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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…
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.1 4
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.1 5
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.2 6
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.2 7
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.3 8
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.3 9
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.3 10
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.3 11
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?
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.3 12
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.3 13
The Effect of Taxes and Government Spending
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.3 14
The Effect of Taxes and Government Spending
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.3 15
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
• Multiplier = 3.57
• Ye = 535.7
416
405.7
380
C I
50
50
50
G
54649555550
535.7482.153.6535.7
51045050
AEYDNTY
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.3 16
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.3 17
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)
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.3 18
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.4 19
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)
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.4 20
G, NTG, NT
NT = tY = 0.2YNT = tY = 0.2Y
G (assumed G (assumed constant)constant)
15001500600600
DeficitDeficit {{
A Government Budget
200200SurplusBalanced
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.4 21
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.4 22
+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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.4 23
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.5 24
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.5 25
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.5 26
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.5 27
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.5 28
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.6 29
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.6 30
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.7 31
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.7 32
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.
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.8 33
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.8 34
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.8 35
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.8 36
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
• Multiplier = 3.125
• Ye = 469
469339398.670.4
380
292
224
51042575
42234060
35425545
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.8 37
(b) X, Z, and NX• X = 100• Z = 0.2Y• NX = 100 – 0.2Y 100600
100500
100400
NXZX Y
-20120100600
0100100500
2080100400
NXZX Y
Equilibrium Income in the Open Economy
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.8 38
(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
Equilibrium Income in the Open Economy
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.8 39
(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
Equilibrium Income in the Open Economy
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.8 40
Equilibrium Income in the Open Economy
1005080500
1005080481
1005080400
1005080300
AEZXGICYDNTY
(e) Numerical Values
490100100508036042575500
48196100508034740972481
44280100508029234060400
39460100508022425554300
AEZXGICYDNTY
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.8 41
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.8 42
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7.9 43
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7 44
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
©2007 McGraw-Hill Ryerson Ltd. Chapter 7 45
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