GDP in an Open Economy with Government Chapter 17

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GDP in an Open Economy with GovernmentChapter 17

• LIPSEY CHRYSTAL
• ECONOMICS 12e

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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The budget surplus function (million)
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Budget Surplus Function
Price Saving m
0
1000
0
2000
3000
4000
5000
6000
National Income GDPm
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Budget Surplus Function
Price Saving m
T - G
0
-170
1000
2000
3000
4000
5000
6000
0
National Income GDPm
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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.

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The net export function (million)
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Export and Import Functions
i. Export and Import Functions
IM 0.25Y
Imports and Exports m
540
X 540
0
1000
2000
3000
Real National Income GDP m
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Export and Import Functions
ii. Net Export Function

540
Net Exports m
2160
0
(X - IM) 540 - 0.25Y
1000
2000
3000
Real National Income GDP m
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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

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The aggregate spending function (million)
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An Aggregate Spending Curve and Equilibrium GDP
AE
Desired Expenditure m
2000
1060
1000
2000
3000
4000
5000
0
Real National Income GDP m
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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.

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The Effect of Change in Government Spending
AE Y
AE1
AE0
Desired Expenditure m
45o
0
Y0
Y0
Real National Income GDP m
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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.

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UK borrowing as a of GDP (1972 to 2005)
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UK fiscal stance as a of UK GDP
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Exports and imports as a of UK GDP