Chapter 28: Macroeconomic Models and Fiscal Policy

Chapter 28 – Macroeconomic Models and Fiscal

Policy

9. The data in columns 1 and 2 in the accompanying table are for a

private closed economy:

a. Use columns 1and 2 to determine the equilibrium GDP for this

hypothetical economy.

(1)
(2)

Real Domestic
Aggregate
Output
Expenditures,

(GDP=DI), Private Closed

Economy, Billions
Billions

$200 $240

250 280

300 320

350 360

400 400

450 440

500 480

550 520

Table 1: GDP and Aggregate Expenditures of Private Closed

Economy

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In the private closed economy, aggregate expenditures consist of

consumption plus investment (C + Ig). There is no government taxation,

international trade which involves export and import and so on.

The equilibrium output is that output whose production creates total

spending just sufficient to purchase that output. Therefore, the equilibrium

level of GDP is the level at which the total quantity of goods produced (GDP)

equals the total goods purchased (C + Ig).

The above table shows the real domestic output levels and aggregate

expenditures, and equilibrium GDP achieved when equality exist at $400

billion of GDP. At this point, the annual rates of productions and spending are

in balance. There is no overproduction, which would accumulate of unsold

goods and consequently cutbacks in the production rate. Nor is there an

excess of total spending, which would draw down inventories of goods and

prompt increases in the rate of production. In brief, there is no reason there

is no reason for businesses to alter this rate of production, thus $400 billion

is the equilibrium GDP. We also measure equilibrium GDP by using graphical

analysis as shown below:

Figure 1: Equilibrium GDP of Private Closed Economy

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b. Now open up this economy to international trade by including the

export and import figures of columns 3 and 4. Fill in columns 5 and

6 and determine the equilibrium GDP for open economy. Explain

why this equilibrium GDP differs from that of the closed economy.

(1) (2) (6)

Real Aggregate (5) Aggregate

(3) (4)
Domestic Expenditure Expenditur
Net
Exports,
Output s, Private Imports, es, Private
Exports,
Closed Billions Open
Billions
(GDP=DI), Billions
Economy, Economy,

Billions Billions Billions

$200 $240 $20 $30 -$10 $230

250 280 20 30 -10 270

300 320 20 30 -10 310

350 360 20 30 -10 350

400 400 20 30 -10 390

450 440 20 30 -10 430

500 480 20 30 -10 470

550 520 20 30 -10 510

Table 2: GDP and Net Exports, and Aggregate Expenditures of

Private Open Economy

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In the private closed economy, aggregate expenditures consist of

consumption plus investment (C + Ig). There is no government taxation,

international trade which involves export and import and so on. Thus, $400

billion is the equilibrium GDP.

However, in this case, we move from closed economy to an open

economy that incorporates exports and imports. Like consumption and

investment, exports create domestic production, income and employment

for a country. Therefore, we include exports as a component of aggregate

expenditures. On the other hand, when an economy is open to international

trade, it will spend part of its income on imports that is goods and services

produced abroad. To avoid overstating the value of domestic production,

amount spent on imported goods should be subtracted because such

spending generates income abroad rather than local economy. As a result, to

measure correctly aggregate expenditures for domestic goods we must

subtract amount of import goods from exports. So, aggregate expenditures

for private open economy are C + Ig + Xn. Xn (net exports) equals with

exports minus imports.

Previously, without international trade the equilibrium GDP is $400

billion. But in private open economy, net exports can be positive and

negative. Based on the above table, net exports are negative $10 billion.

Means in this hypothetical economy, importing are more $10 billion than

exporting goods. The aggregate expenditures schedule shown as C + Ig in

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Table 1 is overstate the expenditures on domestic output at each level of

GDP. Sum of expenditure which previously is $360 billion must be reduced

by subtracting the $10 billion of net exports from C + I g. Thus, the new

aggregate expenditures in private open economy are $350 billion. And

equilibrium GDP falls from $400 billion to $350 billion (refer to Table 2).

GDP = C + Ig + Xn.

GDP = $360 billion + (-10) = $350 billion

A change in net exports of $10 billion has produced a fivefold change in GDP.

Means, other things equal, negative net exports reduce aggregate

expenditures and GDP below what they would b in a closed economy. When

imports exceed exports, the contractionary effect of the larger amount of

import outweighs the expansionary effect of the smaller amount of exports

and equilibrium real GDP decreases from $400 billion to $350 billion.

We also measure equilibrium GDP by using graphical analysis as shown

below:

Figure 2: Equilibrium GDP of Private Open Economy

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 Chapter 28: Macroeconomic Models and Fiscal Policy

c. Given the original $20 billion level of exports:

i. What would be net exports?

ii. Equilibrium GDP?

Imports were $10 billion greater at each level of GDP.

(2) (3) (4) (5) (6)

(1)
Aggregate Exports, Imports, Net Aggregate
Real Expenditure Billions Billions Exports, Expenditur
Domestic s, Private Billions es, Private
Output Closed Open
Economy, Economy,
(GDP =
Billions Billions
DI),
Billions

$200 $ 240 $20 $ 40 -$20 $210

250 280 20 40 -20 260

300 320 20 40 -20 300

350 360 20 40 -20 340

400 400 20 40 -20 380

450 440 20 40 -20 420

500 480 20 40 -20 460

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550 520 20 40 -20 500

Table 3: GDP and Net Exports, and Aggregate Expenditures of

Private Open Economy

In Private Open Economy, equilibrium GDP needs to incorporate

exports and imports. Exports create domestic production, income, and

employment for a nation. Goods and services produced for export are sent

abroad; foreign spending on those goods and services increases production

and create jobs and incomes in the country. Therefore, export is a

component of aggregate expenditure.

Imports on the other hand, is a case whereby a country spends part of

its income on imports of goods and services that are produced abroad. This

spending generates production and income abroad rather than at home. So,

in order to avoid overstating domestic production value and to correctly

measure aggregate expenditures for domestic goods and services, we must

subtract expenditures on imports from total spending. Therefore, in private

open economy, aggregate expenditures are C + Ig + (X – M). The (X – M) or

(Xn), refers to net exports.

Based from the above table, Net Exports are:

Net Exports = Exports – Imports

= $20 billion - $40 billion
= - $20 billion

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In this case, negative $20 billion net exports will occur at each level of

GDP. Net exports are independent of GDP. Negative $20 billion of net exports

means that the economy is importing $20 billion more of goods than it is

exporting and therefore it is overstates the expenditures on domestic output

at each level of GDP. We must reduce sum of expenditures in this case $320

billion by the $20 billion net amount spent on imported goods and

equilibrium GDP falls from $350 billion to $300 billion.

Negative net exports will reduce aggregate expenditures and GDP

below what they would be in a closed economy. When imports exceed

exports, the contractionary effect of the larger amount of imports outweighs

the expansionary effect of the smaller amount of exports and equilibrium

real GDP decreases.

Therefore, a decline in net exports (as we compare to the previous

decline of negative $10 billion of net exports) means that whenever exports

is decreased or maintained and imports is increased, aggregate expenditures

will reduce and ultimately GDP of the nation will contract. In this case,

exports are maintained but imports increased to $40 billion and that gives us

again negative $20 billion of net imports.

d. What is the multiplier in this example?

Multiplier is a ratio of a change in the equilibrium GDP to the change in

investment or in any other component of aggregate expenditures or

aggregate demand; the number by which a change in any such component

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must be multiplied to find the resulting change in the equilibrium GDP.

Multiplier will determine how much larger of a change will be whenever a

change in investment spending that changes output and income by more

than the initial change in the investment spending.

Multiplier effect will show us the effect on equilibrium GDP of a change

in aggregate expenditures or aggregate demand (caused by a change in the

consumption schedule, investment, government expenditures, or net

exports). In this case, the initial change in spending refers to changes in

consumption that is unrelated to changes in income. An increase in initial

spending will create a multiple increase in GDP, while a decrease in spending

will create a multiple decrease in GDP. In this example, the initial change in

Net Exports is decreasing at negative $20 billion. With a change of GDP at

$50 billion, it gives multiple decreases in GDP.

Multiplier = Change in real GDP

Initial change in spending

= 50
20
= 2.5

With a 2.5 multiplier, it tells us that the households use some of the

extra income to purchase additional goods from abroad (imports) and pay

additional taxes. Buying imports and paying taxes drains off some of the

additional consumption spending (on domestic output) created by the

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increases in income. That is why the multiplier kept on reducing from the

previous multiplier.

11. Explain graphically the determination of equilibrium GDP for a

private economy through the aggregate expenditures model. Now

add government purchases (any amount you choose) to your graph,

showing its impact on equilibrium GDP. Finally, add taxation (any

amount of lump-sum tax that you choose) to your graph and show

its effect on equilibrium GDP. Looking at your graph determine

whether equilibrium GDP has increased , decreased or stayed the

same given the size of the government purchases and taxes that

you selected.

Answer:

As we know in the private closed economy aggregate expenditures

consist of consumptions plus investment. Along with this, they both make up

the aggregate expenditures schedule for the private closed economy.

However, in the open economy we can expect to incorporate exports,

imports, government purchases, taxes and so forth. The fundamental

assumption behind the aggregate expenditures model is that the prices in

the economy are fixed or we can say the aggregate expenditures model is an

extreme version of a sticky price model. In fact, it is a stuck-price model

since prices cannot change at all.

If we refer to the question, it expects us to prepare a graph built with

government purchases and its impacts on equilibrium. By doing so, we will

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 Chapter 28: Macroeconomic Models and Fiscal Policy

combine two sides that is non-government and the public sector. This means

adding government purchases and taxes to the model. For simplicity, we will

assume that government purchases are independent of the level of GDP and

do not alter the consumption and investment schedules. Also government’s

net tax revenues – total tax revenues less “negative taxes” in the form of

transfer payments - are derived entirely from personal taxes. Ultimately, a

fixed amount of taxes is collected regardless of the level of GDP.

The Tabular example (Table 4) depicts the impact of the purchase by

government on the Equilibrium GDP. Actually, as for the private closed

economy, the equilibrium GDP was $470 billion. The new items are imports,

exports and government purchases. As shown in the column 7, the addition

of government purchases to private was spending (C+ Ig+ Xn + G). By

comparing columns 1 and 7, we find that aggregate expenditures and real

output are equal at a higher level of GDP which is in row 12. Basically,

increases in public spending, like increases in private spending, shift the

aggregate expenditures schedule upward and produce a higher equilibrium.

Here, we should note that, government spending is subject to the

multiplier. A $30 billion in government purchases has increased equilibrium

GDP by $120 billion that is from $470 billion to $590billion. The multiplier in

this sample is 4. However, that $30billion increase in government spending

is not financed by increased taxes.

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Through graphical Analysis it can be noted that, we vertically add

$30billion of government purchases; G, to the level of private spending, C+

Ig + Xn. As we have mentioned, that added amount of money raises the

aggregate expenditure schedule to C+ Ig+ Xn+ G resulting in a $120 billion

increase in equilibrium GDP, from $470 billion to $590 billion. Conversely, a

decline in government purchases; G will lower the aggregate expenditure

and result in a multiplied decline in the equilibrium GDP.

Table 4: The Impact of Government Purchases on Equilibrium GDP

Figures mentioned above are depicted below in the graphical analysis.

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Figure 3: The Impact of Government Purchases on Equilibrium GDP

Referring to taxation and Equilibrium GDP, one may know that the

government not only spends but also collects money in terms of taxes. If we

suppose that tax is $ 40 billion. So that means government obtains $40

billion of tax revenue at each level of GDP regardless of the level of

government purchases. In tabular example below, we find taxes in column 2

as well as column 3 for disposable (after-tax) income is lower than GDP by

the $40billion amount of tax. As households use disposable income both to

consume and to save, tax lowers both of them. MPC and MPS help us to

comprehend how much consumption and saving will decline as a result of

the $40billion in taxes. As MPC is 0.75, the government tax collection of $40

billion (=.75x$40billion) will reduce consumption by $ 30 billion and saving

will decline by $10 billion (=.25x$40billion).

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Column 4 and 5 list the amounts of consumption and saving at each

level of GDP. If we notice, consumption is $30 billion and saving $10 billion

lower than that in table mentioned above. As it is stated, taxes reduce

disposable income relative to GDP by the amount of taxes.

The Effect of taxes on Equilibrium GDP, we compute aggregate

expenditures as it shown in the table below, in column 9. A comparison of

real output and aggregate expenditures in columns 1 and 9 shows that the

aggregate amounts produced and purchased are equal only at $470 billion of

GDP (row 6). The $40billion lump-sum tax has reduced equilibrium GDP by

$120 billion, from $59 0billion (Table 4, row 12) to $470 billion (Table 5, row

6).

Table 5: Determination of Equilibrium levels of Employment, Output

and Income in
Private and public Sectors

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Graphical Analysis mentioned below depicts what is the effect of the

$40 billion increase in taxes. The decline of $30 billion in consumption

resulted for GDP fall from $590 billion to 470 billion. With no change in

government expenditures, tax increases lower the aggregate expenditures

and reduce the equilibrium GDP. Looking at our graph we have determined

that equilibrium GDP has decreased given the size of the government taxes

that we selected. However, equilibrium GDP has increased because of the

government purchases.

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Figure 4: Lump Sum Tax Effect on Equilibrium GDP

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