Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 22 Adding Government and Trade to the Simple Macro Model

Copyright © 2008 Pearson Addison-Wesley. All rights reserved In this chapter you will learn to 1. Describe the relationship between national income and government purchases and tax revenues. 3. Explain the distinction between the marginal propensity to consume and the marginal propensity to spend. 4. Explain why the presence of government and foreign trade reduces the value of the simple multiplier. 5. Describe the effect of government fiscal policy on the level of national income. 2. Describe the relationship between national income and exports and imports.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Government Purchases Net Tax Revenues Government purchases of goods and services (G) are part of desired aggregate expenditures - not including transfer payments Net taxes (T) are total tax revenues net of transfer payments. Introducing Government

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Budget Balance The budget balance is the difference between G and T: - if G < T: a budget surplus - if G > T: a budget deficit We assume net taxes are given by: T = t Y where t is the net tax rate. Introducing Government

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Budget Balance and Saving Private saving is the amount that household save: = disposable income – consumption expenditure Public saving is saving on the part of the government = T – G Budget surplus: public saving is positive Budget deficit: public saving is negative

Copyright © 2008 Pearson Addison-Wesley. All rights reserved State and Local Governments When measuring the overall contribution of government to desired aggregate expenditure, all levels of government must be included: - federal, state, and local - combined purchases of state and local governments are larger than those of the federal government.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Summary The presence of government affects our simple model by: - adding directly to desired AE through G - collecting tax revenue (T) and make transfer payments

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Introducing Foreign Trade Net Exports For imports, we assume: IM = mY where m is the marginal propensity to import. We make two central assumptions: - U.S. exports are autonomous with respect to U.S. GDP - U.S. imports rise as U.S. GDP rises

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Thus, net exports are given by: NX = X - mY Ceteris paribus, changes in domestic GDP lead to changes in net exports: - as Y rises, NX falls - as Y falls, NX rises The relationship between Y and NX is shown by the net export function. Introducing Foreign Trade

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 22.1 The Net Export Function The NX function is drawn holding constant: foreign GDP domestic and foreign prices the exchange rate

Copyright © 2008 Pearson Addison-Wesley. All rights reserved An increase in foreign income leads to more foreign demand for U.S. goods: - increases X and shifts NX function upward Shifts in the Net Export Function A rise in U.S. prices (holding foreign prices constant): - decreases X - IM function rotates up as Americans switch toward foreign goods  NX function shifts down and gets steeper

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 22.2 Shifts in the Net Export Function Illustration of a rise in U.S. prices relative to foreign prices. This could be caused by: - Δ exchange rate - Δ price levels

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Summary The presence of foreign trade modifies our basic model by: - foreign firms and households purchase U.S.-made goods (X) - all components of domestic expenditure (C, I, and G) include some import content (IM).

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equilibrium National Income Desired Consumption and National Income With taxation, Y D is less than Y. If T = (0.1)Y, then Y D = (0.9)Y. C = 30 + (0.8)(0.9)Y C = 30 + (0.8)Y D C = 30 + (0.72)Y  The MPC out of national income (0.72) is less than the MPC out of disposable income (0.8).

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Desired Consumption Function where b = MPC From the numerical example above, we can generally write: C = a + b(1 – t)Y a = autonomous consumption t = tax rate

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The AE Function Recall that the slope of the AE function is the marginal propensity to spend out of national income. We then expand the AE function: AE = C + I + G + (X – M) Summing the four components of desired AE: AE = a + b(1 – t)Y + I + G + (X – mY) = [ a + I + G + X ] + [b(1 – t) – m]Y We call: b(1 - t) - m = z

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equilibrium National Income In words, equilibrium Y occurs where desired aggregate expenditure equals actual national income. Whenever AE is not equal to Y, there are unintended changes in inventories and firms have an incentive to change production. As before, output is assumed to be demand determined in this model: - equilibrium condition is Y = AE(Y)

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 22.3 The Aggregate Expenditure Function

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Changes in Equilibrium National Income The Multiplier with Taxes and Imports Imports and taxes make z smaller: z = MPC(1 – t) – m The simple multiplier is also smaller: multiplier = 1/{1 –[ MPC(1 – t) – m]}

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Net Exports As with other elements of AE: - if NX function shifts upward, equilibrium Y rises - if NX function shifts downward, equilibrium Y falls Exports are autonomous with respect to domestic GDP, but they depend on: - foreign income - domestic and foreign prices - exchange rate - tastes

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Fiscal Policy Fiscal policy is the use of the government’s spending and tax policies. Any policy that attempts to stabilize Y at or near Y* is called stabilization policy. It is often clear in which direction fiscal policy could be adjusted, but less clear how much adjustment is necessary.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 22.4 The Objective of Stabilization Policy

Copyright © 2008 Pearson Addison-Wesley. All rights reserved e´ 1 Y1Y1 Y0Y0 e1e1 AE 1 AE 0 e0e0 AE =Y E0E0 E1E1 GG  Y Y AE For example, suppose z = 0.62 ==> multiplier =  G = -$100 million ==>  Y = - $263 million. Consider some  G < 0. Equilibrium national income will fall:  Y =  G x simple multiplier Changes in Government Purchases

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 22.5 The Effect of Changing the Tax Rate The government may attempt to change national income by changing the net tax rate. - a lower t causes the AE function to become steeper - a higher t causes the AE function to become flatter

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Demand-Determined Output Our simple macro model (Chapters 21 and 22) is based on three central concepts: equilibrium national income the simple multiplier demand-determined output

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Equilibrium National Income Simple multiplier; 1/(1-z) Closed economy with no government: z = MPC Open economy with government: z = MPC(1-t) - m The equilibrium level of national income is that level where desired AE equals actual national income. The Simple Multiplier Demand-Determined Output

Copyright © 2008 Pearson Addison-Wesley. All rights reserved When firms are price setters they often respond to shocks by changing output (and only later changing their price). 1. When output is below potential, firms can increase output without increasing their costs. When is this a reasonable assumption? In the next chapter, we allow a variable price level: - more complicated - more realistic The model assumes a constant price level so that national income is demand determined. Demand-Determined Output