Macroeconomics (ECON 1211)
Lecturer: Dr B. M. Nowbutsing
Topic: Aggregate demand, fiscal policy, and
foreign trade
1. Some Key Terms
 Fiscal policy
– the government’s decisions about spending and taxes
 Stabilization policy
– government actions to try to keep output close to its
potential level
 Budget deficit
– the excess of government outlays over government
receipts
 National debt
– the stock of outstanding government debt
2.
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The Government and the
Circular Flow
Introduction of Government: Another Agent
AD = C + I + G (assumed that G is autonomous)
YD = Y – NT
If NT = tY (0<t<1); YD = Y (1- t)
C = f (YD), slope of consumption function is lower with taxes.
If autonomous consumption is zero and MPC = 0.8.
Then C = 0.8 YD = 0.8 (1 – t) Y
If tax rate = 0.2, then C = 0.64 Y
This implies MPCT = MPC (1 – t)
3.
Government in the IncomeExpenditure Model
Direct taxes
– affect the slope of the consumption function
– and hence the slope of the AD schedule.
Government expenditure affects the position of
the AD schedule
4.
A Higher Net Tax Rate
45o line
AD0 An increase in tax rate shift
the consumption function
which in turn shift the AD
curve
AD1
Y1
Y0
Income,
output
thus drecreasing
equilibrium
output from Y0 to Y1.
5.
Government Spending
45o
line
AD1
Assume tax rate is zero,
And government spending
Increases.
With a MPC of 0.9,
the multiplier is 10
AD0
A rise in government
expenditure G induce a
rise in output by ten times
that amount
Y0
Y1
Income,
output
6. The Balanced Budget Multiplier
• According to the balanced budget multiplier, an increase in G
accompanied by an increase in NT, has an expansionary effect
on output
• This is because AD increase by the full amount of an increase
in G but AD does not fall by the full amount in taxes as C falls
by less
• If G and T rises by 200, Then AD rises by 200, YD fall by 200
• Assuming MPC = 0.75, AD should fall by 150
• Ultimately, there is a net increase in AD of 50
7.
The Government Budget
The budget deficit equals total government spending
minus total tax revenue; BD = G -NT
If government spending is
independent of income
Balanced
but net taxes depend on
budget
income,
then the budget will be in
G
deficit at low levels of
income
but in surplus at high levels
Income, output
As noted, the balanced budget multiplier states that an
increase in government spending plus an equal increase
in taxes leads to higher equilibrium output.
8.
Investment, Saving and Budget
 Without government, planned savings equal to
planned investment
 With govt. in equilibrium, planned savings equal
planned injections, S + NT = G + I
 This implies S – I = G – NT
 Thus, private sector surplus (S > I) must be matched
by a government budget deficit (G > NT)
9.
Deficits and the Fiscal Stance
 The size of the budget deficit is not a good measure of the
government’s fiscal stance for the following reasons
 BD can change for reasons other than fiscal policy, e.g. If
I falls, Y falls as well as T
 For given level of T and G, BD is higher in recession than
in boom
 Official measures of the deficit treat the whole of the
nominal interest paid by the government on the national
debt as an item of G
10. Deficits and the Fiscal Stance
The structural budget shows what the budget
would have been if output had been at the fullemployment level.
The inflation-adjusted budget uses real not
nominal interest rates to calculate government
spending on debt interest.
11. Automatic Stabilizers &
Discretionary Fiscal Policy
 Automatic Stabilizers are mechanisms in the
economy that reduce the response of GNP to shocks
– for example, in a recession:
– payments of unemployment benefits rise
– and receipts from VAT and income tax fall
 Discretionary fiscal policy is decisions about tax rate
and levels of government spending
12. Limits on Active Fiscal Policy
Why can’t shocks to aggregate demand
immediately be offset by fiscal policy?
 Time lags: it takes time
– to diagnose the problem
– to take action
– for the multiplier process to operate
 Uncertainty
– the size of the multiplier is not known
– aggregate demand is always changing
 Induced effects on autonomous demand
– changes in fiscal policy may induce offsetting effects in other
components of aggregate demand
12. Limits on Active Fiscal Policy (2)
Why doesn’t the government expand fiscal
policy when unemployment is persistently high?
 The budget deficit
– concern about inflation if the budget deficit grows
 Maybe we’re at full employment!
– unemployment may be (at least partly) voluntary
13. Foreign Trade
and Income Determination
 Introducing exports (X) & imports (Z)
 It affects AD and multiplier
 TRADE BALANCE
– the value of net exports (X - Z)
 TRADE DEFICIT
– when imports exceed exports
 TRADE SURPLUS
– when exports exceed imports
 Equilibrium is now where
– Y=C+I+G+X–Z
14. Exports, Imports and the Trade Balance
Assume that exports
are independent of
income,
but that imports increase
with income
Imports
Exports
Y*
Income
At relatively low income,
exports exceed imports – there is a trade surplus.
At higher income levels, there is a trade deficit.
There is trade balance at income Y*, but there is no
guarantee that this corresponds to full employment.
15. Foreign Trade and the Multiplier
 K = 1 / 1 – (MPCT – MPZ) = 1 / 1 – MPCT + MPZ)
 The marginal propensity to import
– is the fraction of additional income that domestic residents
wish to spend on additional imports.
 The effect of foreign trade is to reduce the size of the
multiplier
– the higher the value of the marginal propensity to import,
the lower the value of the multiplier.
16. Investment, Savings, the Budget
Deficit and Trade Deficit
 In equilibrium total injections = total withdrawals
 S + NT + Z = I + G + X
 S – I = (G – NT) + (X – Z)
 Thus, S – I = Budget deficit/Surplus + Trade
Deficit/Surplus