Week_4_-_AE_with_G__NX

# Week_4_-_AE_with_G__NX - 1 ECMA06 Aggregate...

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1 ECMA06 – Aggregate Expenditure (with government and foreign sector) Sector Outline Extend the simple model developed last week by including government and foreign sector in the model. National saving in an open economy. Consider the effects of a change in aggregate expenditure on national income and budget balance.

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2 Enriching the Model – Including Government and Foreign 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. Assumption: Taxes are positively related to income. Tax function: T = T 0 + t 1 Y, where T 0 = autonomous taxes t 1 1 > 0.
3 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. Assumption: Transfer payments are inversely related to income. Transfer payments function: TR = TR 0 – tr 1 Y, where TR 0 = autonomous transfer tr 1 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. Assumption: G is an autonomous variable, (i.e., its value is given), i.e., G = constant.

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4 The Foreign Sector When an economy trades with foreign countries, this economy is an open economy. Exchange Rate 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\$). Question: What happens when E changes? Answer: If E , then C\$ appreciates against the US\$ because it takes more US\$ to exchange 1 C\$. If E , then C\$ depreciates against the US\$ because it takes fewer US\$ to exchange 1 C\$.
5 ECMA06 – Aggregate Expenditure (with government and foreign sector) The foreign sector enters the model in the following ways: 1) Exports, X Assumption: Exports depend on the exchange rate only. When E (i.e., C\$ appreciates ), X because Canadian goods become more expensive to foreigners, foreign demand for Canadian goods . Exports are inversely related to exchange rate. Exports function: X = X 0 – x 1 (E – ), where X 0 = autonomous exports x 1 & are constants

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6 2) Imports, IM Assumption: Imports depend on income and exchange rate. Holding all else constant, IM
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Week_4_-_AE_with_G__NX - 1 ECMA06 Aggregate...

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