Fiscal policy and foreign trade

Fiscal policy
and
foreign trade
Master of Management (Business Management)
Wyzsza Szkola Menedzerska WWarszawie

Hello!
WE ARE GROUP 1
2
NAME ROLL NUMBER
Kumar Nalinaksh (Lead) 75771
Neel Kumar Patel 75744
Rahim Karimpour 75790
Sifaben Vhora 75649
Bhavika Chhatbar 75783
Crispin Baptista 75647
Leul Negash 75637
Naga Puppala 75792
Tinsae Tadesse 75802

The scope
of
government activity

In most European countries, the government directly buys about
a fifth of national output and spends about the same again on
transfer payments. This spending is financed mainly by taxes,
though some is financed by borrowing.
1.What is the macroeconomic impact of government fiscal
policy?
2.Why did governments conclude that a massive fiscal
response was required when confronted with the financial
crash of 2008?
3.Has the extra government debt then incurred constrained
the subsequent use of fiscal policy to boost demand and
economic recovery?
4

1.We first show how fiscal policy affects aggregate demand
and equilibrium output.
2.Then we study three fiscal issues. We analyze opportunities
and limitations in using fiscal policy to stabilize output.
3.We then examine the significance of the government’s
budget deficit.
5

When the government runs a deficit,
it spends more than it earns!
We examine the
size of the
deficit, and ask
how much it
matters.
How can the
government
keep spending
more than it
receives?
6

 A government deficit is financed mainly by borrowing
from the public by selling bonds, which are promises to
pay specified amounts of interest payments at future
dates in exchange for cash up front.
 This borrowing adds to national debt to the public.
7

8
During 2009 governments around the world had huge
budget deficits as they bailed out their banking systems and
spent money on car scrappage schemes to try to prevent the
car industries imploding. Just as for an individual, when a
government spends more than it earns it adds to its debts.
Fiscal policy is government policy on spending and taxes. It
affects the size of government deficits and thus government
debt. Stabilization policy is government action to keep
aggregate demand and actual output close to potential
output.

Government
and
aggregate demand

Government and aggregate demand
▪ Spending G by the government on goods and services boosts overall demand. The
government also takes money out of the circular flow by levying indirect taxes Te on
spending and direct taxes Td on factor incomes, minus transfer benefits B that supplement
factor incomes.
▪ Aggregate demand AD is consumption demand C, investment demand I and government
demand G for goods and services. Transfer payments affect aggregate demand only by
affecting C or I. It would be double-counting to include transfer payments directly in
aggregate demand. Thus AD =C + I+ G.
▪ Net taxes NT are taxes minus transfer benefits. Net taxes reduce personal disposable
income – the amount available for spending or saving by households – relative to national
income and output. If YD is disposable income, Y national income and t the net tax rate
(assumed to be a constant proportion of income), then disposable income YD = (1 − t)Y.
10

Government and aggregate demand
▪ Net taxes are taxes minus transfer benefits.
▪ Disposable income is gross income minus taxes plus
benefits; that is, the net income available to spend
or save.
▪ If the marginal propensity to consume out of
disposable income is c, the marginal propensity to
consume out of national income c′ is reduced to
c(1− t). The larger the net tax rate, the smaller is c′
and the flatter is the slope of the consumption
function, when plotted against national income and
output. The adjoined figure illustrates the same.
11

The effect of net taxes on output
▪ Suppose initially that government spending is zero. Figure
illustrates. A rise in 658 the net tax rate from zero to 0.2 made
the consumption function pivot downwards from CC to CC′.
▪ Adding on the constant investment demand I to that
consumption function, we obtain aggregate demand. Hence, a
rise in the net tax rate rotates the consumption function from
CC to CC′ and rotates aggregate demand from AD to AD′.
▪ Aggregate demand equals actual output at a lower output level
than before, at E′ not E. Equilibrium income and output are
lower. Raising the net tax rate reduces equilibrium output.
▪ Conversely, if aggregate demand and equilibrium output are
below potential output, lower tax rates or higher transfer
benefits will raise aggregate demand and hence equilibrium
output.
12

The effect of government spending on output
▪ Now forget taxes and think government
spending. Suppose the net tax rate is zero.
National income and disposable income once
again coincide.
▪ Figure shows that a higher level of autonomous
government spending has an effect similar to
that of higher autonomous investment demand.
▪ With a marginal propensity to consume of 0.9,
the multiplier is again 1/(1 − c) = 10.
▪ A rise in government spending G induces a rise in
equilibrium output by 10 times that amount. In
Figure equilibrium moves from E to E′ as
aggregate demand shifts from AD to AD′. 13

The combined effects of government spending and taxation
▪ Suppose an economy begins with equilibrium output of 1000
but no government. Assume demand from autonomous
consumption and investment is 100. With a marginal
propensity to consume out of disposable income of 0.9, a
disposable income of 1000 induces consumption demand of
900.
▪ Aggregate demand is (900 + 100) = 1000, which is also
actual output. Now add autonomous demand of 200 from
the government, taking total autonomous demand to 300.
Also introduce a net tax rate of 0.2.
▪ The marginal propensity to consume out of national income
falls from 0.9 to 0.72, and the multiplier becomes 1/(1 −
0.72) = 1/0.28 = 3.57.
▪ Multiplying autonomous demand of 300 by 3.57yields
equilibrium output of 1071, above the original equilibrium
output of 1000. Figure illustrates the same.
14

The balanced budget multiplier
▪ The economy began at an equilibrium output of 1000. With a proportional tax rate
of 20 per cent, initial tax revenue was 200, precisely the amount of government
spending.
▪ This balanced increase in government spending and taxes did not leave demand
and output unaltered. Figure shows equilibrium output is larger. The new 200 of
government spending raises aggregate demand by 200. The tax increase cuts
disposable income by 200, but with c = 0.9 lower disposable income reduces
consumption demand by only 180.
▪ The initial net effect of the tax and spending package raises aggregate demand by
20. Output rises, inducing further rises in consumption demand. When the new
equilibrium is reached, output has increased by 71, from 1000 to 1071. This is the
famous balanced budget multiplier, which gives the government a fiscal tool to
boost aggregate demand without adding to the deficit or debt.
▪ The balanced budget multiplier says that a rise in government spending plus an
equal rise in taxes leads to higher output.
▪ To use this tool, however, the government has to have the political courage to raise
tax revenue in line with higher expenditure. Sometimes governments are unable or
unwilling to do this 15

The multiplier revisited
▪ The multiplier relates changes in autonomous demand to changes in equilibrium income and
output. The formula in Chapter 16 still applies, provided we use c′, the marginal propensity to
consume out of gross income, not out of disposable income. Multiplier = 1/(1 − c′)
▪ With proportional net taxes t, then c′ = (1− t)c, where c remains the marginal propensity to
consume out of disposable income, and (1 − t) shows the amount by which disposable income is
less than national income. For a given marginal propensity to consume out of disposable income,
a higher tax rate t reduces the multiplier. The more the circular flow leaks out into taxation, the
less flows round again to stimulate further expansion of output and income. Table illustrates the
same.
▪ Without government the multiplier was simply 1/(1 − c) or 1/s. With a larger marginal propensity
to save, there was a larger leakage from the circular flow between firms and households, and the
multiplier was correspondingly smaller. Table merely extends this insight. Now leakages arise
both from saving and from net taxes. When both are large, the multiplier is small. The bottom row
of the table has a much smaller multiplier than the top row.
▪ Since 1 − s = c, Table also points out that the denominator of the multiplier [1 − c(1 − t)] is just s +
ct, which can also be written as s(1 − t) + t. From the circular flow, leakages occur through
taxation and through saving out of disposable income. The denominator of the multiplier
continues to reflect the ‘marginal propensity to leak’. Even Table overstates the value of the
multiplier in practice. If there was such a large benefit to fiscal expansion, governments would be
more willing to boost fiscal policy in order to expand output.
16

The government budget
The government budget describes what goods and services the
government will buy during the coming year, what transfer payments it
will make and how it will pay for them. Most of its spending is financed by
taxes. When spending exceeds taxes, there is a budget deficit. When
taxes exceed spending, there is a budget surplus.
Continuing to use G for government spending on goods and services, and
NT for net taxes or taxes minus transfer payments, A budget is the
spending and revenue plan of an individual, a firm or a government.
Government budget deficit= G − N
18

The government purchases G and net taxes tY in relation
to national income. We assume G is fixed at 200. With a
proportional net tax rate of 0.2, net taxes are 0.2Y.
 At outputs below 1000, the government budget is in
deficit;
 at an output of 1000, the budget is balanced; and
 at higher outputs, the budget is in surplus.
19

20
The budget deficit equals total government spending minus total tax revenue or
government purchases of goods and services minus net taxes. Government purchases
are shown as constant independent of income, while net taxes are proportional to
income. Thus, at low levels of income the budget is in deficit and at high income levels
the budget is in surplus.

The budget surplus or deficit is determined by three things:
 the tax rate t,
 the level of government spending G, and
 the level of output Y.
With a given tax rate, an increase in G will raise output and
hence tax revenue. Could the budget deficit be reduced by
higher spending? We now show that this is impossible.
21

Investment, saving and the budget
By definition, actual leakages from the circular flow always equal actual injections
to the circular flow. Payments cannot vanish into thin air.
Our model now has two leakages –
 saving by households, and
 net taxes paid to the government;
and two injections –
 investment spending by firms, and
 government spending on goods and services.
Thus, actual saving plus actual net taxes always equal actual government
spending plus actual investment spending.
22

We know that when the economy is not at equilibrium income, actual saving and
investment differ from desired or planned saving and investment.
Firms make unplanned changes in inventories and households may be forced to
make unplanned saving if demand exceeds the output actually available.
The economy is in equilibrium when all quantities demanded or desired are equal
to actual quantities.
In equilibrium, planned saving S plus planned net taxes NT must equal planned
government purchases G plus planned investment I. Planned leakages equal
planned injections: S +NT =G +I
23

Without the government, this reduces to the equilibrium condition of planned
saving equals planned investment.
Notice that the above equation implies that in equilibrium desired saving minus
desired investment equals the government’s desired budget deficit:
S − I =G − NT
24

A rise in planned government spending G must raise the budget deficit. For a given
tax rate, a rise in G increases aggregate demand and equilibrium income.
Disposable income must rise. Households increase both desired consumption and
desired saving.
Since desired investment I is independent of income, this rise in desired saving
must increase (S − I) and thus raise (G − NT).
This proves that the equilibrium budget deficit rises if government spending
increases but the net tax rate is unaltered.
25

Higher government spending on goods and services increases equilibrium output.
With a given tax rate, tax revenue rises but the budget deficit increases (or the
budget surplus falls).
We can analyze a tax increase in a similar way.
 A rise in the tax rate reduces aggregate demand and equilibrium income.
 Disposable income falls, both because of lower national income and a higher
tax rate.
 With less disposable income, desired saving must fall.
 Since (S − I) is now lower, in equilibrium the budget deficit (G − NT) must also
be lower.
26

For given government spending G, a higher net tax rate
reduces both equilibrium output and the budget deficit.
We can also understand this more intuitively. When one
sector runs a deficit, another sector must be running a
surplus to compensate. Saving minus investment is the net
surplus of the private sector (households plus firms). A
private sector surplus equals a public sector (government)
deficit, and vice versa.
27

Deficits
and
the fiscal stance

Deficits and the fiscal stance
29
 Is the budget deficit a good measure of the government’s fiscal stance?
 Does the size of the deficits how whether fiscal policy is expansionary, aiming
to raise national income ,or contractionary, trying to reduce national income?
 The fiscal stance shows the intended effect of fiscal policy on demand and
output.
The deficit may be a poor measure of fiscal stance. The deficit can change for reasons unconnected
with a change in fiscal policy. Even if Gandara unaltered, a fall in investment demand reduces out
put and income, and hence net tax revenue, raising the budget deficit.
For given levels of government spending and tax rates, the budget has larger deficits in recessions,
when income is low, than in booms, when income is high. Suppose aggregate demand suddenly falls.
The budget will go in to deficit. Some one looking aftereffect might conclude that fiscal policy was
expansionary and that there was no need to expand fiscal policy further. That might be wrong. The
deficit may exist because of there cession.

30
The structural budget
 The structural budget shows what the budget will be if out put is at potential output.
 To indicate the fiscal stance, we calculate the structural budget, sometimes known as the underlying go
cyclically adjusted budget. From actual government spending, we subtract not actual net taxes tY but the taxes
tY* that would apply, at the current net tax rate t , if out put was hypothetically at potential out put Y*.
 The cyclically adjusted budget (G−tY*)is affected by proactive fiscal decisions–changes in government
spending Groin net tax rate t , but is insulated from fluctuations in actual tax revenue caused by cyclical
deviations of out put from potential out put. Through out the recent recession, tax revenue has been
disappointingly small. One reason has been that there covary of out put has been slower than hoped and
expected .Hence there has been less tax revenue and more spending on welfare benefits to support
citizen citizens in economic distress.
 The structural budget depends on the level of potential out put Y*.If a deep recession has permanent
effects on potential out put it self–for example, firms scrap factories that are then lost forever–the
government will have permanently less tax revenue and a permanently larger budget deficit unless other
spending is cut or the tax rate increased.

CYCLICAL OUT PUT FLUCTUATIONS AND THE GOVERNMENT BUDGET
• The current budget includes net tax revenue and government spending on
consumption
• (teachers,nurses,soldiers) but not government investment projects(road building,
school building).
• The total budget deficit, or net borrowing, includes government investment
expenditure as well as current expenditure on government consumption.
• By estimating potential out put, we can compute cyclically adjusted net tax
revenue. The discrepancy between the actual budget and the cyclically adjusted
budget is caused only by the output gap.
The output gap is the percentage deviation of actual output from
potential output.

The table shows actual and cyclically adjusted budget deficits of the
Uk government during2000–15,
Both for the total budget and for the current budget that is,
government consumption plus benefit payments less taxes but
excluding government investment.
A negative number denotes a budget surplus.
It also shows the out put gap during the period.
A positive number means that output temporarily exceeded potential
output; a negative number implies that output was less than potential
output.
32
Budgetdeficitsandtheoutputgap

33
• The budget deficit rose sharply after the financial crash, peaking in 2009/10.
• Was this because there accessioned proved the government of net tax revenue less from
income tax, VAT and excise duties; more on welfare benefits–or because the government
deliberately raised government spending and cut tax rates in order to avert deeper
recession?
• The table helps us answer this question. The actual deficit in 2009/10 was 11.3 percent
of GDP, compared with only 2.6 percent a couple of years earlier.
• The out put gap in 2009/10 was 24.2 percent, the amount by which actual output was
below potential output at the bottom of there cession.
• The cyclically adjusted total deficit in that year was 8.9 percent compared with 2.6
percent a couple of years earlier. What does this imply?

34
 First, the recession deprived the government of net tax revenue equal
to 2.4 per cent of GDP the difference between 11.3 and 8.9 per cent.
 The recession had a big effect on government finances, but it was only
part of the story.
 Since the cyclically adjusted budget deficit rose from 2.6 per cent to
8.9 per cent in two years, deliberate new policy actions by the
government (higher spending, higher subsidies, lower tax rates)
accounted for a rise of 6.3 per cent in the government budget.
 The effect of deliberate fiscal expansion was more than twice as
important as the effect of lower output in causing the actual budget
deficit to rise.

35
• The chart below shows more generally the systematic effect of fluctuations in the output gap
(shown in green) on the difference between the actual deficit and the cyclically adjusted deficit.
• This time we focus on the current budget deficit, excluding government investment.
• The purple columns show the excess of the current budget deficit over its cyclically adjusted
measure.
• The purple columns are about 70 per cent of the height of the green columns.
• Hence a 1 per cent cyclical fall in output is roughly associated with a 0.7 per cent rise in the current
budget deficit (relative to the cyclically adjusted measure), caused by a fall in net tax receipts.

36
 How much the business cycle affects government revenue varies from country to country.
 For example, at the onset of the financial crash, the US and UK governments both suffered large
falls in tax revenue.
 The fall in Germany was much smaller. The explanation ought to depend on the marginal rate of
net taxes – how net tax revenue varies with output and income.
 Despite its low-tax rhetoric, the US has a surprisingly ‘progressive’ tax structure that relies
heavily on taxing the rich.
 Germany and most European countries raise most of their revenues through ‘regressive’
consumption and energy taxes – petrol, alcohol, cigarettes, VAT – bearing mainly on the poor
and the middle class.
 Hence, US tax revenue suffers much more in severe recessions, especially if these hit wealthy
citizens, such as bankers and stock market investors.
 Britain’s system lies somewhere in-between, with more reliance on highly redistributive income
and capital tax than Germany but also a much bigger yield than in the US from less progressive
taxes on energy and from VAT.

37
Inflation- adjusteddeficits
The inflation-adjusted budget uses real not nominal interest rates to calculate government
spending on debt interest.
• A second reason why actual government deficits may be a poor measure of fiscal stance is the distinction
between real and nominal interest rates.
• The budget deficit treats all nominal interest paid by the government on the national debt as government
expenditure on transfer payments.
• It makes more sense to count only the real interest rate multiplied by the outstanding government debt.
Suppose inflation is 10 per cent, nominal interest rates are 12 per cent and real interest rates are 2 per cent.
• From the government’s viewpoint, the interest burden is only really 2 per cent on each £1 of debt
outstanding.
• Although nominal interest rates are 12 per cent, inflation will inflate future nominal tax revenue at 10 per
cent a year, providing most of the revenue needed to pay the high nominal interest rates.
• The real cost of borrowing is only 2 per cent.

38
• Consider what happens when interest rates are 1 per cent (the central bank, worried about
recession, has reduced interest rates to a low level) and inflation is 3 per cent
(booming China and India keep bidding up the prices of energy and food).
• The real interest rate is now minus 2 per cent. Borrowing now hurts the creditor (who gets
insufficient interest to cover even inflation) and therefore helps the borrower (who by next year
will enjoy more than enough inflated tax revenues with which to pay the modest interest charge
on the debt).
• It is very rare to see estimates of the inflation-adjusted budget. Inflation is therefore governments
'secret weapon – it reduces the real burden of the debt unless nominal interest rates exceed the
rate of inflation.

Automatic stabilizers
and
discretionary fiscal policy

• By reducing the responsiveness of the economy to
shocks, automatic stabilizers reduce output
fluctuations.
• All leakages are automatic stabilizers. A higher saving
rate and a higher tax rate reduces the multiplier.
• Automatic stabilizers reduce the multiplier and thus output response to demand
shocks.
• Income tax, VAT and unemployment benefit are important automatic stabilizers,
dampening the output response to changes in autonomous aggregate demand.
Automaticstabilizers

• Governments also use discretionary fiscal policies to
change spending levels or tax rates to stabilize
aggregate demand.
• When other components of aggregate demand are
abnormally low, the government can boost demand
by cutting taxes, raising spending, or both.
• When other components of aggregate demand are
abnormally high, the government raises taxes or cuts
spending.
• Discretionary fiscal policy is decisions about tax rates and levels of government spending.
Discretionaryfiscalpolicy

THE LIMITS TO FISCAL POLICY
Why can demand shocks not be fully offset by fiscal policy?
• Time lags
- It takes time to spot that aggregate demand has changed.. It may take 6 months to get the reliable
statics on output. Then it takes time to change fiscal policy.
- And once the policy is changed, it takes time to work through the steps of the multiplier process to have
its full effect.
• Uncertainty
- The government faces two problems. First, it is unsure of key magnitudes such as the multiplier. It
only has estimates from past data.
- Second, since fiscal policy takes time to work, the government has to forecast the level that demand
will reach by the time fiscal policy has its full effects.

• Induced effects on autonomous demand
-Changes in fiscal policy may lead to offsetting changes
in other components of autonomous demand These
induced effects may offset the direct effect of fiscal
stimulus
-If estimates of these induced effects are wrong, fiscal
changes have unexpected effects.

44
Why not expand fiscal policy when unemployment is high?
• The budget deficit
- When output is low and unemployment high, the budget deficit
may be large.
- The government may worry about the size of the deficit itself or
worry that a large deficit will lead to inflation.
• Maybe we are at full employment
-Fiscal expansion raises demand and output
-People are unemployed only because they do not wish to supply at the going wages or rentals.
-If high unemployment and low output reflect not low demand but low supply, fiscal expansion
is pointless.

46
What is National debt and The deficit
The national debt is simply the net accumulation of the
federal government’s annual budget deficits. Most
governments have budget deficits. The flow of deficits is
what adds to the stock of debt.
A budget deficit occurs when expenses exceed revenue and
indicate the financial health of a country. The government
generally uses the term budget deficit when referring to
spending rather than businesses or individuals.

We measure debt relative to GDP because the latter is a
proxy for the likely tax revenue that can be raised at
‘reasonable’ tax rates. Nominal debt rises when there
is a budget deficit, but nominal GDP rises because of
both real output growth and inflation. Hence, isolating
the effect of the inherited debt, the debt burden’s
effect on this year’s debt/GDP ratio is given by…
debt/GDP = (r −π− g)D/pY
Where,
D = nominal debt
p = the price level
Y = real output
r = the nominal interest rate
g = the growth rate of real output
π = the inflation rate

48
Since both output growth g and inflation π
are normally positive, some steady
increase in debt is sustainable without
endangering the debt/GDP ratio.
When interest rates are higher than the
rate of nominal income growth does
inherited debt create sustainability
problems.

49
In a global financial market, overseas lenders may panic when they
see a country with a high debt/GDP ratio and therefore raise
substantially the interest rate that they charge governments with
high debts. This suggests, there may be two possible outcomes :
1. Lenders lose confidence, charge high interest rates, prevent
sustainable growth and force the country into a tough choice
between a long period of austerity – running budget surpluses
despite having low output and low tax revenue.
2. Lenders may have faith, keep interest rates low and allow
sustainable growth to reduce the debt/GDP ratio.

50
1. It directly increases nominal GDP and the denominator of the debt/GDP ratio.
Future nominal tax revenue increases. Provided interest rates don’t rise by as
much as inflation, the real interest rate on the debt is reduced.
2. This applies automatically to that part of the debt that is cash, which has a zero
interest rate that cannot rise with higher inflation. So inflation erodes the real
value of that part of the debt that is cash rather than bonds.
3. The government cheats. Some taxes are not properly inflation indexed, so that
higher inflation actually raises real tax rates. For example, income tax
thresholds may not be fully raised in line with inflation, and income tax may
apply to nominal interest rates not just to the component that is the real interest
rate.
RAPIDINFLATIONBENEFITSTHEBUDGETIN3WAYS

51
Figure 17.6 UK national debt since 1692 (% of GDP)
Figure17.6showsthehistoryoftheUKnationaldebtsincethefoundationoftheBankofEnglandin1694.
•Figure shows the history of the UK national
debt since the foundation of the Bank of
England in 1694.
•The UK has reached much higher debt GDP
ratios levels on three occasions – 1815, 1918
and 1945.
•The 260 per cent debt/GDP ratio of 1815 was
the prelude to the biggest boom in British
history, nearly a century in which Britain was
the undisputed economic powerhouse of the
world.
•One reason that the national debt fell in the 1970s, despite little real economic growth, was
that double digit inflation eroded the value of nominal debts.

52
Figure 17.7 shows the evolution of debt/GDP ratios in a range of countries – the UK, the US, Japan (J), Spain (E)
andGermany(D).
Figure 17.7Net debt/GDP, 1993–2013 (%)
•In 1993, in the green columns, all these
countries had debt/GDP ratios below 60%.
•By 2003, in the orange columns, the big
change was the increase in Japan’s
government net debt to 78%.
•By 2013, in the purple columns, debt had increased everywhere. Interestingly, in the US it
was much higher than in Spain, yet it was Spain that was experiencing the debt crisis.
Investors knew that the UK and the US could create inflation to ease their budgetary
problems. Spain, like other Euro zone countries, was bound by the common monetary policy.
The European Central Bank could not create inflation for Spain but keep prices stable for
Germany.

Foreign trade
and
income determination

Introduction
In an open economy a part of income
is spent on imported goods and
services. The import function shows
the relation of import and the level of
national income.
M = f(Y)
where M stands for import and Y for
national income. Thus import
depends on national income. The
import function is represented
graphically adjoined Figure. We show
national income on the horizontal axis
and import on the vertical axis.
54
National
income
import
M= I + mY
0

The import function is M = i + mY, where i is
autonomous import having no relation to Y and mY is
induced import, which is related to Y.
A country can import capital goods or essential items of
consumption from its accumulated foreign exchange
reserves or by borrowing from foreign countries or even
from the IMF or the World Bank.
55

Net exports and equilibrium income
▪ We start from the aggregate demand schedule C
+ I + G, described earlier in the chapter, then add
net export demand NX, which is simply export
demand minus import demand.
▪ At low output, net export demand is positive.
▪ Aggregate demand C + I + G + X −Z will then
exceed C + I + G. As output rises, import demand
rises, export demand is
▪ constant, so desired net exports fall.
56

The multiplier in an open economydits
▪ Each extra unit of national income raises consumption
demand for domestically produced goods not by c′, the
induced additional consumption demand, but only by (c′ − z).
▪ The multiplier is lower because there are leakages not only
through saving and taxes but also through imports. In an
open economy, the multiplier becomes 1/[1−(c′ −z)],
1/[1− c′ +z]
1/[t + s(1− t) + z]
57

Higher export demand
▪ A rise in export demand leads to a parallel upward shift in
the aggregate demand schedule AD.
▪ Equilibrium income must increase. A higher AD schedule
crosses the 45-degree line at a higher level of income.
▪ As a matter of national income accounting, total leakages
from the circular flow always equal total injections to the
circular flow. And in equilibrium, desired spending must
coincide with actual income and spending on domestic
goods. Hence the amended equilibrium condition for an
open economy is,
I +G +X =S +NT +Z
58

Imports and employment
▪ By reducing imports, we can create extra output and employment at
home.
▪ This view is correct, but also dangerous. It is correct because higher
consumer spending on domestic rather than foreign goods will
increase aggregate demand for domestic goods and so raise
domestic output and employment.
▪ The view that import restrictions help domestic output and
employment is
▪ dangerous because it ignores the possibility of retaliation by other
countries.
▪ By reducing our imports, we cut the exports of others. If they
retaliate by doing the same thing, the demand for our exports will
fall. In the end, nobody gains employment, but world trade
disappears. 59

1.The government buys goods and services, and levies taxes (net of transfer benefits)
that reduce disposable income below national income and output.
2.Net taxes, if related to income levels, lower the marginal propensity to consume out
of national income. Households get only part of each extra pound of national income
to use as disposable income.
3.Higher government spending on goods and services raises aggregate demand and
equilibrium output. A higher tax rate reduces aggregate demand and equilibrium
output.
4.An equal initial increase in government spending and taxes raises aggregate demand
and output. This is the balanced budget multiplier.
5.The government budget is in deficit (surplus) if spending is larger (smaller) than tax
revenue. Higher government spending raises the budget deficit. A higher tax rate
reduces it.
6.In equilibrium in a closed economy, desired saving and taxes equal desired
investment and government spending. An excess of desired saving over desired
investment must be offset by an excess of government purchases over net tax
revenue.
7.The budget deficit is a poor indicator of fiscal stance. Recessions make the budget go
into deficit; booms generate a budget surplus. The structural budget calculates
whether the budget would be in surplus or deficit if output were at potential output. It
is also important to inflation-adjust the deficit.
8.Automatic stabilizers reduce fluctuations in GDP by reducing the multiplier. Leakages
act as automatic stabilizers.
60

9. The government may also use active or discretionary fiscal policy to try to stabilize
output. In practice, active fiscal policy cannot stabilize output perfectly.
10. Budget deficits add to the national debt. If the debt is mainly owed to citizens of the
country, interest payments are merely a transfer within the economy. However, the
national debt may be a burden if the government is unable or unwilling to raise taxes to
meet high interest payments on a large national debt.
11. Deficits are not necessarily bad. Particularly in a recession, a move to cut the deficit may
lead output further away from potential output. But huge deficits can create a vicious
cycle of extra borrowing, extra interest payments and yet more borrowing.
12. In an open economy, exports are a source of demand for domestic goods but imports are
a leakage since they are a demand for goods made abroad.
13. Exports are determined mainly by conditions abroad and can be viewed as autonomous
demand unrelated to domestic income. Imports are assumed to rise with domestic
income. The marginal propensity to import MPZ tells us the fraction of each extra pound
of national income that goes on extra demand for imports.
14. Leakages to imports reduce the value of the multiplier to 1/[1 − c′ + z].
15. Higher export demand raises domestic output and income. A higher marginal propensity
to import reduces domestic output and income.
16. The trade surplus, exports minus imports, is larger the lower is output. Higher export
demand raises the trade surplus; a higher marginal propensity to import reduces it.
17. In equilibrium, desired leakages S + NT + Z must equal desired injections G + I + X. Thus
any surplus S − I desired by the private sector must be offset by the sum of the
government deficit (G − NT) and the desired trade surplus (X− Z).
61

Reference
▪ Begg, D., Vernasca, G., Fischer, S. and Dornbusch, R.,
2014. Economics. 11th ed. McGraw-Hill Education.
62

63
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