ECON 1102 - PART 2

Principles of Macroeconomics 2

Chapter 7- Adding Government and Trade to the Simple Macro Model
What is Fiscal Policy?
- The use of the government’s tax and spending policies to achieve government objectives.
- Desired government purchases (G) are part of an aggregate desired expenditure (AE).
- Government purchases are autonomous meaning they are not affected by GDP, they enter the AE
function directly.

What is Net Tax Revenue?
- Net tax revenue (T) is total tax revenue minus transfer payments.
- Taxes enter the AE function indirectly, by affecting disposable income (YD) and consumption (C).
- C = Autonomous Consumption (Č) + MPC x Disposable Income (YD = Y-T).
- The net tax revenue function is T = tY (T = 0.3Y, meaning 30% of income is for taxes).

What is the Budget Balance?
- The budget balance is the difference between total government revenue, and total government
expenditures, which equals net tax revenue minus government purchases (T-G).
- The government has a budget surplus if net tax revenue exceeds purchases (T>G).
The government has a budget deficit if purchases exceed net tax revenue (G>T).
- The government has a balanced budget when the two amounts are equal (T=G).

How is Foreign Trade Introduced?
- Exports (X) will not change due to changes in Canadian national income, so they are treated like
autonomous expenditures.
- Imports (IM) do change due to changes in Canadian national income. The marginal propensity to
import (m) is the increase in import expenditure induced by a one-dollar increase in national income.
- Import function: IM = mY (IM = 0.2Y). Net Exports function: NX = X – mY
- Trade is balanced when NX = 0 or X = IM

What are the factors that shift Foreign Trade?
1. Foreign Income
- As foreign income increases, people will import more Canadian goods, making exports shift up (rise)
- As foreign income decreases, people won’t import Canadian goods, making exports shift down (fall)

2. Canadian Prices
- If CAD appreciates (prices increase), exports will go down because Canadian goods are relatively more
expensive, causing people to import fewer Canadian goods, however, Canada will start importing more
goods (m goes up) from other countries, making the net exports slope steeper and lower.
- If CAD depreciates (prices decrease) exports will go up because Canadian goods are relatively less
expensive, causing Canada to import fewer goods from other countries (m goes down), making the net
exports slope higher and flatter.
- Foreigners pay less money to buy CAD, and Canadians pay more money to buy foreign currency.

When do we reach Equilibrium National Income?
- Equilibrium National income is the level of income at which desired aggregate expenditure equals
actual national income (AE = Y).
- The marginal propensity to consume out of national income (after taxes) is less than the marginal
propensity to consume out of disposable income (before taxes).

, - The slope of the AE function is the marginal propensity to spend out of national income (z).
- AE Function: AE = C + I + G + X – IM and z = MPC (1-t) – m.
- To solve for equilibrium: 1. Simplify consumption 2. Add AE components 3. Use AE condition

Example:
C = 200 + 0.8YD
I = 100
G = 300
T = 0.3Y
X = 200
IM = 0.2Y

1. C = 200 + 0.8(0.7Y) = C = 200 + 0.56Y
2. AE = 200 + 0.56Y + 100 + 300 + (200 – 0.2Y) = AE = 800 + 0.36Y
3. Y = AE | Y = 800 + 0.36Y | 1Y- 0.36Y = 800 | 0.64Y/0.64 = 800/0.64 = 1250

Z = MPC (1-t) – m = 0.8 (1-0.3) – 0.2 | 0.8(0.7) – 0.2 = 0.56 – 0.2 = 0.36 = z

What changes Equilibrium National Income?
- Investment increases output, which increases income, which increases consumption.
- The three withdrawals that come out of income are taxes, saving, and exports.
- The presence of imports and taxes reduces the marginal propensity to spend out of national income
and reduces the value of the simple multiplier (z).
- A high marginal propensity to consume would increase the multiplier (steeper AE), while a high
marginal propensity to import or a higher net tax rate would reduce the multiplier (flatter AE).
- Governments use stabilization policy (fiscal) to bring national income closer to potential GDP, Y*. The
policy is designed to reduce the economy, and cyclical fluctuations, thereby stabilizing national income
with smaller peaks and troughs.
- If there is a reduction in the net tax rate or an increase in government purchases the AE curve would
shift upward, causing the multiplier to increase the equilibrium national income.
- G: Change in Y over Change in G = 1 / (1-z) | Change in Y = Change in G x 1/(1-z)
- T: An increase in ‘t’ flattens the AE curve while a decrease in ‘t’ steepens it. (Y1 – Y0 = Change in y)