Some Key Terms

1. Macroeconomics (ECON 1211)Lecturer: Dr B. M. Nowbutsing Topic: Aggregate demand, fiscal policy, and foreign trade

2. 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

3. 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)

4. 3. Government in the Income-Expenditure 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

5. 45o line AD0 Aggregate demand AD1 Y1 Y0 Income, output 4.A Higher Net Tax Rate An increase in tax rate shift the consumption function which in turn shift the AD curve thus drecreasing equilibrium output from Y0 to Y1.

6. 45o line AD1 Aggregate demand AD0 Y0 Y1 Income, output 5. Government Spending Assume tax rate is zero, And government spending Increases. With a MPC of 0.9, the multiplier is 10 A rise in government expenditure G induce a rise in output by ten times that amount

7. 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

8. If government spending is independent of income but net taxes depend on income, Balanced budget then the budget will be in deficit at low levels of income G but in surplus at high levels As noted, the balanced budget multiplier states that an increase in government spending plus an equal increase in taxes leads to higher equilibrium output. 7. The Government Budget The budget deficit equals total government spending minus total tax revenue; BD = G -NT G, NT Income, output

9. 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)

10. 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

11. 10. Deficits and the Fiscal Stance • The structural budget shows what the budget would have been if output had been at the full-employment level. • The inflation-adjusted budget uses real not nominal interest rates to calculate government spending on debt interest.

12. 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

13. 12. Limits on Active 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 Why can’t shocks to aggregate demand immediately be offset by fiscal policy?

14. 12. Limits on Active Fiscal Policy (2) • The budget deficit • concern about inflation if the budget deficit grows • Maybe we’re at full employment! • unemployment may be (at least partly) voluntary Why doesn’t the government expand fiscal policy when unemployment is persistently high?

15. 13. Foreign Tradeand 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

16. Assume that exports are independent of income, Imports but that imports increase with income Exports Y* 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. 14. Exports, Imports and the Trade Balance X, Z Income

17. 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.

18. 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