1. of 42 Copyright © 2008 Pearson Education Canada 1 Chapter 22 Adding Government and Trade to the Simple Macro Model

2. of 42 Copyright © 2008 Pearson Education Canada 2 In this chapter you will learn 1. how government purchases and tax revenues are related to national income. 3. how to distinguish between the marginal propensity to consume and the marginal propensity to spend. 2. how exports and imports are related to national income. 4. why the presence of government and foreign trade reduces the value of the simple multiplier. 5. how government can use fiscal policy to influence the level of national income.

3. of 42 Copyright © 2008 Pearson Education Canada 3 Government Purchases Net Tax Revenues Government purchases of goods and services (G) are part of desired aggregate expenditures - not including transfer payments (CPP, EI, OAS, GIS, Social Assistance, subsidies, grants, etc.) Net taxes (T) are total tax revenues net of transfer payments (CPP, EI, OAS, GIS, Social Assistance, subsidies, grants, etc.) 22.1 INTRODUCING GOVERNMENT MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

4. of 42 Copyright © 2008 Pearson Education Canada 4 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 *(ignoring debt-service payments) We assume net taxes are given by: T = tY where t is the net tax rate. Implies that all taxes are related to the level of income. MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

5. of 42 Copyright © 2008 Pearson Education Canada 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.

6. of 42 Copyright © 2008 Pearson Education Canada 6 Government Expenditure Function Desired government expenditure is treated as autonomous – completely unrelated to the current level of Y We can writeG = G Were G is determined by – what governments do! the budget process! election cycles! Mostly just the provision of ‘goods and services’ (general government, health, education public safety, transportation, etc.) MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

7. of 42 Copyright © 2008 Pearson Education Canada 7 Government Expenditure Function (what does it look like?) Desired Government Expenditures G Actual National Income Y G 0 200 150 100 G’ G’’ Shift up implies a Government spending increases Shift down implies Government spending cuts MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

8. of 42 Copyright © 2008 Pearson Education Canada 8 Government Net Tax Function Desired Net Taxes T Actual National Income Y 0 200 150 100 T = tY -150 -100 Governments set the tax rate (t) but Y determines the total taxes paid (T) Y0Y0 T 1 = tY 1 T 0 = tY 0 Y1Y1 Recall Net taxes (T = Tx less transfers) MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

9. of 42 Copyright © 2008 Pearson Education Canada 9 Changes in Taxes (the tax rate t) Desired Net Taxes T Actual National Income Y T = tY 0 200 100 T’’ = t’’Y Net tax increases Net tax decrease -150 -100 T’ = t’Y Note: t’ > t > t’’ Y0Y0 T 0 ’’ T0T0 T0’T0’ MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

10. of 42 Copyright © 2008 Pearson Education Canada 10 T - G Public Saving 0 300600900 Actual National Income The slope of the public saving function is equal to the net tax rate. The Public Saving Function As national income rises, the budget surplus (public saving) increases. Public Saving is defined as T – G Net tax revenue which the government does not spend MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

11. of 42 Copyright © 2008 Pearson Education Canada 11 Copyright © 2005 Pearson Education Canada Inc. Summary 1. All levels of government add directly to aggregate expenditure. 2. Governments also collect taxes and make transfer payments. 3. Government purchases and taxation, taken together, imply the public saving function, T-G. MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

12. of 42 Copyright © 2008 Pearson Education Canada 12 22.2 INTRODUCING FOREIGN TRADE Net Exports We make two central assumptions: 2) Canada’s imports rise as Canadian GDP rises For imports, we assume: IM = mY where m is the marginal propensity to import. 1) Canada’s exports are autonomous with respect to Canadian GDP The export function is simplyX = X What determines the value of is X? A number of things including FOREIGN NATIONAL INCOMES MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

13. of 42 Copyright © 2008 Pearson Education Canada 13 Export Function (what does it look like?) Desired Exports X Actual National Income Y X 0 200 150 100 X’ X’’ Shift up implies Exports increases Shift down implies Exports decrease MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

14. of 42 Copyright © 2008 Pearson Education Canada 14 Import function (what does it look like?) Desired Imports M Actual National Income Y 0 200 150 100 M = mY Y0Y0 M 1 = mY 1 M 0 = mY 0 Y1Y1 MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

15. of 42 Copyright © 2008 Pearson Education Canada 15 Changes in Imports (the marginal propensity to import m) Desired Imports M Actual National Income Y M = m Y 0 200 100 M’’ = m’’Y Increase in imports Decrease in imports M’ = m’Y Note: m’ > m > m’’ Y0Y0 T 0 ’’ T0T0 T0’T0’ MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

16. of 42 Copyright © 2008 Pearson Education Canada 16 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.

17. of 42 Copyright © 2008 Pearson Education Canada 17 The NX function is drawn holding constant: foreign GDP domestic and foreign prices the exchange rate 72 48 24 0 300 600 900 96 IM = 0.1Y X = 72 72 48 24 0 300 600 900 -24 Imports and Exports Net Exports NX = 72 - 0.1Y Y Y

18. of 42 Copyright © 2008 Pearson Education Canada 18 net exports, (NX = X – IM) is also referred to as the Balance of Trade ifthen we have NX = X – IM > 0 a trade surplus NX = X – IM = 0 a trade balance NX = X – IM < 0 a trade deficit MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

19. of 42 Copyright © 2008 Pearson Education Canada 19 1. An increase in foreign income leads to more foreign demand for Canadian goods: - increases X and shifts NX function upward Shifts in the Net Export Function 2. A rise in Canadian prices (holding foreign prices constant) or an appreciation of the Canadian dollar : - decreases X - IM function rotates up as Canadians switch toward foreign goods  NX function shifts down and gets steeper MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

20. of 42 Copyright © 2008 Pearson Education Canada 20 IM´ X (X - IM) X´ IM (X - IM)´ Illustration of a rise in Canadian prices relative to foreign prices or an appreciation of the Canadian dollar. This could be caused by: - Δ exchange rate ( appreciation) -Δ price levels (increase relative to foreign prices) Imports and Exports Net Exports Actual National Income MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

21. of 42 Copyright © 2008 Pearson Education Canada 21 Foreign Income - An increase in foreign income results in an increase Canadian exports - NX function shifts up. ( and the reverse) Shifts in the Net Export Function - Summary Relative International Prices - A rise in Canadian prices relative to foreign prices reduces Canadian exports (X shifts down). The IM function also rotates up since Canadians now spend a higher fraction of income on foreign goods. The NX (=X-IM) function shifts down and also gets steeper. (and the reverse) Other considerations: Barriers to trade – tariffs, quotas, regulations, etc. Taste – trade promotion, ‘buy Canadian’ Mad cow disease, lead paint on toys, etc. MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007 Appreciation of the Canadian dollar - A rise in the value of the Canadian dollar reduces Canadian exports (X shifts down). The IM function also rotates up since Canadians now spend a higher fraction of income on foreign goods. The NX (=X-IM) function shifts down and also gets steeper. (and the reverse)

22. of 42 Copyright © 2008 Pearson Education Canada 22 Recall the exchange rate is the number of Canadian $’s required to purchase one unit if foreign currency (1.06 Cdn $’s = 1 US $) If the value of the Canadian $ changes such that it requires fewer Canadian $’s to buy one unit of foreign currency, then we say that the Canadian $ has appreciated in value. (a fall in the exchange rate) Jan. 2002Sep. 2007 1.60 Cdn $’s = 1 US $ 1.06 Cdn $’s = 1 US $ OR If the value of the Canadian $ changes such that it requires more Canadian $’s to buy one unit of foreign currency, then we say that the Canadian $ has depreciated in value. (a rise in the exchange rate) Jan 1997Jan 2002 1.35 Cdn $’s = 1 US $ 1.60 Cdn $’s = 1 US $ A fall (rise) in the exchange rate implies an appreciation (depreciation) in the value of the Canadian $ MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

23. of 42 Copyright © 2008 Pearson Education Canada 23 We can look at appreciation and depreciation from the Foreigner’s perspective If the value of the Canadian $ changes such that it requires more foreign currency to buy one Canadian $, then we say that the Canadian $ has appreciated in value. (a fall in the exchange rate) Jan. 2002Sep. 2007 0.63 US $’s = 1 Cdn $ 0.94 US $’s = 1 Cdn $ OR If the value of the Canadian $ changes such that it requires less foreign currency to buy one Canadian $, then we say that the Canadian $ has depreciated in value. (a rise in the exchange rate) Jan 1997Jan. 2007 0.74 US $’s = 1 Cdn $ 0.63 US $’s = 1 Cdn $ A fall (rise) in the exchange rate implies an appreciation (depreciation) in the value of the Canadian $ MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

24. of 42 Copyright © 2008 Pearson Education Canada 24 22.3 EQUILIBRIUM NATIONAL INCOME Desired Consumption and National Income With taxation, Y D is less than Y. Example: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). C = a + bY D where Y D = Y - tY so that C = a + b(Y-tY) or C = a + b(1-t)Y MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

25. of 42 Copyright © 2008 Pearson Education Canada 25 The simple consumption function with taxes is written as: If t increase then the slope of the consumption function, b(1-t), decreases. Y aSlope = b(1-t’) C Note this will cause the slope of the AE line to decrease also. Slope = b(1-t) MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007 C = a + b(1-t)Y where t’ > t

26. of 42 Copyright © 2008 Pearson Education Canada 26 The AE Function – total desired expenditure on Canadian goods and services from all sources Recall that the slope of the AE function is the marginal propensity to spend out of national income — we call this z. AE = C + I + G + NX MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007 AE Y 40 o line (AE=Y) AE = C + I + G + NX

27. of 42 Copyright © 2008 Pearson Education Canada 27 The slope of the AE function IF C = a +bY D where Y D = Y – tY I = IG = G X = X and M = mY where NX = X - M Then AE = C + I + G + NX = a + bY D + I + G + (X - M) = a + b(Y – tY) + I + G + (X - mY) = a + [b(1 – t) -m]Y+ I + G + Xrecall b is the MPC AE = C + I + G + NX In this model, we get: z = MPC(1 - t) - m Clearly, t > 0 and m > 0 lead to a lower value of z. MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

28. of 42 Copyright © 2008 Pearson Education Canada 28 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)

29. of 42 Copyright © 2008 Pearson Education Canada 29 The addition of government and foreign trade does not change the logic of the equilibrium!

30. of 42 Copyright © 2008 Pearson Education Canada 30 An alternative (but equivalent) approach to determining the 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. www.myeconlab.com

31. of 42 Copyright © 2008 Pearson Education Canada 31 22.4 CHANGES IN EQUILIBRIUM NATIONAL INCOME The Multiplier with Taxes and Imports Recall multiplier is equal to 1/(1- z) Imports and taxes make z smaller  the simple multiplier is also smaller z = MPC(1 - t) – m In our complete model, the multiplier is 1 / (1- [MPC(1 - t) – m]) MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007 Using realistic values of taxation and imports for Canada, the evidence shows that the value of the multiplier is closer to 1 than 2.

32. of 42 Copyright © 2008 Pearson Education Canada 32 Y1Y1 Y0Y0 e1e1 AE 1 e0e0 AE =Y E0E0 E1E1  Y Y AE For example, suppose MPC = 0.9, t = 0.3 and m = 0.4 Then z = 0.9 (1 - 0.3) – 0.4 = 0.23 and the multiplier is 1 / (1-z) or 1 / (1 - 0.23) = 1.30  AE The value of z is determined by: z = MPC(1-t) - m z =  AE /  Y - slope of the AE curve z increases as MPC increases and decreases as t and m increase. Try different values for MPC, t, m and recalculate the multiplier. How does the picture change? MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

33. of 42 Copyright © 2008 Pearson Education Canada 33 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

34. of 42 Copyright © 2008 Pearson Education Canada 34 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. Fiscal policy represents an attempt on the part of the government to keep actual output as close as is possible to potential output. (lots of problems with this but lets do the theory anyway) It is often clear in which direction fiscal policy could be adjusted, but less clear how much adjustment is necessary.

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36. of 42 Copyright © 2008 Pearson Education Canada 36 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 = 2.63.  G = -$100 million ==>  Y = - $263 million. Consider a decrease in government expenditures (  G < 0). Equilibrium national income will fall:  Y =  G x simple multiplier MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

37. of 42 Copyright © 2008 Pearson Education Canada 37 AE 0 Y0Y0 Y1Y1 AE 1 E1E1 E0E0 e0e0 e2e2 AE=Y The government may also 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 AE Y

38. of 42 Copyright © 2008 Pearson Education Canada 38 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. www.myeconlab.com

39. of 42 Copyright © 2008 Pearson Education Canada 39 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.

40. of 42 Copyright © 2008 Pearson Education Canada 40 e´ 1 Y1Y1 Y0Y0 e1e1 AE 1 AE 0 e0e0 AE =Y E0E0 E1E1  AE  Y Y AE We say the economy is demand driven. Recall: desired AE = C + I + G + NX The level of desired spending (the position of the AE curve) determines the level of equilibrium national income, Y. Any change in the AE curve (shift or change in slope) implies a different level of equilibrium Y MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007

41. of 42 Copyright © 2008 Pearson Education Canada 41 2. 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

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