# Week_4 - ECMA06 Aggregate Expenditure (with government and...

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ECMA06 – Aggregate Expenditure (with government and foreign sector) Aggregate Expenditure Including Government Foreign Sector Outline We complicate the simple model developed last week and we include government and foreign sector in the model. National saving – revisit. Consider the effects of a change in aggregate expenditure on national income and budget balance. Sector The Government Sector The government enters the model in the following ways: 1) Collecting taxes, T The government collects taxes from households and firms to finance its spending. In our model taxes are positively related to income, i.e., T = T 0 + t 1 Y, where T 0 = constant, 1 > t 1 > 0. 1

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ECMA06 – Aggregate Expenditure (with government and foreign sector) 2) Making transfer payments, TR Transfer payments refer to payments from the government to individuals that are not in exchange for goods and services. Examples include employment insurances (EI), public pension, and etc. Transfer payments are inversely related to income, i.e., TR = TR 0 – tr 1 Y, where TR 0 = constant, 1 > tr 1 > 0 3)Spending on final goods and services, G It is also called government purchases, and it is the government expenditure on final goods and services. In our model, we assume G is an autonomous variable, (i.e., its value is given), i.e., G = constant. 2
ECMA06 – Aggregate Expenditure (with government and foreign sector) The Foreign Sector When an economy trades with foreign countries, this economy is an open economy. Before we discuss how the foreign sector enters the model, we need to talk about the exchange rate. Question: What is the exchange rate? Answer: Exchange rate (E) is the price of a country’s currency in terms of another currency. In our class, exchange rate measures the value of C\$ in foreign currency (i.e., the # of foreign currency needed to exchange 1 C\$). Example: If E = US\$ 0.875/C\$, then the value of 1 C\$ is equivalent to US\$ 0.875 (US\$ 0.875 per C\$). 3

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ECMA06 – Aggregate Expenditure (with government and foreign sector) Question: What happens when E changes? Answer: If E from US\$0.875/C\$ to US\$0.89/C\$, C\$ appreciates against the US\$ because it takes more US\$ to exchange 1 C\$. If E from US\$0.875/C\$ to US\$0.86/C\$, C\$ depreciates against the US\$ because it takes fewer US\$ to exchange 1 C\$. The foreign sector enters the model in the following ways: 1)Exports, X Holding all else constant, X when E (C\$ appreciates ). Canadian goods become more expensive to foreigners, foreign demand for Canadian goods . 4
ECMA06 – Aggregate Expenditure (with government and foreign sector) Example: Suppose a Canadian product sells for C\$200 in Canada. If E = 0.85 (US\$0.85 = C\$1), what is the US\$ price of that

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## This note was uploaded on 06/18/2011 for the course ECMA 06 taught by Professor Dr.atamazaheri during the Spring '10 term at University of Toronto.

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Week_4 - ECMA06 Aggregate Expenditure (with government and...

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