Assignment 2

Chapter 28: Macroeconomic Models and Fiscal Policy

Chapter 28 – Macroeconomic Models and Fiscal Policy

9. The data in columns 1 and 2 in the accompanying table are for a private closed economy:

a. Use columns 1and 2 to determine the equilibrium GDP for this hypothetical economy.

(1)Real Domestic

Output(GDP=DI),

Billions

(2)Aggregate

Expenditures, Private Closed Economy,

Billions

$200 $240

250 280

300 320

350 360

400 400

450 440

500 480

550 520

Table 1: GDP and Aggregate Expenditures of Private Closed Economy

In the private closed economy, aggregate expenditures consist of consumption plus

investment (C + Ig). There is no government taxation, international trade which involves export

and import and so on.

The equilibrium output is that output whose production creates total spending just

sufficient to purchase that output. Therefore, the equilibrium level of GDP is the level at which

the total quantity of goods produced (GDP) equals the total goods purchased (C + Ig).

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The above table shows the real domestic output levels and aggregate expenditures, and

equilibrium GDP achieved when equality exist at $400 billion of GDP. At this point, the annual

rates of productions and spending are in balance. There is no overproduction, which would

accumulate of unsold goods and consequently cutbacks in the production rate. Nor is there an

excess of total spending, which would draw down inventories of goods and prompt increases in

the rate of production. In brief, there is no reason there is no reason for businesses to alter this

rate of production, thus $400 billion is the equilibrium GDP. We also measure equilibrium GDP

by using graphical analysis as shown below:

200 250 300 350 400 450 500 550

GDP 200 250 300 350 400 450 500 550

(C + Ig) 240 280 320 360 400 440 480 520

$50

$150

$250

$350

$450

$550

Equilibrium GDP

Agg

rega

te E

xpen

ditu

res

(C+I

g)

Figure 1: Equilibrium GDP of Private Closed Economy

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b. Now open up this economy to international trade by including the export and import

figures of columns 3 and 4. Fill in columns 5 and 6 and determine the equilibrium GDP for

open economy. Explain why this equilibrium GDP differs from that of the closed economy.

(1)Real

Domestic Output

(GDP=DI),Billions

(2)Aggregate

Expenditures, Private Closed

Economy, Billions

(3)Exports,Billions

(4)Imports, Billions

(5)Net Exports,

Billions

(6)Aggregate

Expenditures, Private Open

Economy, Billions

$200 $240 $20 $30 -$10 $230

250 280 20 30 -10 270

300 320 20 30 -10 310

350 360 20 30 -10 350

400 400 20 30 -10 390

450 440 20 30 -10 430

500 480 20 30 -10 470

550 520 20 30 -10 510

Table 2: GDP and Net Exports, and Aggregate Expenditures of Private Open Economy

In the private closed economy, aggregate expenditures consist of consumption plus

investment (C + Ig). There is no government taxation, international trade which involves export

and import and so on. Thus, $400 billion is the equilibrium GDP.

However, in this case, we move from closed economy to an open economy that

incorporates exports and imports. Like consumption and investment, exports create domestic

production, income and employment for a country. Therefore, we include exports as a

component of aggregate expenditures. On the other hand, when an economy is open to

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international trade, it will spend part of its income on imports that is goods and services

produced abroad. To avoid overstating the value of domestic production, amount spent on

imported goods should be subtracted because such spending generates income abroad rather than

local economy. As a result, to measure correctly aggregate expenditures for domestic goods we

must subtract amount of import goods from exports. So, aggregate expenditures for private open

economy are C + Ig + Xn. Xn (net exports) equals with exports minus imports.

Previously, without international trade the equilibrium GDP is $400 billion. But in

private open economy, net exports can be positive and negative. Based on the above table, net

exports are negative $10 billion. Means in this hypothetical economy, importing are more $10

billion than exporting goods. The aggregate expenditures schedule shown as C + Ig in Table 1 is

overstate the expenditures on domestic output at each level of GDP. Sum of expenditure which

previously is $360 billion must be reduced by subtracting the $10 billion of net exports from C +

Ig. Thus, the new aggregate expenditures in private open economy are $350 billion. And

equilibrium GDP falls from $400 billion to $350 billion (refer to Table 2).

GDP = C + Ig + Xn.

GDP = $360 billion + (-10) = $350 billion

A change in net exports of $10 billion has produced a fivefold change in GDP. Means, other

things equal, negative net exports reduce aggregate expenditures and GDP below what they

would b in a closed economy. When imports exceed exports, the contractionary effect of the

larger amount of import outweighs the expansionary effect of the smaller amount of exports and

equilibrium real GDP decreases from $400 billion to $350 billion.

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We also measure equilibrium GDP by using graphical analysis as shown below:

Figure 2: Equilibrium GDP of Private Open Economy

240 280 320 360 400 440 480 520

GDP 200 250 300 350 400 450 500 550

(C + Ig) 240 280 320 360 400 440 480 520

(C + Ig+Xn) 230 270 310 350 390 430 470 510

$50

$150

$250

$350

$450

$550

Equilibrium GDP

Aggr

egat

e Ex

pend

iture

s (C+

Ig)

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c. Given the original $20 billion level of exports:

i. What would be net exports?

ii. Equilibrium GDP?

Imports were $10 billion greater at each level of GDP.

(1)Real

Domestic Output

(GDP = DI), Billions

(2)Aggregate

Expenditures, Private Closed

Economy, Billions

(3)Exports, Billions

(4)Imports, Billions

(5)Net Exports,

Billions

(6)Aggregate

Expenditures, Private Open

Economy, Billions

$200 $ 240 $20 $ 40 -$20 $210

250 280 20 40 -20 260

300 320 20 40 -20 300

350 360 20 40 -20 340

400 400 20 40 -20 380

450 440 20 40 -20 420

500 480 20 40 -20 460

550 520 20 40 -20 500

Table 3: GDP and Net Exports, and Aggregate Expenditures of Private Open Economy

In Private Open Economy, equilibrium GDP needs to incorporate exports and imports.

Exports create domestic production, income, and employment for a nation. Goods and services

produced for export are sent abroad; foreign spending on those goods and services increases

production and create jobs and incomes in the country. Therefore, export is a component of

aggregate expenditure.

Imports on the other hand, is a case whereby a country spends part of its income on

imports of goods and services that are produced abroad. This spending generates production and

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income abroad rather than at home. So, in order to avoid overstating domestic production value

and to correctly measure aggregate expenditures for domestic goods and services, we must

subtract expenditures on imports from total spending. Therefore, in private open economy,

aggregate expenditures are C + Ig + (X – M). The (X – M) or (Xn), refers to net exports.

Based from the above table, Net Exports are:

Net Exports = Exports – Imports

= $20 billion - $40 billion

= - $20 billion

In this case, negative $20 billion net exports will occur at each level of GDP. Net exports

are independent of GDP. Negative $20 billion of net exports means that the economy is

importing $20 billion more of goods than it is exporting and therefore it is overstates the

expenditures on domestic output at each level of GDP. We must reduce sum of expenditures in

this case $320 billion by the $20 billion net amount spent on imported goods and equilibrium

GDP falls from $350 billion to $300 billion.

Negative net exports will reduce aggregate expenditures and GDP below what they

would be in a closed economy. When imports exceed exports, the contractionary effect of the

larger amount of imports outweighs the expansionary effect of the smaller amount of exports and

equilibrium real GDP decreases.

Therefore, a decline in net exports (as we compare to the previous decline of negative

$10 billion of net exports) means that whenever exports is decreased or maintained and imports

is increased, aggregate expenditures will reduce and ultimately GDP of the nation will contract.

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In this case, exports are maintained but imports increased to $40 billion and that gives us again

negative $20 billion of net imports.

d. What is the multiplier in this example?

Multiplier is a ratio of a change in the equilibrium GDP to the change in investment or in

any other component of aggregate expenditures or aggregate demand; the number by which a

change in any such component must be multiplied to find the resulting change in the equilibrium

GDP. Multiplier will determine how much larger of a change will be whenever a change in

investment spending that changes output and income by more than the initial change in the

investment spending.

Multiplier effect will show us the effect on equilibrium GDP of a change in aggregate

expenditures or aggregate demand (caused by a change in the consumption schedule, investment,

government expenditures, or net exports). In this case, the initial change in spending refers to

changes in consumption that is unrelated to changes in income. An increase in initial spending

will create a multiple increase in GDP, while a decrease in spending will create a multiple

decrease in GDP. In this example, the initial change in Net Exports is decreasing at negative $20

billion. With a change of GDP at $50 billion, it gives multiple decreases in GDP.

Multiplier = Change in real GDPInitial change in spending

= 5020

= 2.5

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With a 2.5 multiplier, it tells us that the households use some of the extra income to

purchase additional goods from abroad (imports) and pay additional taxes. Buying imports and

paying taxes drains off some of the additional consumption spending (on domestic output)

created by the increases in income. That is why the multiplier kept on reducing from the previous

multiplier.

11. Explain graphically the determination of equilibrium GDP for a private economy

through the aggregate expenditures model. Now add government purchases (any amount

you choose) to your graph, showing its impact on equilibrium GDP. Finally, add taxation

(any amount of lump-sum tax that you choose) to your graph and show its effect on

equilibrium GDP. Looking at your graph determine whether equilibrium GDP has

increased , decreased or stayed the same given the size of the government purchases and

taxes that you selected.

Answer:

As we know in the private closed economy aggregate expenditures consist of

consumptions plus investment. Along with this, they both make up the aggregate expenditures

schedule for the private closed economy. However, in the open economy we can expect to

incorporate exports, imports, government purchases, taxes and so forth. The fundamental

assumption behind the aggregate expenditures model is that the prices in the economy are fixed

or we can say the aggregate expenditures model is an extreme version of a sticky price model. In

fact, it is a stuck-price model since prices cannot change at all.

If we refer to the question, it expects us to prepare a graph built with government

purchases and its impacts on equilibrium. By doing so, we will combine two sides that is non-

government and the public sector. This means adding government purchases and taxes to the

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model. For simplicity, we will assume that government purchases are independent of the level of

GDP and do not alter the consumption and investment schedules. Also government’s net tax

revenues – total tax revenues less “negative taxes” in the form of transfer payments - are derived

entirely from personal taxes. Ultimately, a fixed amount of taxes is collected regardless of the

level of GDP.

The Tabular example (Table 4) depicts the impact of the purchase by government on the

Equilibrium GDP. Actually, as for the private closed economy, the equilibrium GDP was $470

billion. The new items are imports, exports and government purchases. As shown in the column

7, the addition of government purchases to private was spending (C+ Ig+ Xn + G). By comparing

columns 1 and 7, we find that aggregate expenditures and real output are equal at a higher level

of GDP which is in row 12. Basically, increases in public spending, like increases in private

spending, shift the aggregate expenditures schedule upward and produce a higher equilibrium.

Here, we should note that, government spending is subject to the multiplier. A $30 billion

in government purchases has increased equilibrium GDP by $120 billion that is from $470

billion to $590billion. The multiplier in this sample is 4. However, that $30billion increase in

government spending is not financed by increased taxes.

Through graphical Analysis it can be noted that, we vertically add $30billion of

government purchases; G, to the level of private spending, C+ Ig + Xn. As we have mentioned,

that added amount of money raises the aggregate expenditure schedule to C+ Ig+ Xn+ G

resulting in a $120 billion increase in equilibrium GDP, from $470 billion to $590 billion.

Conversely, a decline in government purchases; G will lower the aggregate expenditure and

result in a multiplied decline in the equilibrium GDP.

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Table 4: The Impact of Government Purchases on Equilibrium GDP

Figures mentioned above are depicted below in the graphical analysis.

Figure 3: The Impact of Government Purchases on Equilibrium GDP

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Referring to taxation and Equilibrium GDP, one may know that the government not only spends

but also collects money in terms of taxes. If we suppose that tax is $ 40 billion. So that means

government obtains $40 billion of tax revenue at each level of GDP regardless of the level of

government purchases. In tabular example below, we find taxes in column 2 as well as column 3

for disposable (after-tax) income is lower than GDP by the $40billion amount of tax. As

households use disposable income both to consume and to save, tax lowers both of them. MPC

and MPS help us to comprehend how much consumption and saving will decline as a result of

the $40billion in taxes. As MPC is 0.75, the government tax collection of $40 billion

(=.75x$40billion) will reduce consumption by $ 30 billion and saving will decline by $10 billion

(=.25x$40billion).

Column 4 and 5 list the amounts of consumption and saving at each level of GDP. If we

notice, consumption is $30 billion and saving $10 billion lower than that in table mentioned

above. As it is stated, taxes reduce disposable income relative to GDP by the amount of taxes.

The Effect of taxes on Equilibrium GDP, we compute aggregate expenditures as it shown

in the table below, in column 9. A comparison of real output and aggregate expenditures in

columns 1 and 9 shows that the aggregate amounts produced and purchased are equal only at

$470 billion of GDP (row 6). The $40billion lump-sum tax has reduced equilibrium GDP by

$120 billion, from $59 0billion (Table 4, row 12) to $470 billion (Table 5, row 6).

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Table 5: Determination of Equilibrium levels of Employment, Output and Income in Private and public Sectors

Graphical Analysis mentioned below depicts what is the effect of the $40 billion increase

in taxes. The decline of $30 billion in consumption resulted for GDP fall from $590 billion to

470 billion. With no change in government expenditures, tax increases lower the aggregate

expenditures and reduce the equilibrium GDP. Looking at our graph we have determined that

equilibrium GDP has decreased given the size of the government taxes that we selected.

However, equilibrium GDP has increased because of the government purchases.

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Figure 4: Lump Sum Tax Effect on Equilibrium GDP

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Assignment 2