open Economy

©2007 McGraw-Hill Ryerson Ltd.Chapter (c) Equilibrium with International Trade Y = AE = C + I + G + X – Z C = (1-0.15)Y I = 80, G =50, NT =0.15 Y X = 100, Z =0.2 Y Autonomous expenditure = 250 Multiplier = Equilibrium Output Y e = 481 Equilibrium Income in the Open Economy

©2007 McGraw-Hill Ryerson Ltd.Chapter (d) Leakages and Injections At Y e = 481, S = YD – C = 62 NT = 0.15Y = 72 Z = 0.2Y = 96 I =80, G = 50, X =100 S + NT + Z = I + G + X BB = NT – G = 72 – 50 = +22 NX = X – Z= 100 – 96 = +4 S- I = 62 – 80 = -18 Equilibrium Income in the Open Economy

©2007 McGraw-Hill Ryerson Ltd.Chapter Equilibrium Income in the Open Economy AEZXGICYDNTY (e) Numerical Values AEZXGICYDNTY

©2007 McGraw-Hill Ryerson Ltd.Chapter The Multiplier in an Open Economy The Multiplier in Canada MPC(1-t) = 0.54, MPZ = 0.34

©2007 McGraw-Hill Ryerson Ltd.Chapter Exports and Equilibrium Output A change in exports is a change in autonomous expenditure An increase in exports produces a rise in income and consequently in imports to moderate the change in trade balance Total Leakages = Total Injection S + NT + Z = I + G + X

©2007 McGraw-Hill Ryerson Ltd.Chapter o Real domestic product, GDP Aggregate Expenditures AE Y=AE Equilibrium Output and Aggregate Demand with Government and Trade AE A2A2 YeYe YenYen AE’ ΔY A0A0 ΔA YeYe YenYen P0P0 ΔY AS AD 0 AD 2 Real domestic product, GDP ΔY

©2007 McGraw-Hill Ryerson Ltd.Chapter 744 Chapter Summary Government expenditure autonomousGovernment expenditure on goods and service is an autonomous part of AE Net taxes the slope of AE, reducethe multiplierNet taxes reduce the change in consumption caused by a change in national income, reduce the slope of AE, and reduce the multiplier government budget balanceThe government budget balance Fiscal policyFiscal policy is the government’s use of its taxing and spending powers to offset business cycle fluctuations in AD, output, and employment Structural budget balancediscretionary fiscal policyStructural budget balance and discretionary fiscal policy Automatic stabilizers discretionary fiscal policyAutomatic stabilizers reduce fluctuations in real GDP; discretionary fiscal policy makes changes to the structural budget balance

©2007 McGraw-Hill Ryerson Ltd.Chapter 745 Chapter Summary NationaldebtNational debt and debt to GDP ratio Budget deficitsBudget deficits are not necessarily bad exports importsOpen economy exports and imports Exports autonomousMPZExports can be viewed as autonomous expenditure. MPZ tells us how much imports will change as a result of change in domestic income Leakages to net taxes and imports reduce the slope of the AE function Higher export expenditure higher MPZ and tHigher export expenditure raises AE, equilibrium output, and AD. A higher MPZ and t reduces AE, equilibrium output, and AD. S + NT + Z = G + I + XS + NT + Z = G + I + X fluctuations in AD autonomous expenditure the multiplierIn the open economy, fluctuations in AD and output are caused by fluctuations in autonomous expenditure through the multiplier