# F07Adding Taxes and Imports - 1 ECONOMICS 304L FALL 2007...

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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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To = 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(Y-T ). 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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## F07Adding Taxes and Imports - 1 ECONOMICS 304L FALL 2007...

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