Slides are prepared by Dr. Amy Peng, Ryerson University Chapter Seven Government and International...

Slides are prepared by Dr. Amy Peng, Ryerson University

Chapter SevenChapter SevenGovernment and Government and

International TradeInternational TradeMacroeconomics by Curtis, Irvine, and BeggMacroeconomics by Curtis, Irvine, and Begg

Canadian Edition, Canadian Edition, McGraw-Hill Ryerson, 2007McGraw-Hill Ryerson, 2007

©2007 McGraw-Hill Ryerson Ltd. Chapter 7 2

Learning OutcomesThis chapter explains:This chapter explains:• The size of the government and international trade sectors of

Canadian Economy• How the government sector is included in the circular flow• How taxes and government expenditure affect equilibrium real

GDP• The government’s budget function and budget balance• Fiscal policy and the government’s budget function and

budget balance• Automatic stabilizers and discretionary fiscal policy• The public debt and the government’s budget balance• International trade and its effect on equilibrium income and

output• Government, international trade, and aggregate demand

©2007 McGraw-Hill Ryerson Ltd. Chapter 7.1 3

Government and International Trade

in Canada• Government activity and international

trade are both important to Canadian economy.

Illustrate…Illustrate…


The General Government Sector in G7 Countries 2004

50.2-4.140.436.3G7 average

95.6-3.148.645.5Italy

44.4-3.754.450.7France

57.4-3.647.744.0Germany

37.0-3.444.140.7UK

78.4-6.137.331.2Japan

37.0-4.336.031.7US

32.2+1.339.440.7Canada

Public Debt ratio

Budget Balance

Expendi-ture

Total Revenue

% of GDP

Countries


International Trade in Canada and US (1985 – 2005)

-5.816.210.44.633.738.32005

-3.915.011.25.239.744.92000

-0.910.69.73.533.136.61995

-0.88.57.8-0.527.426.91990

-2.37.85.42.322.825.11985

NXImportExportNXImportExport% of GDP

United StatesCanada


Government and Circular Flow

• Government spending affects aggregate expenditure

• The management of government revenues and expenditures has implications beyond just adding to aggregate expenditures

• Fiscal PolicyFiscal Policy is the use of government taxing and spending power to change output and employment


Government and Circular Flow

Budget Balance, surplus (+) or deficit (-) in 2004, +7.8

199.5Total207.3Total

7.0Other2.7Other

3.6Subsidies and assistance3.6Capital consumption

32.9Interest on public debt6.7Investment income

46.8Indirect taxes

41.1Transfer to provincial and local governments

17.3Contributions to social insurance plans

68.6Transfer to persons4.6 On non-residents

31.2 On corporations

94.4 On persons

46.3Goods and servicesDirect Taxes

BillionExpenditureBillionRevenue


Government Expenditure, Taxes, and Equilibrium Real GDP

• Adding government expenditure (G) to Aggregate expenditure (AE) AE = C + I + G

G = G0

• But taxes and transfer payments affect consumption Net tax, NT = tYNT = tY, tt net tax rate

YD = Y – NT = (1-t)Y


Government Expenditure, Taxes, and Equilibrium Real GDP

• Assume C = 20 + 0.8DI• T = 15%• YD = (1-t)Y• So C = 20 + 0.8(1 – 0.15)Y

C = 20 + 0.68Y• Each extra dollar of national income

increase DI by $0.85, out of which household spend 68 cents and save 17 cents


Net Taxes and Consumption

0500

0300

0100

SCYDNTY

• C = 0.8DI• NT = 0• YD = Y• C = 20 + 0.8Y

804205000500

402603000300

01001000100

SCYDNTY

500

300

100

SCYDNTY

• C = 0.8DI• NT = 0.15• YD = (1-0.15)Y• C = 20 + 0.68Y

6536042575500

3122425545300

-3888515100

SCYDNTY


Net Taxes and Consumption Function

Real Consumption C

Real GDP and Income

C = 20 + 0.8Y, t = 0

C = 20 + 0.68Y, t = 0.15

300

20

204

240

ΔC/ΔY = MPC(1-t)

= 0.8 x 0.85

What about Multiplier?


The Effect of Taxes and Government Spending

on Equilibrium Income

80600

80500

80400

AEICY(a) No Government• Y = AE = C + I • C = 20 + 0.8Y• I = 80• Autonomous

Expenditure of 100• Multiplier = 5

• Ye = 50058080500600

50080420500

42080340400

AEICY



on Equilibrium Income

C

80

80

80

I

0

0

0

G

400

312.5

200

AEYDNTY

(b) Tax t = 0.15, G = 0• Y = AE = C + I C = 20 + 0.8(1-0.15)Y• I = 80

• Autonomous Expenditure =100

• Multiplier = 3.125

• Ye = 312.5

292

232.5

156

C

80

80

80

I

0

0

0

G

37234060400

312.5265.646.9312.5

23617030200

AEYDNTY



on Equilibrium IncomeG

80800

80750

80700

AEICY(c) t = 0, G = 50• Y = AE = C + I + G• C = 20 + 0.8Y• I = 80• G = 50• Autonomous

Expenditure of 100• Multiplier = 5• Ye = 750

50

50

50

G

79080660800

75080620750

71080580700

AEICY


The Effect of Taxes and Government Spending on Equilibrium Income

C

80

80

80

I

5

50

50

G

550

535.7

500

AEYDNTY

(d) Tax t = 0.1, G = 50• Y = AE = C + I + G• C = 20 + 0.8(1 - 0.1)Y• I = 80

• Autonomous Expenditure = 150


• Ye = 535.7

416

405.7

380

C I

50

50

50

G

54649555550

535.7482.153.6535.7

51045050

AEYDNTY


o45

o

GDP (billions of dollars)

AE’

AE

Equilibrium GDP output rises by 5 times the rise in G

500

Ag

gre

gat

e e

xpen

dit

ure

s (

bil

lio

ns

of

do

lla

rs)

150

100

Y = AE

Government Expenditure, Taxes, and Equilibrium Output

750

G =

50


o45

o

GDP (billions of dollars)

AE’

AE

500

Ag

gre

gat

e e

xpen

dit

ure

s (

bil

lio

ns

of

do

lla

rs)

150

100

Y = AE

Government Expenditure, Taxes, and Equilibrium Output

537.5

G = 50, t = 0.1

• AE increased by 50 (intercept effect)AE increased by 50 (intercept effect)• AE becomes flatter (t = 0.1, slope effect)AE becomes flatter (t = 0.1, slope effect)


The Multiplier Revisited

eExpenditur Aggregate of slope-1

1 multiplier The

MPC-1

1

A

Y

t)-(1MPC Y

AE

t)-(1MPC-1

1

A

Y

Without Government and Taxes

With Tax proportional to Income

The Multiplier is smaller


The Government’s Budget and Fiscal Policy

• Government budget– What goods and services the government will

buy during the coming year, what transfer payments it will make, and how it will pay for them

• Government budget balance BB = NT (Net Tax) – G (Government

expenditure)

BB = tY – G (tY = NT)


G, NTG, NT

NT = tY = 0.2YNT = tY = 0.2Y

G (assumed G (assumed constant)constant)

15001500600600

DeficitDeficit {{

A Government Budget

200200SurplusBalanced


Real GDP, Income, and the Government BB

1800

1400

1000

600

200

0

BBGNTGDP

G =200

NT = tY = 0.2Y

BB = NT – G = 0.2Y -200

+ 160200360

+ 80200280

0200200

- 80200120

- 16020040

- 2002000

BBGNTGDP


+BB+BB

BB = 0.2Y-200BB = 0.2Y-200

14001400

A Government Budget Function

00

--8080 600600 10001000

Real GDP and Income

Bud

get

Bal

ance

+80+80

-200-200


Investment, Saving, and the Budget

• Leakages = Injections

• Actual savingsActual savings plus actual net taxesactual net taxes always equal actual government expenditureactual government expenditure plus actual investment expenditureactual investment expenditure

• S + NT = I + G

• I – S = NT – G

• A rise in planned government expenditure must reduce the government’s budget balance


Fiscal Policy and Government Budget Balance

• Fiscal policy is government use of its taxes and spending to affect aggregate expenditure and equilibrium GDP

• Expansionary fiscal policy eliminates recessionary gaps

• Restrictive fiscal policy eliminates inflationary gaps

• Automatic or Built-in Stabilizers


Real GDP and income

AE0

o45

o

RecessionaryRecessionaryGapGap

AE1

Y0 Yp

Ag

gre

gat

e e

xpen

dit

ure

s (

bil

lio

ns

of

do

lla

rs)

ΔG

Expansionary Fiscal Policy


Real GDP and income

AE2

o45

o

InflationaryInflationaryGapGap

AE3

Yp Y2

Ag

gre

gat

e e

xpen

dit

ure

s (

bil

lio

ns

of

do

lla

rs)

Δt

Restrictive Fiscal Policy


The Structural Budget Balance

• The The structural budget balancestructural budget balance is the estimate of what the budget balance would be if the economy were operating at potential output

• SBB = tYp - G

• Changes in the government’s fiscal policy fiscal policy programprogram change the structural budget balance and shift the budget function


BB0 = t0Y – G0

SBB0 = t0Yp – G0

The Actual and the Structural or Cyclically Adjusted Budget

Balance

0

-BB1

Real GDP and Income

Bud

get

Bal

ance

-G0

Yp

+BB2

SBB0

Y2

Y1

B

A

CStructural budget Balance Budget Surplus

Budget Deficit


Automatic and Discretionary Fiscal Policy

• Automatic stabilizer– Income taxes and transfers– They are built into the budget program by

setting the net tax rate and work automatically– All leakages are automatic stabilizers

• Discretionary fiscal policies


BB0 = t0Y – G0

Automatic and Discretionary Fiscal Policy

0

-BB1

Real GDP and Income

Bud

get

Bal

ance

-G0

Yp

+BB2

SBB0

Y2

Y1

B

A CDiscretionary Policy

Automatic Stabilization


The Public Debt and the Budget Balance

• Budget balances and outstanding debt are closely related

• The outstanding public debt (PD)public debt (PD) is the sum of past government budget balances

• ΔPD = - BB

• Debt to GDP Ratio


Government of Canada Net Debt Ratio

41.270.555.744.524.616.421.4

2005199519901985198019751970

% GDP

The Government of Canada’s net debt to GDP ratio has declined from a peak of 70.5 percent in 1995 to 41.2 percent in 2005.


International Trade and Income Determination

• Export (X)

• Import (Z)

• Net export NX = X – Z

• Y = AE = C + I + G + X – Z

• Export expenditure is autonomous

• Import expenditure rises as national income rises– Slope of the import function is MPZ


Exports, Imports, and Net Exports

100

500 Y

X0

Z = 0.2Y

Exp

orts

and

Im

port

s

0500

Y

NX = X0 - 0.2Y

Net

Exp

orts

(X

-Z) 100


Real GDP and income

AE1=C+I+G+NX

o45

o

AE0=C+I+G

Ye Ye’ Y1

Ag

gre

gat

e e

xpen

dit

ure

s (

bil

lio

ns

of

do

lla

rs)

Slope = ΔAE/ΔY

= MPC(1-t) - MPZ

Equilibrium Income in an Economy with International Trade

NX

C0+I0+G0

C0+I0+G0+X0


Equilibrium Income in the Open Economy

5080469

C

80

80

80

I

50

50

50

G

500

400

300

AEYDNTY

(a) Equilibrium with No Trade• Y = AE = C + I + G• C = 20 + 0.8(1-0.15)Y• I = 80, G = 50, NT = 0.15Y

• Autonomous Expenditure ΔA = 150


• Ye = 469

469339398.670.4

380

292

224

51042575

42234060

35425545


(b) X, Z, and NX• X = 100• Z = 0.2Y• NX = 100 – 0.2Y 100600

100500

100400

NXZX Y

-20120100600

0100100500

2080100400

NXZX Y



(c) Equilibrium with International Trade• Y = AE = C + I + G + X – Z• C = 20 + 0.8(1-0.15)Y• I = 80, G =50, NT =0.15 Y• X = 100, Z =0.2 Y• Autonomous expenditure = 250• Multiplier = 1.923• Equilibrium Output Ye= 481



(d) Leakages and Injections• At Ye= 481, S = YD – C = 62• NT = 0.15Y = 72• Z = 0.2Y = 96• I =80, G = 50, X =100• S + NT + Z = I + G + X• BB = NT – G = 72 – 50 = +22• NX = X – Z= 100 – 96 = +4• S- I = 62 – 80 = -18




1005080500

1005080481

1005080400

1005080300

AEZXGICYDNTY

(e) Numerical Values

490100100508036042575500

48196100508034740972481

44280100508029234060400

39460100508022425554300

AEZXGICYDNTY


The Multiplier in an Open Economy

MPZtMPC

)1(1

1

AE of slope1

1

AE

YMultiplier

The Multiplier in Canada

• MPC(1-t) = 0.54, MPZ = 0.34

25.12.01

1

34.054.01

1

AE

Y


Exports and Equilibrium Output

• A change in exports is a change in autonomous expenditure

• An increase in exports produces a rise in income and consequently in imports to moderate the change in trade balance

• Total Leakages = Total Injection

• S + NT + Z = I + G + X


45o

Real domestic product, GDP

Ag

gre

gat

e E

xpen

dit

ure

s

AEY=AE

Equilibrium Output and Aggregate Demand with Government and

Trade

AE

A2

YeYen

AE’

ΔY

A0

ΔA

YeYen

P0

ΔY

AS

AD0

AD2

Real domestic product, GDP

ΔY


Chapter Summary• Government expenditureGovernment expenditure on goods and service is an

autonomousautonomous part of AE• Net taxesNet taxes reduce the change in consumption caused by

a change in national income, reduce the slope of AE,the slope of AE, and reducereduce the multiplierthe multiplier

• The government budget balancegovernment budget balance• Fiscal policyFiscal policy is the government’s use of its taxing and

spending powers to offset business cycle fluctuations in AD, output, and employment

• Structural budget balanceStructural budget balance and discretionary fiscal policydiscretionary fiscal policy• Automatic stabilizersAutomatic stabilizers reduce fluctuations in real GDP;

discretionary fiscal policydiscretionary fiscal policy makes changes to the structural budget balance


Chapter Summary• NationalNational debtdebt and debt to GDP ratio• Budget deficitsBudget deficits are not necessarily bad• Open economy exports exports and imports imports• Exports Exports can be viewed as autonomousautonomous expenditure. MPZMPZ tells

us how much imports will change as a result of change in domestic income

• Leakages to net taxes and imports reduce the slope of the AE function

• Higher export expenditureHigher export expenditure raises AE, equilibrium output, and AD. A higher MPZ and thigher MPZ and t reduces AE, equilibrium output, and AD.

• S + NT + Z = G + I + XS + NT + Z = G + I + X• In the open economy, fluctuations in ADfluctuations in AD and output are

caused by fluctuations in autonomous expenditureautonomous expenditure through the multiplierthe multiplier

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Slides are prepared by Dr. Amy Peng, Ryerson University Chapter Seven Government and International...

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