1. Chapter 22: Adding Government and Trade to the Simple Macro Model
Copyright © 2014 Pearson Canada Inc.

2. Chapter Outline/Learning Objectives
Section
Learning Objectives
After studying this chapter, you will be able to
22.1 Introducing Government
understand how government purchases and tax revenues relate to national income.
22.2 Introducing Foreign Trade
understand how exports and imports relate to national income.
22.3 Equilibrium National Income
distinguish between the marginal propensity to consume and the marginal propensity to spend.
22.4 Changes in Equilibrium National Income
explain why the introduction of government and foreign trade in the macro model reduces the value of the simple multiplier.
explain how government can use fiscal policy to influence the level of national income.
22.5 Demand-Determined Output
understand that output is demand determined in our simple macro model.
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide

3. 22.1 Introducing Government
Government Purchases
Government purchases of goods and services (G) are part of desired aggregate expenditures
not including transfer payments
Net Tax Revenues
Net taxes (T) are total tax revenues net of transfer payments.
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Chapter 22, Slide

4. The Budget Balance We assume net taxes are given by: T = tY
where t is the net tax rate.
The Budget Balance
The budget balance is the difference between G and T (ignoring debt-service payments).
if G < T: a budget surplus
if G > T: a budget deficit
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Chapter 22, Slide

5. Provincial and Municipal Governments
When measuring the overall contribution of government to desired aggregate expenditure, all levels of government must be included:
particularly important in Canada
combined purchases of provincial and municipal governments are larger than those of the federal government
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Chapter 22, Slide

6. 22.2 Introducing Foreign Trade
Net Exports
We make two central assumptions:
Canada's exports are autonomous with respect to Canadian GDP.
Canada's imports rise as Canadian GDP rises.
For imports, we assume:
IM = mY
where m is the marginal propensity to import
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide

7. 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.
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide

8. Fig. 22-1 The Net Export Function
The NX function is drawn holding constant:
foreign GDP
domestic and foreign prices
the exchange rate
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Chapter 22, Slide

9. Shifts in the Net Export Function
An increase in foreign income leads to more foreign demand for Canadian goods:
increases X and shifts NX function upward
A rise in Canadian prices (holding foreign prices constant):
decreases X
IM function rotates up as Canadians switch toward foreign goods
 NX function shifts down and gets steeper
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide

10. Illustration of a rise in Canadian prices relative to foreign prices.
Fig The Net Export Function and a Change in International Relative Prices
Illustration of a rise in Canadian prices relative to foreign prices.
This could be caused by:
Δ exchange rate
Δ price levels
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide

11. 22.3 Equilibrium National Income
Desired Consumption and National Income
With taxation, YD is less than Y.
If T = (0.1)Y, then YD = (0.9)Y.
C = 30 + (0.8)YD
C = 30 + (0.8)(0.9)Y
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 © 2014 Pearson Canada Inc.
Chapter 22, Slide

12. The AE Function
We then expand the AE function: AE = C + I + G + NX Recall that the slope of the AE function is the marginal propensity to spend out of national income—we call this z. In this model, we get: z = MPC(1 – t) – m Clearly, t > 0 and m > 0 lead to a lower value of z.
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide

13. Equilibrium National Income
As before, output is assumed to be demand determined in this model:  equilibrium condition is Y = AE(Y) 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.
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide

14. Fig. 22-3 The Aggregate Expenditure Function
Adding government and foreign trade does not change the logic of the equilibrium!
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide

15. MyEconLab www.myeconlab.com
An alternative (but equivalent) approach to determining the equilibrium level of national income is based on the relationship between national saving and the accumulation of national assets. For more details, look for The Saving-Investment Approach to Equilibrium in an Open Economy with Government in the Additional Topics section of this book's MyEconLab.
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide

16. 22.4 Changes in Equilibrium National Income
The Multiplier with Taxes and Imports
Imports and taxes make z smaller
 the simple multiplier is also smaller
z = MPC(1 – t) – m
APPLYING ECONOMIC CONCEPTS 22-1
How Large is Canada’s Simple Multiplier?
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide

17. 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 © 2014 Pearson Canada Inc.
Chapter 22, Slide

18. 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 is necessary.
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide

19.  Y =  G x simple multiplierAE
AE =Y
Consider some  G < 0.
Equilibrium national income will fall:
 Y =  G x simple multiplier E0 e0 •
AE0
 G
AE1 •
e´1 e1 • E1 Y1 Y0 Y
 Y
For example, suppose z = ==> multiplier = 1.30.
 G = –$100 million ==>  Y = – $130 million.
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide

20. Fig. 22-4 The Effect of Changing the Net 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 © 2014 Pearson Canada Inc.
Chapter 22, Slide

21. MyEconLab www.myeconlab.com
Governments can also combine an increase in government purchases with an increase in tax revenues in such a way that the budget is left unchanged. How do such balanced budget changes affect the level of national income? To see more details on this type of fiscal policy, look for What is the Balanced Budget Multiplier? in the Additional Topics section of this book's MyEconLab.
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide

22. 22.5 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
The second and third are closely connected to our assumption of a constant price level.
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide

23. When is this a reasonable assumption?
When output is below potential, firms can increase output without increasing their costs.
When firms are price setters they often respond to shocks by changing output (and only later changing their price).
In the next chapter, we allow a variable price level:
more complicated
more realistic
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide

24. Review
1. A fall in the Canadian-dollar price of foreign currency, other things being equal, causes Canada's net export (NX) function to shift ________ and ________. A) downward; become steeper B) upward; become flatter C) downward; become flatter D) downward; keep the same slope E) upward; become steeper
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25. Review
The rotation from AE0 to AE1 could be caused by A) lower government purchases. B) a lower net tax rate. C) higher government purchases. D) a higher net tax rate. E) a balanced budget.
© 2014 Pearson Education Canada Inc.

26. Review
Consider a simple macro model with a constant price level and demand-determined output. The equations of the model are: C = Y, I = 150, G = 260, T = 0, X = 90, IM = 0.06Y. The trade balance at equilibrium national income is ________. A) a deficit of B) a deficit of C) zero D) a surplus of E)a surplus of 36.67
© 2014 Pearson Education Canada Inc.