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Chapter 28 – Macroeconomic Models and Fiscal Policy
9. The data in columns 1 and 2 in the accompanying table are for a private closed economy: a. Use columns 1and 2 to determine the equilibrium GDP for this hypothetical economy. (1) Real Domestic Output (GDP=DI), Billions $200 250 300 350 400 450 500 550
(2) Aggregate Expenditures, Private Closed Economy, Billions
$240 280 320 360 400 440 480 520
Table 1: GDP and Aggregate Expenditures of Private Closed Economy
the annual rates of productions and spending are in balance. the equilibrium level of GDP is the level at which the total quantity of goods produced (GDP) equals the total goods purchased (C + Ig). In brief. At this point. international trade which involves export and import and so on.Chapter 28: Macroeconomic Models and Fiscal Policy In the private closed economy. and equilibrium GDP achieved when equality exist at $400 billion of GDP. which would draw down inventories of goods and prompt increases in the rate of production. aggregate expenditures consist of consumption plus investment (C + Ig). which would accumulate of unsold goods and consequently cutbacks in the production rate. thus $400 billion is the equilibrium GDP. We also measure equilibrium GDP by using graphical analysis as shown below: Figure 1: Equilibrium GDP of Private Closed Economy 2 . The above table shows the real domestic output levels and aggregate expenditures. There is no government taxation. The equilibrium output is that output whose production creates total spending just sufficient to purchase that output. there is no reason there is no reason for businesses to alter this rate of production. There is no overproduction. Nor is there an excess of total spending. Therefore.
Chapter 28: Macroeconomic Models and Fiscal Policy b. Now open up this economy to international trade by including the export and import figures of columns 3 and 4. Billions (5) (4) Net Imports. (1) Real Domestic Output (GDP=DI). and Aggregate Expenditures of Private Open Economy 3 . Private (6) Aggregate Expenditur (3) Table 2: GDP and Net Exports. Explain why this equilibrium GDP differs from that of the closed economy. Billions Billions Economy. Economy. Fill in columns 5 and 6 and determine the equilibrium GDP for open economy. Billions $200 250 300 350 400 450 500 550 Billions $240 280 320 360 400 440 480 520 $20 20 20 20 20 20 20 20 $30 30 30 30 30 30 30 30 -$10 -10 -10 -10 -10 -10 -10 -10 (2) Aggregate Expenditure s. Private Closed Exports. Exports. Billions $230 270 310 350 390 430 470 510 Open es.
income and employment for a country. when an economy is open to international trade. Therefore. There is no government taxation. it will spend part of its income on imports that is goods and services produced abroad. On the other hand. net exports are negative $10 billion. As a result.Chapter 28: Macroeconomic Models and Fiscal Policy In the private closed economy. Xn (net exports) equals with Previously. we move from closed economy to an open economy that incorporates exports and imports. amount spent on imported goods should be subtracted because such spending generates income abroad rather than local economy. The aggregate expenditures schedule shown as C + Ig in 4 . exports create domestic production. aggregate expenditures consist of consumption plus investment (C + Ig). Based on the above table. Means in this hypothetical economy. So. Like consumption and investment. net exports can be positive and negative. international trade which involves export and import and so on. we include exports as a component of aggregate expenditures. to measure correctly aggregate expenditures for domestic goods we must subtract amount of import goods from exports. $400 billion is the equilibrium GDP. Thus. To avoid overstating the value of domestic production. But in private open economy. importing are more $10 billion than exporting goods. aggregate expenditures for private open economy are C + Ig + Xn. without international trade the equilibrium GDP is $400 billion. exports minus imports. However. in this case.
When imports exceed exports. Thus.Chapter 28: Macroeconomic Models and Fiscal Policy Table 1 is overstate the expenditures on domestic output at each level of GDP. Sum of expenditure which previously is $360 billion must be reduced by subtracting the $10 billion of net exports from C + I g. the contractionary effect of the larger amount of import outweighs the expansionary effect of the smaller amount of exports and equilibrium real GDP decreases from $400 billion to $350 billion. GDP = $360 billion + (-10) = $350 billion A change in net exports of $10 billion has produced a fivefold change in GDP. We also measure equilibrium GDP by using graphical analysis as shown below: Figure 2: Equilibrium GDP of Private Open Economy 5 . the new aggregate expenditures in private open economy are $350 billion. negative net exports reduce aggregate expenditures and GDP below what they would b in a closed economy. Means. And equilibrium GDP falls from $400 billion to $350 billion (refer to Table 2). other things equal. GDP = C + Ig + Xn.
Billions (3) Exports.Chapter 28: Macroeconomic Models and Fiscal Policy c. Billions (5) Net Exports. (2) Aggregate Expenditure s. What would be net exports? ii. Billions $200 250 300 350 400 450 500 $ 240 280 320 360 400 440 480 $20 20 20 20 20 20 20 $ 40 40 40 40 40 40 40 -$20 -20 -20 -20 -20 -20 -20 $210 260 300 340 380 420 460 6 . Billions (4) Imports. Given the original $20 billion level of exports: i. Equilibrium GDP? Imports were $10 billion greater at each level of GDP. Private Closed Economy. Billions (1) Real Domestic Output (GDP = DI). Billions (6) Aggregate Expenditur es. Private Open Economy.
equilibrium GDP needs to incorporate exports and imports. Exports create domestic production. Based from the above table. is a case whereby a country spends part of its income on imports of goods and services that are produced abroad. refers to net exports. Therefore. and employment for a nation. aggregate expenditures are C + Ig + (X – M). This spending generates production and income abroad rather than at home. in private open economy. export is a component of aggregate expenditure.$20 billion 7 . foreign spending on those goods and services increases production and create jobs and incomes in the country.Chapter 28: Macroeconomic Models and Fiscal Policy 550 520 20 40 -20 500 Table 3: GDP and Net Exports. The (X – M) or (Xn). Therefore. income. and Aggregate Expenditures of Private Open Economy In Private Open Economy. So. Imports on the other hand.$40 billion = . in order to avoid overstating domestic production value and to correctly measure aggregate expenditures for domestic goods and services. Net Exports are: Net Exports = Exports – Imports = $20 billion . Goods and services produced for export are sent abroad. we must subtract expenditures on imports from total spending.
negative $20 billion net exports will occur at each level of GDP. exports are maintained but imports increased to $40 billion and that gives us again negative $20 billion of net imports. the number by which a change in any such component 8 . Therefore. Negative net exports will reduce aggregate expenditures and GDP below what they would be in a closed economy. aggregate expenditures will reduce and ultimately GDP of the nation will contract. In this case. a decline in net exports (as we compare to the previous decline of negative $10 billion of net exports) means that whenever exports is decreased or maintained and imports is increased.Chapter 28: Macroeconomic Models and Fiscal Policy In this case. Net exports are independent of GDP. the contractionary effect of the larger amount of imports outweighs the expansionary effect of the smaller amount of exports and equilibrium real GDP decreases. When imports exceed exports. Negative $20 billion of net exports means that the economy is importing $20 billion more of goods than it is exporting and therefore it is overstates the expenditures on domestic output at each level of GDP. What is the multiplier in this example? Multiplier is a ratio of a change in the equilibrium GDP to the change in investment or in any other component of aggregate expenditures or aggregate demand. d. We must reduce sum of expenditures in this case $320 billion by the $20 billion net amount spent on imported goods and equilibrium GDP falls from $350 billion to $300 billion.
it tells us that the households use some of the extra income to purchase additional goods from abroad (imports) and pay additional taxes.5 multiplier.Chapter 28: Macroeconomic Models and Fiscal Policy must be multiplied to find the resulting change in the equilibrium GDP. while a decrease in spending will create a multiple decrease in GDP. the initial change in spending refers to changes in consumption that is unrelated to changes in income. An increase in initial spending will create a multiple increase in GDP. With a change of GDP at $50 billion. In this example. Multiplier will determine how much larger of a change will be whenever a change in investment spending that changes output and income by more than the initial change in the investment spending. the initial change in Net Exports is decreasing at negative $20 billion. investment. Multiplier = Change in real GDP Initial change in spending = 50 20 = 2. In this case. or net exports).5 With a 2. it gives multiple decreases in GDP. government expenditures. Buying imports and paying taxes drains off some of the additional consumption spending (on domestic output) created by the 9 . Multiplier effect will show us the effect on equilibrium GDP of a change in aggregate expenditures or aggregate demand (caused by a change in the consumption schedule.
Looking at your graph determine whether equilibrium GDP has increased .Chapter 28: Macroeconomic Models and Fiscal Policy increases in income. showing its impact on equilibrium GDP. imports. it expects us to prepare a graph built with government purchases and its impacts on equilibrium. decreased or stayed the same given the size of the government purchases and taxes that you selected. we will 10 . taxes and so forth. government purchases. add taxation (any amount of lump-sum tax that you choose) to your graph and show its effect on equilibrium GDP. in the open economy we can expect to incorporate exports. Along with this. By doing so. The fundamental assumption behind the aggregate expenditures model is that the prices in the economy are fixed or we can say the aggregate expenditures model is an extreme version of a sticky price model. 11. Explain graphically the determination of equilibrium GDP for a private economy through the aggregate expenditures model. it is a stuck-price model since prices cannot change at all. If we refer to the question. Finally. Now add government purchases (any amount you choose) to your graph. Answer: As we know in the private closed economy aggregate expenditures consist of consumptions plus investment. In fact. That is why the multiplier kept on reducing from the previous multiplier. they both make up the aggregate expenditures schedule for the private closed economy. However.
Ultimately. we will assume that government purchases are independent of the level of GDP and do not alter the consumption and investment schedules. as for the private closed economy. that $30billion increase in government spending is not financed by increased taxes.Chapter 28: Macroeconomic Models and Fiscal Policy combine two sides that is non-government and the public sector. The Tabular example (Table 4) depicts the impact of the purchase by government on the Equilibrium GDP. Here. increases in public spending. the addition of government purchases to private was spending (C+ Ig+ Xn + G). a fixed amount of taxes is collected regardless of the level of GDP. The new items are imports. 11 . The multiplier in this sample is 4. shift the aggregate expenditures schedule upward and produce a higher equilibrium. we should note that. Also government’s net tax revenues – total tax revenues less “negative taxes” in the form of transfer payments . This means adding government purchases and taxes to the model. exports and government purchases. However. the equilibrium GDP was $470 billion. we find that aggregate expenditures and real output are equal at a higher level of GDP which is in row 12. government spending is subject to the multiplier. As shown in the column 7.are derived entirely from personal taxes. Actually. A $30 billion in government purchases has increased equilibrium GDP by $120 billion that is from $470 billion to $590billion. Basically. like increases in private spending. By comparing columns 1 and 7. For simplicity.
G will lower the aggregate expenditure and result in a multiplied decline in the equilibrium GDP. C+ Ig + Xn.Chapter 28: Macroeconomic Models and Fiscal Policy Through graphical Analysis it can be noted that. we vertically add $30billion of government purchases. 12 . As we have mentioned. to the level of private spending. Conversely. G. from $470 billion to $590 billion. that added amount of money raises the aggregate expenditure schedule to C+ Ig+ Xn+ G resulting in a $120 billion increase in equilibrium GDP. a decline in government purchases. Table 4: The Impact of Government Purchases on Equilibrium GDP Figures mentioned above are depicted below in the graphical analysis.
If we suppose that tax is $ 40 billion. As households use disposable income both to consume and to save. 13 .25x$40billion).75. tax lowers both of them. In tabular example below. the government tax collection of $40 billion (=. one may know that the government not only spends but also collects money in terms of taxes. we find taxes in column 2 as well as column 3 for disposable (after-tax) income is lower than GDP by the $40billion amount of tax.75x$40billion) will reduce consumption by $ 30 billion and saving will decline by $10 billion (=. So that means government obtains $40 billion of tax revenue at each level of GDP regardless of the level of government purchases. As MPC is 0. MPC and MPS help us to comprehend how much consumption and saving will decline as a result of the $40billion in taxes.Chapter 28: Macroeconomic Models and Fiscal Policy Figure 3: The Impact of Government Purchases on Equilibrium GDP Referring to taxation and Equilibrium GDP.
consumption is $30 billion and saving $10 billion lower than that in table mentioned above. If we notice. As it is stated. taxes reduce disposable income relative to GDP by the amount of taxes.Chapter 28: Macroeconomic Models and Fiscal Policy Column 4 and 5 list the amounts of consumption and saving at each level of GDP. A comparison of real output and aggregate expenditures in columns 1 and 9 shows that the aggregate amounts produced and purchased are equal only at $470 billion of GDP (row 6). The $40billion lump-sum tax has reduced equilibrium GDP by $120 billion. in column 9. we compute aggregate expenditures as it shown in the table below. from $59 0billion (Table 4. row 6). Table 5: Determination of Equilibrium levels of Employment. Output and Income in Private and public Sectors 14 . row 12) to $470 billion (Table 5. The Effect of taxes on Equilibrium GDP.
The decline of $30 billion in consumption resulted for GDP fall from $590 billion to 470 billion. equilibrium GDP has increased because of the government purchases. With no change in government expenditures.Chapter 28: Macroeconomic Models and Fiscal Policy Graphical Analysis mentioned below depicts what is the effect of the $40 billion increase in taxes. tax increases lower the aggregate expenditures and reduce the equilibrium GDP. 15 . However. Looking at our graph we have determined that equilibrium GDP has decreased given the size of the government taxes that we selected.
Chapter 28: Macroeconomic Models and Fiscal Policy Figure 4: Lump Sum Tax Effect on Equilibrium GDP 16 .
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