Learning MBA Master Degree

TEACHER: In this module we will start to relax some of the assumptions we made before when we designed a simple model of GDP.

You surely recall that the Simplified Model of GDP (also called the Simple Keynesian Model) assumed an economy with no government, no foreign trade, a fixed price level, and excess capacity.

You will also remember that in the Simplified Model we explained that:

GDP = aggregate domestic product = aggregate domestic income.

We now will make the model more realistic, and for that purpose in this Module we will relax the assumption that there are neither government nor foreign trade.

STUDENT: What will this expanded model allow us to do?

TEACHER: The following:

1. Adding the government sector allows us to study fiscal policy.
2. Adding the foreign trade sector allows us to study the effect of imports and exports on the GDP equilibrium level.

STUDENT: Let me guess: in the following module you will relax the other two assumptions, a fixed price level and excess capacity.

TEACHER: Right. But some key elements will remain unchanged. Let me tell you which:

Unchanged Key Elements

The following key elements of the theory remain unchanged:

1. Aggregate desired expenditure can be divided into autonomous and induced, The latter depends on (is a function of) the level of national income.
2. The equilibrium level of GDP is the level at which the aggregate desired expenditure is equal to output.
3. The Simple Multiplier is the measure of the changes in the equilibrium GDP caused by a unit change in autonomous domestic expenditure. It is called "simple" because it is assumed that the price level does not change.


Government expenditure and gross domestic product

In the simple Keynesian model we built in Module 2, we assumed that government spending was not going to affect the consumption function or the level of intended investment. That is, in our very simple model government spending did not change the intended (desired) propensity to consume or invest at each level of income.

STUDENT: Which of course was not realistic.

TEACHER: True, but as I said before, a theory must be developed in steps, and explaining it in this way helps in understanding it.

Now suppose that the government purchases say $100 billion worth of goods and services, independently of the level of the GDP (an autonomous expenditure, independent of the level of national income). We must distinguish here between purchases and "transfer payments", the latter being payments made by the government without receiving a good or service in return, like unemployment insurance, welfare payments, pensions, etc. There is no doubt that adding those $100 billion to the private expenditures on consumption and investment results in a higher level of desired spending.

Remember: No foreign sector here yet, so at this point we can say:

1. Total Intended Spending (IS) = Consumption IS + Investment IS + Government IS. Remember also: The equilibrium level of GDP is the level at which total intended (desired) spending equals GDP.
2. The formula in point 1 shows that as we add Government Intended Spending, the equilibrium value of the GDP increases.

Let me show you a figure:
In Figure B203_1, on the horizontal axis we have the value of the GDP. On the vertical axis we have the value of Aggregate Desired Spending (ADS).

The 45° line is the value of Equilibrium GDP.

STUDENT: Why is it that when the value of equilibrium GDP is plotted on a graphic, it always results a 45° line?

TEACHER: Because we defined the equilibrium level as the point where GDP equals aggregate desired demand. This means that each point of the line is a point where GDP = ADS

In line C we have plotted the Consumption Function: Intended Consumption at each level of GDP.

When Intended Investment is added to Consumption we can plot line C + I., and as we add Government Intended Expenditure, the line is C+ I + G.

Summing up: The C + I + G line is Aggregate Desired Spending (ADS); the Equilibrium Level of GDP is where ADS = GDP. This means that the equilibrium level in the graphic is where line C + I + G intersects the 45° line.

Effect of Increased Government Spending

STUDENT: OK, I see that government spending increases the equilibrium level of GDP. What happens if government expenditure fluctuates?

TEACHER: We will establish what happens to the equilibrium level of GDP if government expenditure changes. To illustrate this situation graphically, let me show you.... well, a graph, what else!
In Figure B203_2 we see the C + I + G line representing the Aggregate Desired Spending (ADS) at a given moment.

If government expenditure increases, the line "shifts to the left" as represented by line C + I + G1; it now intersects with the 45° line at a higher level of GDP, the new higher equilibrium level of GDP.

Obvious conclusion: more government spending increases the equilibrium level of GDP.

The contrary is naturally true also: less government spending diminishes the equilibrium level of GDP.

This we can see represented by line C + I + G2 which is the original line "shifted to the right" that now intersects with the 45° equilibrium line at a lower level of GDP.

Multiplier effect of Government Spending

The multiplier effect of Government Expenditure is the same as the effect of consumption or investment expenditure.

Effect of taxes on GDP

We will speak of taxes as being net of transfer payments, since the latter are not expenditures by the government but a transfer of purchasing power from tax payers to people who receive the payments. Thus transfer payments will be reflected in the disposable income and affect desired consumption indirectly.

Let’s assume for simplicity that all tax revenues come from personal taxes, and that the average tax rate is 20% (remember, net of transfer payments). The effect of such a tax is a reduction of 20% in aggregate disposable income DI.

Without taxes, DI was equal to GDP; with the 20% tax, DI now equals 80% of GDP.

The reduction of DI affects the Consumption Function because people must spend less at each level of equilibrium GDP than before.

Here is a graphic representation:
We can see in Picture B203_3 that the tax rate has changed the slope of the consumption function; it has pivoted and the slope is less steep. It now intersects the 45° equilibrium line at a lower level of GDP. The effect of a tax is then a reduction of the equilibrium level of GDP.

We can also easily conclude that the higher the increase in the tax rate the larger the decrease in the equilibrium level of GDP will be. We can also see in the picture that the decrease will not be proportional: there was not a parallel shift to the right of the line, but a non-parallel change of slope.

This is because the higher the income tax rate, the smaller the simple multiplier (and vice-versa, of course).

The Budget Balance

The budget balance is the difference between total government revenue and total government expenditure. When revenues exceed expenditure, the government is running a budget surplus. When expenditures exceed revenues, the government is running a budget deficit. When expenditures are equal to revenues, the government has a balanced budget.

Government spending is part of the "autonomous" aggregate expenditure. This is so because government spending does not depend on the level of personal income.

Fiscal Policy

A very large part of government expenditure has no relationship with fiscal policy. The amount of money spent on bureaucracy, health services, road maintenance, etc. is to a high degree fixed.

But the government can marginally increase or diminish expenditure, and make changes in the tax rate, pursuing a macroeconomic goal: avoiding undesirable booms and recessions.

We have already seen that if the government increases expenditure, the aggregate desired expenditure curve shifts to the left intersecting the 45° line at a higher level of GDP. On the other hand, higher taxes tend to lower the equilibrium level of GDP.

Knowing this, it is easy to deduce in what direction government spending and tax rates should move to counter a negative tendency towards an unsustainable boom or a depression. This procedure is called a stabilization policy.

If the economy is moving towards a boom, less government spending and more taxation are advisable. If the economy is heading to a depression, more spending and less taxation are the remedy.

STUDENT: Sounds very simple. Why is it then that we still have booms and depressions?

TEACHER: It is easy to determine the direction of the correction. But the problem is to define the right timing, the size of the changes in the variables, and the mix of spending and taxation changes that will do the job. You will often hear or read on the news that government corrective measures were "too little too late", "or too much too early".

And let me stress that when we discuss changes in government spending we mean that this is done without changing aggregate tax revenue. We have seen that taxes have a negative effect on the GDP. If government were to "increase spending" and finance the increase by rising more taxes, or reduce expenditure while diminishing tax revenue by the same amount, the effect of the changes in expenditure would be very small.

The Keynesian Revolution

Until Keynes presented his proposition that governments can avoid or get out of a recession by stimulation aggregate demand, economists and policy makers believed that in a recession the government should "save" and spend less. This procedure of course worsened recessions by diminishing aggregate desired expenditure still more.

STUDENT: But saving sounds like a reasonable thing to do in crisis times.

TEACHER: Remember what we said in Module I about the fallacy of composition. In a recession, when salaries fall and unemployment is a menace, it is wise for a family to reduce expenditure and save "for a rainy day". But what is good for individuals is often not good for the aggregate of individuals. When feeling threatened by a depression people save for their own good, but in acting so they worsen the recession and eventually harm themselves too. Now, if the government also reduces its expenditure, the situation is a deflationary spiral: as the recession gets worse, people and government save more, the recession gets worse, and in response economic actors save more, and so on. A real vicious circle.

Keynes’ ideas created a revolution in economic thought. The concept that "GDP can get stuck at a level below its maximum potential (large unemployment) and that the remedy could be to use fiscal policy to direct the economy towards its potential level is still called "the Keynesian revolution".

We will examine fiscal policy in more detail in a following Module.

Including the Balance of Trade (BT) in the Simple Keynesian Model

It is time to relax the assumption that our economy is closed, with no foreign trade.

We will add the effect of the BT to the formation of GDP. BT is the difference between Imports (I) and Exports of goods and services (X). In a formula it is expressed as BT = (X – I)

With the addition of the foreign sector, we now say that GDP is equal to consumption plus investment plus government spending plus balance of trade. Expressed by means of a formula,

GNP = C + I + G + (X - I).

Some textbooks use the expression "Net Exports" for the Balance of Trade concept.

Macro is interested in how the value of the BT or Net Exports responds to changes in the exchange rate, the price level and national income.

Exports are autonomous or exogenous expenditures because they depend on the decisions of foreigners of how much to import.

We can then safely assume that gross exports are not related to changes in GDP in the exporting country

On the other hand, imports depend on the decisions of local residents; they are the ones who decide how much to spend. We also know that normally many locally produced goods include imported materials.

In conclusion, we can say that...

1. Since consumption rises with income, as income increases the resulting higher consumption will include more foreign components (a higher value of imports).
2. Higher imports will negatively affect BT (the balance of trade), also called "net exports".

We can then say that the net export function is the negative relationship between net exports and national income; that is to say, as income increases net exports diminish.

Changes in the Net Export Function

We can easily identify the major factors that affect the level of net exports:

1. Foreign income. With the usual proviso that "other things are equal", a change in income in other countries will tend to affect local exports. Higher foreign income will increase demand for local exports, and vice-versa.
2. Relative international prices.

1. If local prices fall relative to foreign prices, foreigners will be more inclined to import, and local exports will increase as a result. This tendency to a higher level of net exports will be re-enforced by the fact that local residents will tend to replace foreign products and purchase more local substitutes.
2. If local prices rise relative to foreign prices, by the same reasoning the level of net exports will fall.

STUDENT: What causes these changes in relative international prices?

TEACHER: Basically, in the short run, inflation and exchange rates. In the long run other factors may appear, such as changes in productivity due to investment, innovations and training of labor.

Now we will show the effects of Net Exports on the GDP equilibrium level in graphical form.
In Figure B203_4 we see line C+I+G representing aggregate desired spending without considering the balance of trade ("net exports", i.e. eXports less Imports)

When net exports (NE) are added, we notice that:

1. If NE is a positive number (exports higher than imports), the line shifts to the left and intersects the 45° line at a higher level of GDP.
2. If NE is a negative number, the line shifts to the right and intersects the 45° line at a lower level of GDP.

It is also important to notice how changes in the value of net exports affect the equilibrium GDP level.

Let’s look at this picture:
In Figure B203_5 we can very clearly see the effect of changes in the value of net exports: as net exports rise, so does the equilibrium level of GDP.

Well, it’s time for a break. See you in next module!