Adding Government and Trade To The Simple Macro Model

Chapter 22
Adding
Government
and Trade to
the Simple
Macro Model
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

In this chapter you will learn to
1. Describe the relationship between national income and

government purchases and tax revenues.
2. Describe the relationship between national income and

exports and imports.
3. Explain the distinction between the marginal propensity to
consume and the marginal propensity to spend.
4. Explain why the presence of government and foreign
trade reduces the value of the simple multiplier.
5. Describe the effect of government fiscal policy on the level
of national income.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 22-2
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.

Introducing Government
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:
- if G < T: a budget surplus
- if G > T: a budget deficit

Budget Balance and Saving
Private saving is the amount that household save:
= disposable income – consumption expenditure
Public saving is saving on the part of the government

=T–G
Budget surplus: public saving is positive
Budget deficit: public saving is negative

State and Local Governments
When measuring the overall contribution of government to

desired aggregate expenditure, all levels of government must
be included:
- federal, state, and local
- combined purchases of state and local

governments are larger than those of the federal
government.

Summary
The presence of government affects our simple model by:
- adding directly to desired AE through G
- collecting tax revenue (T) and make transfer

payments

Introducing Foreign Trade
Net Exports
We make two central assumptions:
- U.S. exports are autonomous with respect to U.S.
GDP
- U.S. imports rise as U.S. GDP rises
For imports, we assume:

IM = mY
where m is the marginal propensity to import.

Introducing Foreign Trade
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.

Figure 22.1 The Net Export
Function
The NX function is drawn

holding constant:
• foreign GDP
• domestic and foreign prices
• the exchange rate

Shifts in the Net Export Function
An increase in foreign income leads to more foreign demand

for U.S. goods:
- increases X and shifts NX function upward
A rise in U.S. prices (holding foreign prices constant):

- decreases X
- IM function rotates up as Americans switch
toward foreign goods
 NX function shifts down and gets steeper

Figure 22.2 Shifts in the Net
Export Function
Illustration of a rise in U.S.

prices relative to foreign
prices.
This could be caused by:

- Δ exchange rate
- Δ price levels

Summary
The presence of foreign trade modifies our basic model by:
- foreign firms and households purchase U.S.-made

goods (X)
- all components of domestic expenditure (C, I, and

G) include some import content (IM).

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.
 The MPC out of national

C = 30 + (0.8)YD
income (0.72) is less than
C = 30 + (0.8)(0.9)Y the MPC out of disposable
income (0.8).
C = 30 + (0.72)Y
The Desired Consumption Function
From the numerical example above, we can generally write:
C = a + b(1 – t)Y
where b = MPC
t = tax rate
a = autonomous consumption

The AE Function
We then expand the AE function:
AE = C + I + G + (X – M)
Recall that the slope of the AE function is the marginal

propensity to spend out of national income.
Summing the four components of desired AE:
AE = a + b(1 – t)Y + I + G + (X – mY)

= [ a + I + G + X ] + [b(1 – t) – m]Y
We call: b(1 - t) - m = z
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.
Figure 22.3 The Aggregate
Expenditure Function

Changes in Equilibrium National
Income
The Multiplier with Taxes and Imports

Imports and taxes make z smaller:
• z = MPC(1 – t) – m
The simple multiplier is also smaller:

• multiplier = 1/{1 –[ MPC(1 – t) – m]}

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
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 adjustment is necessary.

Figure 22.4 The Objective of
Stabilization Policy

Changes in Government
Purchases
AE AE =Y
Consider some G < 0. E0
e0 • AE0
Equilibrium national G AE1

income will fall: e´1 •
Y = G x simple multiplier e1 •
E1
Y1 Y0
Y
Y
For example, suppose z = 0.62 ==> multiplier = 2.63.
G = -$100 million ==> Y = - $263 million.
Figure 22.5 The Effect of
Changing the 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

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 equilibrium level of national income is that level where
desired AE equals actual national income.
The Simple Multiplier

Simple multiplier; 1/(1-z)
Closed economy with no government: z = MPC
Open economy with government: z = MPC(1-t) - m

The model assumes a constant price level so that national income
is demand determined.
When is this a reasonable assumption?
1. When output is below potential, firms can increase output
without increasing their costs.
2. 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

Adding Government and Trade To The Simple Macro Model

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Chapter 22

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

1. Describe the relationship between national income and

2. Describe the relationship between national income and

Net Tax Revenues

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 22-3

We assume net taxes are given by:

The Budget Balance

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 22-4

Private saving is the amount that household save:

= disposable income – consumption expenditure

Public saving is saving on the part of the government

Budget surplus: public saving is positive

Budget deficit: public saving is negative

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 22-5

When measuring the overall contribution of government to

- federal, state, and local

- combined purchases of state and local

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 22-6

The presence of government affects our simple model by:

- adding directly to desired AE through G

- collecting tax revenue (T) and make transfer

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 22-7

For imports, we assume:

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 22-8

Thus, net exports are given by:

Ceteris paribus, changes in domestic GDP lead to changes

The relationship between Y and NX is shown by the net

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 22-9

The NX function is drawn

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 22-10

An increase in foreign income leads to more foreign demand

A rise in U.S. prices (holding foreign prices constant):

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 22-11

Illustration of a rise in U.S.

This could be caused by:

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 22-12

The presence of foreign trade modifies our basic model by:

- foreign firms and households purchase U.S.-made

- all components of domestic expenditure (C, I, and

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 22-13

Desired Consumption and National Income

If T = (0.1)Y, then YD = (0.9)Y.

 The MPC out of national

From the numerical example above, we can generally write:

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 22-15

We then expand the AE function:

Recall that the slope of the AE function is the marginal

AE = a + b(1 – t)Y + I + G + (X – mY)

As before, output is assumed to be demand determined in

In words, equilibrium Y occurs where desired aggregate

Whenever AE is not equal to Y, there are unintended

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 22-18

The Multiplier with Taxes and Imports

The simple multiplier is also smaller:

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 22-19

As with other elements of AE:

Fiscal policy is the use of the government’s spending and tax

Any policy that attempts to stabilize Y at or near Y* is called

It is often clear in which direction fiscal policy could be

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 22-21

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 22-22

Equilibrium national G AE1