The document discusses GDP in an open economy with government. It covers how government spending, taxes, and the budget surplus/deficit affect aggregate demand. A budget surplus occurs when tax revenues exceed spending, while a deficit is when spending exceeds revenues. The net export function is negatively sloped, as imports increase with national income. Equilibrium GDP occurs when aggregate demand equals output. The size of the multiplier is affected by tax rates and import propensities. An increase in government spending shifts the aggregate demand curve up, increasing equilibrium GDP.
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GDP in an open economy with govt
1. GDP in an Open Economy with
Government
Chapter 17
2. 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.
3. 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.
4. 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 increase disposable income.
5. 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.
6. 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.
• Government spending and tax rates are
exogenous factors while tax revenue is an
endogenous factor.
7. 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].
• Shifts in the net export function are due to foreign
GDP and relative international prices. Changes in
relative international prices might be due to
national differences in inflation rates, exchange
rate variation.
8. 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
9. 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.
GDP IN OPEN ECONOMY WITH
GOVERNMENT
13. 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%.
15. 1000 2000 3000
X = 540
540
Imports
and
Exports
[£m]
Export and Import Functions
IM = 0.25Y
0
Real National Income [GDP] [£m]
[i]. Export and Import Functions
16. Export and Import Functions
1000 2000 3000
Net
Exports
[£m]
Real National Income [GDP]
[£m]
[ii]. Net Export Function
(X - IM) = 540 - 0.25Y
0
540
2160
17. 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
19. AE
1060
1000 2000 3000 4000 5000
Real National Income [GDP] [£m]
An Aggregate Spending Curve and Equilibrium GDP
Desired
Expenditure
[£m]
0
450
AE = Y
E0
2000
20. 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.
21. AE0
Real National Income [GDP] [£m]
0
AE = Y
45o
AE1
Y0 Y0
Desired
Expenditure
[£m]
The Effect of Change in Government Spending
22. 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.
The Effect of Change in Government Spending