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Chapter 22:
Adding Government
and Trade to the
Simple Macro Model
Copyright © 2014 Pearson Canada Inc.
Chapter Outline/Learning Objectives
Section
Learning Objectives
After studying this chapter, you will be able to
22.1 Introducing
Government
1.
understand how government purchases and tax
revenues relate to national income.
22.2 Introducing
Foreign Trade
2.
understand how exports and imports relate to national
income.
22.3 Equilibrium
National Income
3.
distinguish between the marginal propensity to
consume and the marginal propensity to spend.
22.4 Changes in
Equilibrium
National Income
4.
explain why the introduction of government and foreign
trade in the macro model reduces the value of the
simple multiplier.
5.
explain how government can use fiscal policy to
influence the level of national income.
22.5 Demand-Determined 6.
Output
Copyright © 2014 Pearson Canada Inc.
understand that output is demand determined in our
simple macro model.
Chapter 22, Slide 2
22.1 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.
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide 3
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
(ignoring debt-service payments).
• if G < T: a budget surplus
• if G > T: a budget deficit
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide 4
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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Chapter 22, Slide 5
22.2 Introducing Foreign Trade
Net Exports
We make two central assumptions:
• Canada's exports are autonomous with respect to
Canadian GDP.
• Canada's imports rise as Canadian GDP rises.
For imports, we assume:
IM = mY
where m is the marginal propensity to import
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide 6
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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Chapter 22, Slide 7
Fig. 22-1
The Net Export Function
The NX function is drawn holding
constant:
• foreign GDP
• domestic and foreign prices
• the exchange rate
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Chapter 22, Slide 8
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):
• decreases X
• IM function rotates up as Canadians switch toward
foreign goods
 NX function shifts down and gets steeper
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide 9
Fig. 22-2
The Net Export Function and a Change in
International Relative Prices
Illustration of a rise in
Canadian prices relative
to foreign prices.
This could be caused by:
• Δ exchange rate
• Δ price levels
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide 10
22.3 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.
C = 30 + (0.8)YD
C = 30 + (0.8)(0.9)Y
 The MPC out of national
income (0.72) is less than the MPC
out of disposable income (0.8).
C = 30 + (0.72)Y
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide 11
The AE Function
We then expand the AE function:
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.
In this model, we get:
z = MPC(1 – t) – m
Clearly, t > 0 and m > 0 lead to a lower value of z.
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide 12
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.
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide 13
Fig. 22-3
The Aggregate Expenditure Function
Copyright © 2014 Pearson Canada Inc.
Adding government and
foreign trade does not
change the logic of the
equilibrium!
Chapter 22, Slide 14
MyEconLab
www.myeconlab.com
Copyright © 2014 Pearson Canada Inc.
An alternative (but equivalent) approach to determining the
equilibrium 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.
Chapter 22, Slide 15
22.4 Changes in Equilibrium National Income
The Multiplier with Taxes and Imports
Imports and taxes make z smaller
 the simple multiplier is also smaller
z = MPC(1 – t) – m
APPLYING ECONOMIC CONCEPTS 22-1
How Large is Canada’s Simple Multiplier?
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Chapter 22, Slide 16
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
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide 17
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 is necessary.
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide 18
Consider some  G < 0.
AE
AE =Y
E0
•
e0
Equilibrium national income
will fall:
 Y =  G x simple multiplier

G
e´
1
e1
•
Y1
•
AE0
AE1
E1
Y
Y0
Y
For example, suppose z = 0.25 ==> multiplier = 1.30.
 G = –$100 million ==>  Y = – $130 million.
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide 19
Fig. 22-4
The Effect of Changing the Net 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
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide 20
MyEconLab
www.myeconlab.com
Copyright © 2014 Pearson Canada Inc.
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.
Chapter 22, Slide 21
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.
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide 22
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
Copyright © 2014 Pearson Canada Inc.
Chapter 22, Slide 23
Review
1. A fall in the Canadian-dollar price of foreign currency, other things
being equal, causes Canada's net export (NX) function to shift
________ and ________.
A) downward; become steeper
B) upward; become flatter
C) downward; become flatter
D) downward; keep the same slope
E) upward; become steeper
© 2014 Pearson Education Canada Inc.
24
Review
The rotation from AE0 to AE1
could be caused by
A) lower government purchases.
B) a lower net tax rate.
C) higher government purchases.
D) a higher net tax rate.
E) a balanced budget.
© 2014 Pearson Education Canada Inc.
25
Review
Consider a simple macro model with a constant price level and
demand-determined output. The equations of the model are: C = 60
+ 0.43Y, I = 150, G = 260, T = 0, X = 90, IM = 0.06Y. The trade balance
at equilibrium national income is ________.
A) a deficit of 36.67
B) a deficit of 21.43
C) zero
D) a surplus of 21.43
E)a surplus of 36.67
© 2014 Pearson Education Canada Inc.
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