GDP in an Open Economy with
Government
Chapter 17
LIPSEY & CHRYSTAL
ECONOMICS 12e
Learning Outcomes
• Government consumption contributes to
aggregate spending in the same way as any other
component of autonomous spending.
• Taxes affect private consumption via their effect
on disposable income.
• Net exports are negatively related to domestic
income.
Learning Outcomes
• A necessary condition for GDP to be in
equilibrium is that desired aggregate domestic
spending is equal to national output.
• The size of the multiplier is negatively related to
the income tax rate and the marginal propensity
to import.
GDP IN OPEN ECONOMY WITH GOVERNMENT
Government Spending and Taxes
• Government consumption is part of autonomous
aggregate spending.
• Taxes minus transfer payments are called net taxes and
affect aggregate spending indirectly.
• Taxes reduce disposable income, whereas transfers
increased disposable income.
GDP IN OPEN ECONOMY WITH GOVERNMENT
Government Spending and Taxes
• Disposable income, in turn, determines desired private
consumption, according to the consumption function.
• The budget balance is defined as government revenues
minus government spending.
• When this difference is positive, the budget is in surplus;
when it is negative, the budget is in deficit.
GDP IN OPEN ECONOMY WITH GOVERNMENT
• When the budget is in surplus, there is positive public
saving, because the government is spending less on the
national product than the amount of income that it is
withdrawing from the circular flow of income and
spending.
• When the government budget is in deficit, public saving is
negative.
GDP IN OPEN ECONOMY WITH GOVERNMENT
Net Exports
• Since desired imports increase as national income
increases, desired net exports decrease as national
income [GDP] increases, other things being equal.
• Hence the net export function is negatively sloped [net
exports fall as GDP rises].
GDP IN OPEN ECONOMY WITH GOVERNMENT
Equilibrium GDP
• GDP is in equilibrium when desired aggregate
expenditure, C + I + G [X - IM], equals national output.
• The sum of investment and net exports is called national
asset formation because investment is the increase in
the domestic capital stock and net exports result in
investment in foreign assets.
• At the equilibrium level of GDP, desired national saving,
S + T - G, is equal to national asset formation, I + X - IM.
GDP IN OPEN ECONOMY WITH GOVERNMENT
Changes in Aggregate Spending
• The size of the multiplier is negatively related to the
income tax rate.
• A shift in exogenous spending changes GDP by the value
of the shift times the simple multiplier.
• A shift in aggregate spending can be brought about by
fiscal policy changes or by a change in official interest
rate.
The budget surplus function
(£million)
Budget Surplus Function
0
0
1000
2000
3000
4000
National Income [GDP][£m]
5000
6000
Budget Surplus Function
T-G
0
-170
0
1000
2000
3000
4000
National Income [GDP][£m]
5000
6000
The budget surplus function
• The budget surplus is negative at low levels of GDP
and becomes positive at high levels of GDP.
• Tax revenue increases with GDP while government
spending is assumed not to vary with GDP.
• The slope of the budget surplus function is 0.1 when
the income tax rate is assumed to be 10%.
The net export function (£million)
Export and Import Functions
Imports and Exports [£m]
[i]. Export and Import Functions
IM = 0.25Y
540
X = 540
0
1000
2000
3000
Real National Income [GDP] [£m]
Net Exports [£m]
Export and Import Functions
[ii]. Net Export Function
540
2160
0
(X - IM) = 540 - 0.25Y
1000
2000
3000
Real National Income [GDP]
[£m]
The net export function
• Net exports, defined as exports minus imports, are
negatively related to GDP.
• Exports are assumed to be constant at £540 million
while imports are 0.25 of National income.
• So the net export function is given by: 540-0.25Y
The aggregate spending function
(£million)
Desired Expenditure [£m]
An Aggregate Spending Curve and Equilibrium GDP
AE = Y
AE
E0
2000
1060
450
0
1000
2000
3000
4000
5000
Real National Income [GDP] [£m]
Aggregate expenditure
• The aggregate expenditure function is the sum of
desired consumption, investment, government
spending, and net exports.
• Equilibrium GDP occurs at E0 where the desired
aggregate expenditure line intersects the 450 line.
• Only when GDP is £2000 will desired spending equal
national output.
The Effect of Change in Government Spending
AE = Y
AE1
Desired Expenditure [£m]
AE0
45o
0
Y0
Y0
Real National Income [GDP] [£m]
The Effect of Change in Government Spending
• A change in government spending changes GDP by
shifting the AE line parallel to its initial position.
• The initial level of AE is at AE0 and GDP is Y0 with
desired expenditures at e0.
• An increase in government spending raises AE to
AE1.
• GDP rises to Y1 at which level desired expenditures
are e1.
• The increase in GDP from Y0 to Y1 is equal to the
increase in government spending times the multiplier.
UK borrowing as a % of GDP
(1972 to 2005)
UK fiscal stance as a % of UK GDP
Exports and imports as a % of UK
GDP