Adding Government and Trade to the Simple Macro Model (Chapter 7 Study Notes)

Chapter 7: Adding Government and Trade to the Simple Macro Model

Chapter Outline and Learning Objectives

This chapter expands the basic macroeconomic model by incorporating the roles of government and foreign trade. Students will learn how government purchases, tax revenues, exports, and imports affect national income, and how equilibrium is determined in an open economy with government intervention.

• Introducing Government: Understand how government purchases and tax revenues relate to national income.

• Introducing Foreign Trade: Describe how exports and imports relate to national income.

• Equilibrium National Income: Determine equilibrium in the macro model with government and foreign trade.

• Changes in Equilibrium National Income: Explain how government and foreign trade affect the multiplier and equilibrium income.

• Demand-Determined Output: Understand why output is demand determined in the simple macro model.

Introducing Government

Fiscal Policy

Fiscal policy refers to the use of government tax and spending policies to achieve economic objectives such as growth, stability, and redistribution.

• Government Purchases (G): These are part of aggregate desired expenditures and are typically considered autonomous (not directly dependent on national income).

• Autonomous Expenditure: Expenditures that do not vary with the level of national income.

Net Tax Revenues

Net tax revenue (T) is the total tax revenue minus transfer payments. It is calculated as:

• Formula: $T = tY$

• Y: Gross Domestic Product (GDP) or national income

• t: Net tax rate (the additional tax revenue generated when national income rises by $1)

There is a distinction between national income (Y) and disposable income (Y_D), which is the amount households receive after taxes and transfers:

• Formula: $Y_D = Y - T = Y - tY = (1 - t)Y$

The Budget Balance

The budget balance (BB) is the difference between total government revenue and total government expenditure:

• Formula: $BB = T - G$

• Budget Surplus: When net revenues exceed purchases ($T > G$)

• Budget Deficit: When purchases exceed net revenues ($G > T$)

• Balanced Budget: When revenues equal expenditures ($T = G$)

Provincial and Municipal Governments

All levels of government (federal, provincial, municipal) are included when measuring the government's contribution to aggregate expenditure (AE).

• Government enters the AE function directly through its purchases of goods and services ($G$).

• Government enters the AE function indirectly through the effect of tax revenue and transfer payments on national income, disposable income, and consumption.

Introducing Foreign Trade

Net Exports

Net exports (NX) represent the difference between exports and imports. Exports ($X$) depend on foreign demand and are typically considered autonomous. Imports ($M$) depend on domestic national income.

• Marginal Propensity to Import (m): The increase in imports induced by a $1 increase in national income.

• Formula: $M = mY$

• Net Exports Formula: $NX = X - M = X - mY$

• Net exports are negatively related to national income because imports rise as income rises, while exports are autonomous.

Key Terms and Definitions

• Autonomous Expenditure: Spending that does not depend on the level of national income.

• Marginal Propensity to Import (m): The fraction of additional income spent on imports.

• Net Exports (NX): The value of exports minus the value of imports.

Example

• If $X = 100$ (autonomous exports) and $m = 0.2$, then for $Y = 500$, $M = 0.2 imes 500 = 100$, so $NX = 100 - 100 = 0$.

Summary Table: Government and Trade in the Macro Model

Concept	Definition	Formula
Net Tax Revenue (T)	Total tax revenue minus transfer payments	$T = tY$
Disposable Income ($Y_D$)	Income after taxes and transfers	$Y_D = (1 - t)Y$
Budget Balance (BB)	Difference between government revenue and expenditure	$BB = T - G$
Net Exports (NX)	Exports minus imports	$NX = X - mY$
Marginal Propensity to Import (m)	Increase in imports per $1 increase in income	$M = mY$

Additional info: These notes are based on the Canadian context, but the principles apply broadly to open economies with government intervention. The chapter continues with equilibrium analysis and the multiplier, which are covered in subsequent sections.