Chapter 22 PDF

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Chapter 22...

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Chapter 22 Learning Objectives: 1. Understanding how government purchases and tax revenues relate to national income 2. Explain how exports and imports relate to national income 3. Determine equilibrium in our macro model with government and foreign trade 4. Explain why the introduction of government and foreign trade in the macro model reduces the value of the simple multiplier 5. Describe how government can use fiscal policy to influence the level of national income 6. Understand why output is demand determined in our simple macro model Introducing Government: - A government’s fiscal policy is defined by its plans for taxes and spending - Taxes reduce disposable income relative to national income (GDP) - In contrast, transfer payments raise disposable income relative to national income - Net tax revenue is defined as total tax revenue received by the government minus total transfer payments made by the government, and it is denoted T - As GDP rises, a tax system with given tax rates will yield more net revenue - When GDP rises, the government generally reduces its transfers to households and firms - We will use the following simple form for government net tax revenues, T:  T = tY - Where Y is GDP and t is the net tax rate- the increase in net tax revenue generated when GDP increase by $1 - The budget balance is the difference between total government revenue and total government expenditure; equivalently, it equals net tax revenue minus government purchases, T – G

- When net revenue exceed purchases, the government has a budget surplus - When purchases exceed net revenues, the government has a budget deficit - When the two amount are equal, the government has a balanced budget - When the government has a budget deficit, it must borrow the excess of spending over revenues - When measuring the overall contribution of government purchases to desired aggregate expenditure, all levels of government must be included - How does the presence of government affect our simple macro model? Lets summarize: 1. All levels of government add directly to desired aggregate expenditure through their purchases of goods and services, G. 2. Governments also collect tax revenue and make transfer payments 3. Net tax revenues are denoted T and are positively related to national income 4. Since T does not represent expenditure on goods and services, it is not included directly in the AE function. T will enter the AE function indirectly, however, through its effect on disposable income (YD) and consumption. 5. Recall that YD = Y – T and that desired consumption is assumed to depend on YD Introducing Foreign Trade: - To see how foreign trade is incorporated into our macro model, we need ti see how exports (X) and imports (IM) affect desired aggregate expenditure (AE) - Exports are purchases by foreigners of Canadian products and so are a component of AE - Imports are expenditures by Canadians on goods and services produced elsewhere and thus must be subtracted from total expenditures to determine AE Net Exports: - Exports depend on spending decisions made by foreign households and firms that purchase Canadian products

- In our macro model, we use the following simple form for desired imports:  IM = mY - Where Y is GDP and m is the marginal propensity to import, the amount that desired imports rise when national income rises by $1 - In our model, net exports can be described by the following question:  NX = X – mY - Since exports are autonomous with respect to Y but imports are positively related to Y, we see that net exports are negatively related to national income - The negative relationship is called the net export function Shift in the Net Export Function: - Any given net export function is drawn under the assumption that everything affecting net exports, except domestic national income, remains constant - The two major influences that are held constant when we draw the NX function are:  Foreign national income  International relative prices - If either one changes, the NX function will shift - Changes in foreign GDP, especially in the United States, are an important determinant of Canada’s exports - Any changes in the prices of Canadian products relative to the prices of foreign products will cause both imports and exports to change - A rise in Canadian prices relative to those in other countries reduces Canadian net exports at any level of national income - A fall in Canadian prices increases net exports at any level of national income - How does the presence of foreign trade modify our basic model? Let’s summarize: 1. Foreign firms and households purchase Canadian- made products. Changes in foreign income and international relative prices will affect Canadian exports (X), but we assume that X is autonomous with respect to Canadian national income

2. When we construct the economy’s aggregate expenditure (AE) function, we will include X since it represents expenditure on domestically produced goods and services 3. All components of domestic expenditure (C, I and G) include some important content. Since C is positively related to national income, imports (IM) are also related positively to national income 4. When we construct the economy’s AE function, which shows the desired aggregate expenditure on domestic products, we will subtract IM because these expenditures are on foreign products Equilibrium National Income: - Equilibrium national income is the level of income at which desired aggregate expenditure equals actual national income - The addition of government and net exports changes the calculations that we must make but does not alter the equilibrium concept of the basic workings of the model - Disposable income is equal to national income minus net taxes  YD = Y – T 1. First, assume that the net tax rate, t, is 10 percent, so that net tax revenues are 10 percent of national income (GDP):  T = (0.1)Y 2. Disposable income must therefore be 90 percent of national income:  YD = Y – T  = Y – (0.1)Y  = (0.9)Y 3. The consumption function we used last chapter is given as  C = 30 + (0.8)YD  Which tells us that the MPN out of disposable income is 0.8 4. 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

- 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: - The only components of desired aggregate expenditure were consumption and investment

- Our first step in constructing the AE function is to express desired consumption in terms of national income - By using the fours steps we write desired consumption as:  C = c + MPC(1 – t)Y - Where c is autonomous consumption and MPC is the marginal propensity to consume out of disposable income - Now we sum the four components of desired aggregate expenditure:

- The marginal propensity to spend out of national income (z) is not simply equal to the marginal propensity to consume (MPC) Changes in Equilibrium National Income: - Changes in any of the components of desired aggregate expenditure will cause changes in equilibrium national income (GDP)

- The presence of imports and taxes reduces the marginal propensity to spend out of national income and therefore reduces the value of the simple multiplier - Without Government and Foreign Trade:

- With Government and Foreign Trade:

- The higher is the marginal propensity to import, the lower is the simple multiplier. The higher is the net tax rate, the lower is the simple multiplier Fiscal Policy: Government Spending and Taxation: - When Y < Y*, factor incomes are low and unemployed of factors is high - When Y> Y*, rising costs create inflationary pressures - To reduce these problems, governments often try to stabilize the level of real GDP close to Y* - Any attempt to use government policy in this manner is called stabilization policy - There are two fiscal policy tools available to government policymakers – the net tax rate (t) and government purchases (G) - Recall that the slope of the AE function is z, the marginal propensity to spend out of national income. As we saw earlier,  Z = MCP(1 – t) – m - A change in the net tax rate will change z, rotate the AE function, and change the equilibrium level of national income Demand- Determined Output: - The equilibrium level of national income is the level at which desired aggregate expenditure equals actual national income (AE = Y)

- If actual national income exceeds desired expenditure, inventories are rising and so firms will eventually reduce production, causing national income to fall - If actual national income is less than desired expenditure, inventories will be falling and so firms will eventually increase production, causing national income to rise - The simple multiplier measures the change in equilibrium national income that results from a change in the autonomous part of desired aggregate expenditure - The simple multiplier is equal to 1/(1 – z), where z is the marginal propensity to spend out of national income

- National income depends only on how much is demanded - There are two situations in which we might expect national income to be demand determined 1. When there are unemployed resources and firms have excess capacity, firms will often be prepared to provide whatever is demanded from them at uncharged prices 2. When firms are price setters - A simple model of national income determination assumes a constant price level. In this model, national income is demand determined Summary: 22.1 Introducing Government: - Desired government purchases, G, are assumed to be part of autonomous aggregate expenditure. Taxes minus transfer payments are called net taxes and affect aggregate expenditure indirectly through households’ disposable income. Taxes reduce disposable income, whereas transfers increase disposable income, whereas transfers increase disposable income - The budget balance is defined as net tax revenues minus government purchases, (T – G), when (T - G) is positive, there is a budget surplus; when (T – G) is negative, there is a budget deficit 22.2 Introducing Foreign Trade:

- Exports are foreign purchases of Canadian goods, and thus do not depend on Canadian national income. Desired imports are assumed to increase as national income increases. Hence, net exports decrease as national income increases - Changes in international relative prices lead to shifts in the net export function. A depreciation of the Canadian dollar implies that Canadian goods are now cheaper relative to foreign goods. This leads to a rise in exports and a fall in imports, shifting the net export function up. An appreciation of the Canadian dollar has the opposite effect 22.3 Equilibrium National Income: - National income is in equilibrium when desired aggregate expenditure equals actual national income. The equilibrium condition is  Y = AE, where AE = C + I + G + (X – IM) - The slope od the AE function in the model with government and foreign trade is z = MPC(1 – t) – m, where MPC is the marginal propensity to consume out of disposable income, t is the net tax rate, and m is the marginal propensity to import 22.4 Changes in Equilibrium National Income: - The presence of taxes and net exports reduces the value of the simple multiplier, with taxes and imports, every increase in national income induces less new spending than in a model with no taxes or imports - An increase in government purchases shifts up the AE functions and thus increases the equilibrium level of national income. A decrease in the net tax rate makes the AE function rotate upward and increases the equilibrium level of national income - An increase in exports can be caused by an increase in foreign demand for Canadian goods, a fall in the Canadian price level, or a depreciation of the Canadian dollar. An increase in exports shifts the AE function up and increases the equilibrium level of national income 22.5 Demand-Determined Output: - Our simple model of national income determination is constructed for a given price level. That prices are assumed

not to change in response to an increase is desired expenditure reflects a related assumption that output is demand determined - Output may be demand determined in two situations: if there are unemployed resources, or if firms are price setters...