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ECONOMICS 304L
FALL 2007
DR. WOLITZ
Adding Taxes and Imports to Macroeconomic Model
1)
Oversimplified Model
We have been working with the following oversimplified model:
Taxes = 0
Transfers = 0
So Y = real GDP = Yd
Yd = Disposable Income
C = a + bYd
C = a + bYd
is the same as C = a + bY
when Y= Yd
I = Io = some constant
G= Go = some constant
(Ex  Im) = (Ex  Im)o = NEo = some constant
Please Note:
The subscript
o
signifies a value in the initial period
(say I = Io)
Io, Go and NEo all represent the values of I, G and
NE in some initial period. They are all constants (that is some number,
like 100, not a function of Y (like C
= a + bY)
Also Please Note that throughout this handout
MPC = b
and are used interchangeably
Aggregate Expenditures = AE = C + I + G + NE
eq Y = AE = C + I + G + NE
eq Y = a + bY + I + G + NE
b = MPC = the slope of AE
a, I , G, and NE are all constants
2)
Adding a Flat Tax
Now drop the assumption that Taxes = 0 and Transfers = 0
This means that Y no longer equals Yd.
Rather,
Yd = (Y  T)
where T = Net Taxes = Taxes  Transfers
We can write a Net Tax function:
T = To + t Y
1
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View Full DocumentTo = a flat tax or a fixed tax or a constant tax, ie. a tax
independent
of Y
.( for example, T= 100)
t = an income tax where t = tax rate
. For example, if the income
tax rate were 10%, t = .10.
First, let us add only a
flat tax
to our model. This is a
tax that enters as
a constant
, independent of Y. Assume t = 0, or that there is no income tax.
The addition of a flat tax creates a gap between Y and Yd.
Yd = Y  T
or
Yd
+ T = Y
The addition of a flat tax to our model will shift the Consumption function
horizontally by the amount of the tax and vertically by MPC times the tax.
Remember that C is expressed in terms of Yd, so
C = a + bYd
. becomes
C = a + b(YT
). A
change in a flat tax
will shift
C
by
MPC times the change in
the tax
. Put another way, an
increase
in a flat tax will shift C
down
. A
decrease
in a flat tax will shift C
up
. The amount C will change is given by the MPC times
the change in the tax. C moves in the opposite direction of the tax, hence the
minus sign.
For example, suppose that the
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 Spring '07
 Staff
 Economics

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