EDIT 12ce Ch22

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

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In this chapter you will learn

1. how government purchases and tax revenues are related
to national income.
2. how exports and imports are related to national income.
3. how to distinguish between the marginal propensity to

consume and the marginal propensity to spend.
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.
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22.1 INTRODUCING
GOVERNMENT
Government Purchases
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 Tax Revenues
Net taxes (T) are total tax revenues net of transfer payments
(CPP, EI, OAS, GIS, Social Assistance, subsidies, grants,
etc.)
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007
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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.
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)

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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.

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Government Expenditure Function
Desired government expenditure is treated as

autonomous – completely unrelated to the current
level of Y
We can write G=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.)

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Government Expenditure Function (what does it look like?)
Desired Government
Expenditures Shift up implies a Government spending increases
G
200 G’
G
150
Shift down implies Government spending cuts
100 G’’
0 Y
Actual National Income

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Government Net Tax Function
Desired Net Taxes

T T = tY
200
T0 = tY0 Governments set the tax

150 rate (t) but Y determines the
total taxes paid (T)
T1 = tY1
100
0 Y
Y1 Y0 Actual National Income
-100
Recall Net taxes (T = Tx less transfers)

-150 Copyright © 2008 Pearson Education Canada
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Changes in Taxes (the tax rate t)
Desired Net Taxes T’ = t’Y

Net tax increases
T
T=
200 tY
T’’ = t’’Y
T0’
T0 Net tax decrease
T0’’
100
0 Y
Y0 Actual National Income
-100
Note: t’ > t > t’’

-150 Copyright © 2008 Pearson Education Canada
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The Public
Public Saving
T-G
Saving Function
Public Saving is defined as 0
300 600 900
T–G Actual
Net tax revenue which the National
government does not spend Income
Y G T = 0.1 x Y T-G
As national income 150 51 15 -36
rises, the budget 300 51 30 -21
surplus (public saving) 525 51 52.5 1.5
increases. 600 51 60 9
900 51 90 39
The slope of the public
saving function is equal
to the net tax rate.

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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.

Copyright © 2005 Pearson Education Canada Inc.
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22.2 INTRODUCING FOREIGN TRADE

Net Exports We make two central assumptions:
1) Canada’s exports are autonomous with respect to

Canadian GDP
The export function is simply X=X
What determines the value of is X? A number of things including FOREIGN

NATIONAL INCOMES
2) Canada’s imports rise as Canadian GDP rises

For imports, we assume: IM = mY
where m is the marginal propensity to import.

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Export Function (what does it look like?)
Desired Exports
Shift up implies Exports increases
X
200 X’
X
150
Shift down implies Exports decrease
100 X’’
0 Y

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Import function (what does it look like?)
Desired Imports
M M = mY
200
M0 = mY0
150
M1 = mY1
100
0 Y
Y1 Y0 Actual National Income

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Changes in Imports (the marginal propensity to import m)
Desired Imports M’ = m’Y

Increase in imports
M
M=mY
200
M’’ = m’’Y
T0’
T0 Decrease in imports
T0’’
100
0 Y
Y0 Actual National Income
Note: m’ > m > m’’

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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.

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Y X IM = 0.1 x Y NX IM = 0.1Y
Imports and Exports

96
0 72 0 72
300 72 30 42 72
600 72 60 12 X = 72
720 72 72 0 48
900 72 90 -18
24
0 300 600 900

Y
The NX function is drawn
holding constant: 72
• foreign GDP Net Exports 48

NX = 72 - 0.1Y
• domestic and foreign prices 24
• the exchange rate 0 300 600 900
Y
-24
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net exports, (NX = X – IM)
is also referred to as the Balance of Trade
if then we have
NX = X – IM > 0 a trade surplus
NX = X – IM = 0 a trade balance
NX = X – IM < 0 a trade deficit

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Shifts in the Net Export Function

1. An increase in foreign income leads to more foreign
demand for Canadian goods:
- increases X and shifts NX function upward
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
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Imports and Exports

IM´ IM
Illustration of a rise in
X
Canadian prices relative X´
to foreign prices or an
appreciation of the
Canadian dollar.
This could be caused by:
Net Exports
- Δ exchange rate
(appreciation) (X - IM)
-Δ price levels
(increase relative to foreign
prices)
(X - IM)´

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Shifts in the Net Export Function -

Summary
Foreign Income - An increase in foreign income results in an increase
Canadian exports - NX function shifts up. (and the reverse)
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)
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)
Other considerations: Barriers to trade – tariffs, quotas, regulations,

etc.
Taste – trade promotion, ‘buy Canadian’
Mad cow disease, lead paint on toys, etc.
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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. 2002 Sep. 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 1997 Jan 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 $
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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. 2002 Sep. 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 1997 Jan. 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 $
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22.3 EQUILIBRIUM NATIONAL INCOME

Desired Consumption and National
Income
With taxation, YD is less than Y.
C = a + bYD where YD = Y - tY so that
C = a + b(Y-tY) or C = a + b(1-t)Y
Example: If T = (0.1)Y, then YD = (0.9)Y.

C = 30 + (0.8)YD  The MPC out of national
income (0.72) is less than
C = 30 + (0.8)(0.9)Y
the MPC out of disposable
C = 30 + (0.72)Y income (0.8).

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The simple consumption function with taxes is written as:
C = a + b(1-t)Y
If t increase then the slope of the consumption function, b(1-t),
decreases.
C Slope = b(1-t)
where t’ > t
a Slope = b(1-t’) Note this will cause the slope

of the AE line to decrease
also.
Y
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The AE Function – total desired expenditure on

Canadian goods and services from all
sources
AE = C + I + G + NX
AE 40o line (AE=Y)
AE = C + I + G + NX
Recall that the slope of the AE function is the marginal

propensity to spend out of national income — we call this z.

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The slope of the AE function

AE = C + I + G + NX
IF C = a +bYD where YD = Y – tY
I=I G=G X = X and M = mY where NX = X - M
Then AE = C + I + G + NX
= a + bYD + I + G + (X - M)
= a + b(Y – tY) + I + G + (X - mY)
= a + [b(1 – t) -m]Y+ I + G + X recall b is the MPC
In this model, we get:

z = MPC(1 - t) - m
Clearly, t > 0 and m > 0 lead to a lower value of z.

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Equilibrium National Income
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.

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The addition of
government and
foreign trade does
not change the
logic of the
equilibrium!

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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

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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])
Using realistic values of taxation and imports for Canada, the evidence
shows that the value of the multiplier is closer to 1 than 2.
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z = ∆AE / ∆Y - slope of the AE curve

AE AE =Y
The value of z is
determined by: e
E0
0 • AE1
∆AE E1
z = MPC(1-t) - m
e1
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
Y1 Y0
1 / (1-z) or 1 / (1 - 0.23) = 1.30 ∆Y
Y
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?
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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
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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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Consider a decrease in
AE
government expenditures AE =Y
(∆ G < 0). E0
e0 •
Equilibrium national income AE0
will fall:
∆G AE1
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.
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The government may also

attempt to change national
income by changing the net
tax rate. AE AE=Y AE1
- a lower t causes the E1 AE0

e2 •
AE function to become
steeper
e0 •E0
- a higher t causes the Y0 Y1 Y

AE function to become
flatter

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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

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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.

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The level of desired AE AE =Y

spending (the position of
the AE curve) determines E0
e0 • AE0
the level of equilibrium
∆AE
national income, Y.
AE1
e´1 •
Any change in the AE
curve (shift or change in e1 •
slope) implies a E1
different level of
equilibrium Y Y1 Y0
∆Y
Y
We say the economy is demand driven.
Recall: desired AE = C + I + G + NX

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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
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1 of 42

Copyright © 2008 Pearson Education Canada

In this chapter you will learn

2. how exports and imports are related to national income.

3. how to distinguish between the marginal propensity to

4. why the presence of government and foreign trade reduces

5. how government can use fiscal policy to influence the level

Net Tax Revenues

We assume net taxes are given by:

The Budget Balance

*(ignoring debt-service payments)

Provincial and Municipal Governments

When measuring the overall contribution of government to

- particularly important in Canada

- combined purchases of provincial and municipal

Copyright © 2008 Pearson Education Canada

Government Expenditure Function

Desired government expenditure is treated as

We can write G=G

Were G is determined by – what governments do!

Mostly just the provision of ‘goods and services’

Copyright © 2008 Pearson Education Canada

Government Expenditure Function (what does it look like?)

Copyright © 2008 Pearson Education Canada

Government Net Tax Function

Desired Net Taxes

T0 = tY0 Governments set the tax

Recall Net taxes (T = Tx less transfers)

Changes in Taxes (the tax rate t)

Desired Net Taxes T’ = t’Y

Note: t’ > t > t’’

Copyright © 2008 Pearson Education Canada

1. All levels of government add directly to aggregate

3. Government purchases and taxation, taken together,

Copyright © 2008 Pearson Education Canada

22.2 INTRODUCING FOREIGN TRADE

1) Canada’s exports are autonomous with respect to

What determines the value of is X? A number of things including FOREIGN

2) Canada’s imports rise as Canadian GDP rises

Copyright © 2008 Pearson Education Canada

Export Function (what does it look like?)

Copyright © 2008 Pearson Education Canada

Import function (what does it look like?)

Copyright © 2008 Pearson Education Canada

Changes in Imports (the marginal propensity to import m)

Desired Imports M’ = m’Y

Note: m’ > m > m’’

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 Education Canada

Imports and Exports

0 300 600 900

• foreign GDP Net Exports 48

net exports, (NX = X – IM)

is also referred to as the Balance of Trade

NX = X – IM > 0 a trade surplus

NX = X – IM < 0 a trade deficit

Copyright © 2008 Pearson Education Canada

Shifts in the Net Export Function

2. A rise in Canadian prices (holding foreign prices

Imports and Exports

Actual National Income