Government and Trade

Government and Trade Introduction

• The lecture relaxes simplifying assumptions in the model and adds government and international trade
• Addition of government and international trade will add complexities but a richer understanding of macroeconomics

Government Purchases

• G indicates desired government purchases in the model
• Government spending decisions rely on economic and political factors
• Desired government spending is assumed to be entirely autonomous
• Government chooses desired spending level separate from national income/GDP (Y)
• Desired spending level is the same approach used with desired investment spending

Government Revenue

• Government purchases are financed through taxation or borrowing
• Borrowing cannot be used to pay for spending indefinitely
• Borrowing is costly
• Interest payments can become unsustainable

Taxes

• Payment for government purchases ultimately comes from taxation
• Governments tax both households and firms
• Taxes are usually set as a proportion of income in most countries
• Tax revenue is given by T = tY, T = total tax collected, t = tax rate, Y = national income
• Government uses government transfers to transfer money to households
• Transfers can be thought of as a negative tax
• Transfers are less than tax collected
• T is referred to as net tax revenue and t as net tax rate

Canadian Flat Tax Rates

• Canada has a progressive tax system where tax rates rise as income rises
• Tax rates only apply to marginal income earned
• Provinces charge income tax
• Model assumes a flat tax rate, the same tax rate for everyone

Budget Balance

• The budget balance is the difference between total government revenue and total government expenditure T-G
• Budget surplus occurs when net tax revenue exceeds purchases
• Budget deficit occurs when purchases exceed net tax revenue
• Balanced budget occurs when both are equal

Deficit vs Debt

• Persistent budget deficits have long-run consequences and lead to increased public debt
• Deficit is a one-year difference between, government takes in and spends
• Debt is the sum of money a government owes at a particular point in time and reflects past deficits/surpluses
• Canada's federal debt current:
• $692 billion (Dec 2019)
• $949 billion (Dec 2020)
• $1,186 billion (Dec 2021)
• $1,197 billion (Dec 2022)
• $1,248 billion (Jan 2024)
• Public debt may crowd out investment spending, which reduces long-run economic growth
• High debt levels can lead to government default, further economic and financial turmoil
• High interest rates make it costly to service the debt
• The interest payment on the national debt was 26.4% of the federal budget in 1999/2000

Debt and Printing money

• Printing money to run a deficit leads to inflation
• Zimbabwe in 2008, Germany in the early 1920s, and Latin America are case studies

Debt Level

• Debt-to-GDP ratio is a widely used measure of fiscal health
• Formula is Federal Government Debt / GDP
• The debt can remain stable or fall if the economy is growing and deficits are small
• 31.4% of Canada's GDP was federal debt in 2008
• 38.3% of Canada's GDP was federal debt in 2012
• 32.5% of Canada's GDP was federal debt in 2014 even though the debt has grown

Debt and Austerity

• Canada's federal debt is $29,785 per person
• Ontario's debt is $434 billion or $28,061 per person
• They stop lending or demand higher interest rates if people believe the government will not pay off its debt
• Austerity measures by a government can demonstrate it is capable of paying back debt by lowering spending and raising taxes

Levels of Government

• Three levels of government exist: federal, provincial, and municipal
• All three make purchases and impose taxes
• The model accounts for all three levels by grouping all taxes and spending together

International Trade

• International trade is important to Canada's economy
• About 1/3 of goods and services produced in Canada are sold to other countries
• A similar amount of goods and services are imported into the country
• Canada is a trading nation

Exports and Imports

• Exports (X) are goods produced domestically but sold to other countries, amount depends on factors outside of the country
• Decisions to purchase Canadian exports depend on household and firm decisions by people in other countries
• These decisions are independent of Canada's national income in the model
• Exports are an autonomous expenditure and will not depend on Canada's actual national income
• The approach is the same as that of government purchases and investment spending
• Imports (IM) are goods produced internationally but purchased domestically
• Amount depends on decisions made by domestic households and firms
• Consumption goods have imported components and cause a strong link between consumption demand and imports
• Import demand and income have a link
• The marginal propensity to import (m) is the increase in import expenditures induced by a $1 increase in national income
• Formula is IM = mY

Net Exports, Slopes, and Trade

• Net exports (NX) are simply exports minus imports, NX = X – mY
• Slope of the import function equals the marginal propensity to import
• Slope of the net export function equals the negative of the marginal propensity to import
• Trade surplus occurs when exports are greater than imports
• Trade deficit: exports are less than imports
• Balanced trade: both equal, net exports are zero
• National income will be balanced at a specific level for trade
• Trade surplus: income is below
• Trade deficit: income is above

Shifts

• Foreign countries become richer, either through more income or more wealth leading to changes in national economies
• These countries wish to import more goods, increasing exports
• Export function shift upwards parallel to the original line
• Net export function will shift upwards

Relative Prices

• As the price of goods increases in Canada relative to the price of goods in the US...
• Foreigners will see Canadian goods as more expensive
• Exports will fall
• Assume an elasticity of demand greater than 1
• Reduction in demand will more than offset, a net fall in the value of exports
• Canadian consumer will substitute imports for domestic goods

Prices and Canadian Currency

• Marginal propensity to import will increase, causing import line to rotate upwards
• The net export line will shift down, and become steeper
• Rise in domestic prices will lead to a fall in net exports
• Fall in domestic prices will lead to a rise in net exports
• Change in relative prices caused by exchange rate changes between countries
• Exchange rate changes cost more or less to buy domestic curency
• Canadian dollar depreciates: price of Canadian goods becomes cheaper, and net exports rise
• Canadian dollar appreciates: price of Canadian goods become expensive, and net exports fall

Exchange Rate Example

• During the 1990s, the Canadian dollar depreciated to the American dollar
• In October 1991 the exchange rate was 1.13
• By January 2002 it had depreciated to 1.60
• By 2002, exchange rate prices made purchasing tires in Ontario much less expensive
• American firms purchased many more goods from Canada

Aggregate Expenditure

• Integrate model with new components: AE = C + I + G + X − IM
• Taxes impact the disposable income of households, so it enters through consumption
• C = a + MPC × (YD) where:
• YD = Y – T, YD = Y – tY, YD = (1 – t) Y
• C = a + MPC × (1 – t) Y

National Income and Propensity

• Marginal propensity to consume out of national income (0.72) is less than the marginal propensity out of disposable income (0.9)
• The slope of the aggregate expenditure function is 0.6
• For every additional dollar of national income, aggregate expenditure increases by 60 cents
• This is less than 90 cents from marginal propensity to consume
• Leakage to tax and imports

Equilibrium

• This economy is in equilibrium when actual national income is 2500
• If desired aggregate expenditure and actual national income are unequal, the adjustment process still occurs as previously described
• Accumulation/depletion of inventories will induce firms to change behaviour, and resulting change to desired aggregate expenditure

Surplus and Deficits

• Government is running a budget deficit of 50 billion
• Taxes are 500 (0.2 × 2500) and spending is 550
• The country is running a trade deficit of 150 billion
• Exports are 150 and imports are 300 (0.12 × 2500)

Multiplier

• The simple multiplier will be smaller with taxes and imports
• Leakages out of the system imply the multiplication process is not as large and does not last long
• Delta Y/ Delta A = 1 / 1 -z if z is marginal propensity to spend out of national income and the simple multiplier is still
• Marginal propensity to spend is no longer equal to the marginal propensity to consume and is now z = MPC (1 – t) – m
• The larger the net tax rate and the marginal propensity to import, the smaller the multiplier will be

Canada's Multiplier and Estimates

• Canada's MPC has been increasing with a recent estimate at 0.96
• Canada's progressive tax structure makes the net tax rate hard to pin down, 0.25 is a reasonable approximation
• Imports roughly 35% of Canada's GDP, and a good marginal propensity to import is 0.35

Net Exports and Multipliers

• GDP will increase if net exports increase
• If exports increase by 1 billion dollars, GDP will increase by 1 billion multiplied by the value of the simple multiplier
• The AE curve will shift up by the size of the change in autonomous spending, GDP will increase by this distance multiplied by the simple multiplier
• The AE curve shifts down due to a reduction in exports
• The aggregate expenditure curve rotates, not shifts when changes to imports occur
• The marginal propensity to import decreases: Consumers more likely to buy domestic goods The AE curve will rotate upwards GDP will increase The multiplier will increase in size Aggregate expenditure curve to rotate downwards: An increase in the marginal propensity to import GDP decreases Multiplier will decrease

Fiscal Policy and Equilibrium

• Need to consider potential GDP and full employment
• The government may wish to take action to fix operating the economy away from potential GDP
• Stabilization policies is the action to remove the economy from the operation
• Fiscal policy attempts to remove the economy from the operation with government taxation and spending efforts

Government Spending

• With Fiscal Poilcy, the government increases its spending by 1 billion dollars
• With Fiscal Policy, the AE curve will shift up by the size of the change in autonomous spending (1 billion dollars)
• With Fiscal Policy, GDP will increase by this distance multiplied by the simple multiplier
• The AE curve shifts down during reduction in government spending
• If the economy is operating below its potential GDP by 5 billion dollars, and the simple multiplier is 1.25, the government could increase spending by 4 billion dollars to bring the economy back to its potential level

Taxation

• More complicated by a change in the net tax rate
• Aggregate expenditure curve will rotate if the net tax rates change
• If net tax rate decreases, consumers have more disposable income, spend has increased
• The AE curve rotates upwards, GDP increases, and multiplier increases
• An increase in the net tax rate causes the AE curve to rotate downwards with a GDP decrease, and multiplier decrease

General Multiplier Use

• Cannot use the simple multiplier to calculate the effect on the economy
• The average expenditure curve receives a change to the slope during change
• Simple multiplier can do the average expenditure curve change and change autonomous spending
• Multiplier is only useful in certain instances or can involve algebra

Demand-Determined Output Model

• Our simple model is demand-determined
• Firms will increase/decrease in production with no effect on price
• National income is determined entirely in this model by how much is demanded
• This occurs when:
• an economy has unemployed factors of production (factors can be brought into production at low cost).
• firms are price setters (they tend to adjust production before changing prices).
• Next step is to relax the fixed price assumption

Summary

• Government's spending and taxation abilities are a starting examination point
• After government, the model expands with exports and imports is added
• Model expansions add to reduction on multiplier by adding the two elements
• Macroeconomy has influences from various areas: changes to exports, imports, government spending, and taxation