CHAPTER 18: THE KEYNESIAN MODEL WITH A GOVERNMENT AND FOREIGN SECTOR

In the previous chapter we learned about the simple macro-economic model and
relationships such as aggregate spending, total income, macro-economic equilibrium and the
role and calculation for the multiplier.

In this chapter we introduce the government and foreign sector to the model.

18.1 The Keynesian model with a government sector

We must introduce two concepts: Government expenditure (G) and taxation (T)

These 2 components form the main elements of fiscal policy.

Responsibilities of the National Treasury.

Government expenditure (G)

Government expenditure (G) concerns purchase of goods and services by the general
government

Government expenditure concerns the purchase of goods and services by the general
government.
It consists of exhaustive expenditure and transfers
In national accounts data, only the consumption expenditure by the general government is
indicated separately.
Government investment is included in the gross capital formation (investment) figure.
Total government expenditure (G) sums both.

G is a direct influence of total real expenditure

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G and T decisions are taken outside the economy – thus exogenous – independent of income.

Therefore G = Ḡ
Graphically see Figure 18.1 in the text book.

Adding to the model:

Y=A
Y = C+I+Ḡ

Taxes (T)

T – indirect influence of total real expenditure (influence disposable income and therefore C).
The tax multiplier is smaller than the expenditure multiplier by a factor equal to the marginal
propensity to consume (MPC).
This means that a R1million increase in government expenditure, for example, will not have
the same impact on equilibrium income Y as a R1million reduction in total taxation.

LECTURER NOTES | ECON 122 CHAPTER 18

T YdC

See Figure 18.4 in the textbook

If the government is added, then its spending (G) will shift the spending line up. Autonomous
spending increases by 350, from 250 up to 250+350 which is = to 600. Taxation will reduce

LECTURER NOTES | ECON 122 CHAPTER 18

spending, by taking a way a percentage of people’s income. So instead of people spending,
for example, 80% of their money, they will spend maybe only 60% of their money. As you
may remember, the % of people’s income that they spend is called the MPC, and so taxes
reduce the MPC. MPC determines the slope of the spending line, so if there are taxes, the
MPC will decrease, and thus the slope of the spending line will decrease.

Therefore the equilibrium looks like this:

See figure 18.5 in the textbook.

Equilibrium:
Y = Spending
Y=A
Y=C+I+G
Where C + I + G cuts the 45o line
Ye = Multi x Auto E
But the multiplier changes now

Fiscal Policy

LECTURER NOTES | ECON 122 CHAPTER 18

If government wants to increase the equilibrium income level, they can:
Increase G (direct effect – E increases)
Reduce t =>> increase C (indirect effect)
If government wants to reduce the equilibrium income level, they can:
Reduce G (direct effect – E decreases)
Increase t =>> decrease C (indirect effect)

18.2 Introducing the Foreign sector

real exports (X) and imports (Z)

 South Africa has an open economy.
 Large portion of total production is exported and a large portion of total
expenditure is spent on the purchase of imported items.
 For now, focus on NX (exports minus imports)
 Total expenditure (E) = C + I + G + (X – Z)
Macroeconomic equilibrium:
 Total expenditure = total production
 C + I + G + (X – Z) = total production
 Total production equivalent to total income
 C + I + G + (X – Z) = Y
 (X – Z) increase =>> total expenditure increases =>> total production
increases =>> Y increases
Exports
X is exogenous

Expenditure by foreigners on SA goods and services

Independent of Y
No influence on multiplier
Influences Aggregate expenditure (A) positively
Shifts Aggregate expenditure (A)-slope upwards

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SA expenditure on foreign goods and services
Depends partially on Y. The relationship is +: imports increase if Y increases
The slope = m: marginal propensity to import. (Definition is: Percentage of additional income
that will be spent on imports)
Also has an autonomous part independent of income
Leakage, moves slope down
Influences Ā & α
(X-Z) = net exports

Graphically:

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See Figure 18.7

In Circular flow terms the model can be presented by:

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Referring back to the multiplier:
The formula for the complete multiplier is therefore:

Multiplier Definition:
 Any change in expenditure will result in a BIGGER change in income
 KE = ΔY / ΔE
 KE = 1 / (1 – c(1- t) + m)
 Each amount spent is received by (the income of) someone else =>> proportion
respent is again the income of someone else =>> proportion respent is again
the income of someone else…
 How big is the multiplier?
 Depends on the % respent
 A % of the income is respent and the other % is a leakage from the circular flow
 Leakages = imports, savings, taxes
The value is therefore determined by:
C = mpc
t = tax rate

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m = marginal propensity to import.

These are leakages in the above circular flow model.

See Box 18.3 in the textbook for a mathematical example of an increase in government
expenditure and the impact on equilibrium income.

See Box 18.4 in the textbook for a mathematical example of an increase in the tax rate and
the impact on equilibrium income.

LECTURER NOTES | ECON 122 CHAPTER 18