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Adding the Government and Open Economy

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## Adding the Government and Open Economy

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**Adding the Government and Open Economy**Alomar_111_15**Government Purchases**• We now add the government (G and T) and foreign sector (Xn) • Now, personal income ≠ disposable income • GDP = NI = PI • T is fixed. • G is fixed= $20 of goods and services. Alomar_111_15**Exports (X) and Imports (M)**• Open economy: international trade • Net exports (Xn) = X – M • X > M: increase aggregate expenditure and Y*. • X < M: reduces aggregate expenditure and Y*. Alomar_111_15**Adding G and Xn will shift aggregate expenditure schedule**upward by their amount. (X > M) • We will assume that demand for (X) is constant. Thus: X is constant. • We will assume that demand for (M) is independent of GDP. Thus: M is constant. Alomar_111_15**What are the equilibrium conditions?**• GDP = C + I + G + XnGDP = Aggregate expenditure • S + M + T = I + G + XLeakages = Injections Alomar_111_15**Finding the Equilibrium**• 1) GDP = C + I + G + X – M 490 = 450 + 20 + 20 + 10 – 10 √ • 2) S + M + T = I + G + X 20 + 10 + 20 = 20 + 20 + 10 √ Alomar_111_15**The Multipliers**• Government multiplier: ∆GDP = (1/MPS) x ∆G • The change in GDP as G changes.Since (MPC=75%), then the multiplier = 4 • A $100 increase in G leads to a $400 increase in GDP. • A $100 decrease in G leads to a $400 decrease in GDP. Alomar_111_15**The effect of taxes**• DI = C + S • A tax will reduce DI, then C and S decline • ∆C = T x MPC • ∆S = T x MPS • ∆GDP = (-MPC/MPS) ∆T • If T increased by ($100), and (MPC=75%), then ∆GDP = -300 Alomar_111_15**Balanced-Budget Multiplier**• If ∆G=∆T=20, then ∆Y=20 • This is the case since the (BBM) = 1 • ∆GDP = ∆G (1/MPS) + ∆T(-MPC/MPS) • Since ∆ G = ∆T • ∆ GDP = ∆G ( 1 - MPC ) MPS MPS • ∆ GDP = ∆ G Alomar_111_15**An increase in G affects AE more powerfully than the same**increase in T. • G has a direct effect on AE while T affect AE indirectly. Alomar_111_15**a. Recessionary Gap**AE AE The Gap YF GDP Alomar_111_15**Is the amount of the required AE to achieve YF.**• This depresses the economy. • Need to increase the level of AE (through the components of the GDP) Alomar_111_15**b. Inflationary Gap**AE AE Inflationary Gap YF GDP Alomar_111_15**The amount of the excess AE that is required to achieve YF.**• This inflate (pull-up) prices in the economy. • Need to reduce the level of AE (through the components of the GDP) Alomar_111_15