2023ECO152 Chapter+7

ECO152: Macroeconomics
Chapter 7: The Keynesian model with a government and a foreign sector

1st Edition: Section 4.7 and Section 5.4
Additional worked examples: Page 82 – 88 of the ECO152 exercise book
In this chapter…
• Explain the Keynesian model with a government and foreign sector
• Graphically illustrate and explain the Keynesian model with the
government and foreign sector.
• Calculate the equilibrium level of income.
• Explain how the multiplier changes with the inclusion of the
government and foreign sector in the Keynesian model.
The government
Section 7.1 (2nd edition)
Section 4.7 (1st edition)
Government spending (G)
• Political issue
• Independent of Y
• Therefore, autonomous 𝐺𝐺̅
• Raises aggregate spending
• Leaves the multiplier unchanged
• Raises the equilibrium level of income
Change in equilibrium
with inclusion of G
Algebraically
• 𝑌𝑌 = 𝐴𝐴
• 𝑌𝑌 = 𝐶𝐶 + 𝐼𝐼 ̅ + 𝐺𝐺̅
• 𝐶𝐶 = 𝐶𝐶̅ + 𝑐𝑐𝑐𝑐
• 𝑌𝑌 = 𝐶𝐶̅ + 𝑐𝑐𝑐𝑐 +𝐼𝐼 ̅ + 𝐺𝐺̅
• 𝑌𝑌 − 𝑐𝑐𝑐𝑐 = 𝐶𝐶̅ + 𝐼𝐼 ̅ + 𝐺𝐺̅
• 𝑌𝑌(1 − 𝑐𝑐) = 𝐶𝐶̅ + 𝐼𝐼 ̅ + 𝐺𝐺̅
1
• 𝑌𝑌0 = [𝐶𝐶̅ + 𝐼𝐼 ̅ + 𝐺𝐺̅ ]
1−𝑐𝑐
• 𝑌𝑌0 = α (𝐴𝐴̅)
Taxes (T)
• Taxes constitute leakage or withdrawal from circular flow
• Taxes reduce disposable income (𝑌𝑌𝑑𝑑 )
• Pay taxes before you receive you salary in your bank account
• 𝑌𝑌𝑑𝑑 = 𝑌𝑌 − 𝑇𝑇
• Taxes are related to income
• Why?
• 𝑇𝑇 = 𝑡𝑡𝑡𝑡, where t is the tax rate
• Therefore 𝑌𝑌𝑑𝑑 = 𝑌𝑌 − 𝑡𝑡𝑡𝑡
• 𝑌𝑌𝑑𝑑 = (1 − 𝑡𝑡)𝑌𝑌
• Taxes reduce consumption indirectly
• Taxes:
• Reduces the multiplier
• Reduces the equilibrium level of income
Taxes as a function of income
Consumption and aggregate
spending with taxes
Algebraically…
• 𝑌𝑌𝑑𝑑 = 𝑌𝑌 − 𝑡𝑡𝑡𝑡 = 1 − 𝑡𝑡 𝑌𝑌
• 𝐶𝐶 = 𝐶𝐶̅ + 𝑐𝑐𝑌𝑌𝑑𝑑 = 𝐶𝐶̅ + 𝑐𝑐 1 − 𝑡𝑡 𝑌𝑌
• 𝐴𝐴 = 𝑌𝑌 = 𝐶𝐶 + 𝐼𝐼 ̅ + 𝐺𝐺̅ = 𝐶𝐶̅ + 𝑐𝑐 1 − 𝑡𝑡 𝑌𝑌 + 𝐼𝐼 ̅ + 𝐺𝐺̅
• Equilibrium:
• 𝐴𝐴 = 𝑌𝑌 = 𝐶𝐶 + 𝐼𝐼 ̅ + 𝐺𝐺̅ = 𝐶𝐶̅ + 𝑐𝑐 1 − 𝑡𝑡 𝑌𝑌 + 𝐼𝐼 ̅ + 𝐺𝐺̅
• 𝑌𝑌0 − 𝑐𝑐 1 − 𝑡𝑡 𝑌𝑌 = 𝐶𝐶̅ + 𝐼𝐼 ̅ + 𝐺𝐺̅
1
• 𝑌𝑌0 = [𝐶𝐶̅ + 𝐼𝐼 ̅ + 𝐺𝐺̅ ]
1−𝑐𝑐 1−𝑡𝑡
1
• 𝛼𝛼 = The multiplier
1−𝑐𝑐 1−𝑡𝑡
Exercise
• 𝑌𝑌 = 𝐶𝐶 + 𝐼𝐼 + 𝐺𝐺, where 𝐶𝐶 = 60 + 0,6 𝑌𝑌 − 𝑇𝑇 , 𝐼𝐼 = 250, 𝐺𝐺 = 150, 𝑇𝑇 = 100
1. What is the type of tax system in the economy?
2. Derive the equilibrium level of income for the economy.
3. Illustrate the equilibrium on an appropriate diagram.
4. Find the equilibrium value of income if G = 200.
5. What is the value of the multiplier in the economy?
Exercise
1. What is the tax system in the economy? Proportional, because it is not
determined by income.
2. Derive the equilibrium level of income for the economy.
• 𝑌𝑌 = 𝐶𝐶 + 𝐼𝐼 + 𝐺𝐺 = 60 + 0,6 𝑌𝑌 − 𝑇𝑇 + 250 + 150
• 𝑌𝑌 = 460 + 0.6𝑌𝑌 − 60
• 𝑌𝑌 = 400 + 0.6𝑌𝑌
• 0.4𝑌𝑌 = 400
• 𝑌𝑌 = 1000
Exercise
3. Illustrate the equilibrium on an appropriate diagram.
Exercise
4. Find the equilibrium value of income if G = 200.
• 𝑌𝑌 = 𝐶𝐶 + 𝐼𝐼 + 𝐺𝐺 = 60 + 0,6 𝑌𝑌 − 𝑇𝑇 + 250 + 200
• 𝑌𝑌 = 510 + 0.6𝑌𝑌 − 60
• 𝑌𝑌 = 450 + 0.6𝑌𝑌
• 0.4𝑌𝑌 = 450
• 𝑌𝑌 = 1 125
Exercise
5. What is the value of the multiplier in the economy?
• Δ𝑌𝑌 = 𝛼𝛼Δ𝐺𝐺
• Δ𝑌𝑌 = 1125 − 1000 = 125
• Δ𝐺𝐺 = 200 − 150 = 50
ΔY 125
• 𝛼𝛼 = = = 2.5
Δ𝐺𝐺 50
The foreign sector
Section 7.2 (2nd edition)
Section 5.4 (1st edition)
The foreign sector
• The foreign section has two components to consider
• Exports (X)
• Imports (Z)
• We consider net exports i.e. X – Z.
Exports
• Exports depend on:
• Economic conditions in the rest
of the world
• International competitiveness
• Exchange rate
• No systematic relationship with
national income
• Exports are autonomous
• X = X (autonomous)
Imports
• When spending and income increases, the demand for foreign goods
increase and imports increase
• A positive relationship exists between domestic economic activity and
imports
• Income Y is the main determinant of imports Z
• The import function is written as:
• Z = Z + mY,
• where m = marginal propensity to import,
• Z being autonomous imports
• mY being induced imports
Equilibrium income and multiplier in 4 sector model
• 𝑌𝑌𝑑𝑑 = 𝑌𝑌 − 𝑡𝑡𝑡𝑡 = 1 − 𝑡𝑡 𝑌𝑌
• 𝐶𝐶 = 𝐶𝐶̅ + 𝑐𝑐𝑌𝑌𝑑𝑑 = 𝐶𝐶̅ + 𝑐𝑐 1 − 𝑡𝑡 𝑌𝑌
• 𝑍𝑍 = 𝑍𝑍̅ + 𝑚𝑚𝑚𝑚
• 𝐴𝐴 = 𝑌𝑌
• Y= 𝐶𝐶 + 𝐼𝐼 ̅ + 𝐺𝐺̅ + 𝑋𝑋 − (𝑍𝑍̅ + 𝑚𝑚𝑚𝑚) = 𝐶𝐶̅ + 𝑐𝑐 1 − 𝑡𝑡 𝑌𝑌 + 𝐼𝐼 ̅ + 𝐺𝐺̅ + 𝑋𝑋� − 𝑍𝑍̅ − 𝑚𝑚𝑚𝑚
• Equilibrium:
• 𝑌𝑌 − 𝑐𝑐 1 − 𝑡𝑡 𝑌𝑌 + 𝑚𝑚𝑚𝑚 = 𝐶𝐶̅ + 𝐼𝐼 ̅ + 𝐺𝐺̅ + 𝑋𝑋� − 𝑍𝑍̅
• 𝑌𝑌 1 − 𝑐𝑐 1 − 𝑡𝑡 + 𝑚𝑚 = 𝐶𝐶̅ + 𝐼𝐼 ̅ + 𝐺𝐺̅ + 𝑋𝑋� − 𝑍𝑍̅
1
• 𝑌𝑌0 = 𝐶𝐶̅ + 𝐼𝐼 ̅ + 𝐺𝐺̅ + 𝑋𝑋� − 𝑍𝑍̅ = 𝛼𝛼𝐴𝐴̅
1−𝑐𝑐 1−𝑡𝑡 +𝑚𝑚
Note: The larger the size of m, the smaller is the multiplier.. The proportion that leaks
from the flow of spending and income is greater.
Imports as a function of Y
• Imports are a leakage
from the economy
• If imports are
dependent on income:
𝑍𝑍 = 𝑍𝑍̅ + 𝑚𝑚𝑚𝑚
Equilibrium income with government and
foreign sector: graphically
Exercise
• Suppose 𝐶𝐶̅ = 100, 𝐼𝐼 ̅ = 200, 𝐺𝐺̅ = 300, 𝑋𝑋� = 150, 𝑍𝑍̅ = 50,
𝑐𝑐 = 0,9, 𝑡𝑡 = 0,33, 𝑚𝑚 = 0,1
Calculate the equilibrium level of income.
Exercise
• Suppose 𝐶𝐶̅ = 100, 𝐼𝐼 ̅ = 200, 𝐺𝐺̅ = 300, 𝑋𝑋� = 150, 𝑍𝑍̅ = 50,
𝑐𝑐 = 0,9, 𝑡𝑡 = 0,33, 𝑚𝑚 = 0,1
Calculate the equilibrium level of income.
𝐴𝐴̅ = 𝐶𝐶̅ + 𝐼𝐼 ̅ + 𝐺𝐺̅ + 𝑋𝑋� − 𝑍𝑍̅ = 100 + 200 + 300 + 150 − 50 = 700
1 1 1 1
𝛼𝛼 = = = = =2
1−𝑐𝑐 1−𝑡𝑡 +𝑚𝑚 1−0.9 1−0.33 +0.1 1−0.6+0.1 0.5
𝑌𝑌0 = 𝛼𝛼𝐴𝐴̅ = 2 × 700 = 1 400
Summary of the impact of X and Z
• Exports (X)
– raise the level of aggregate spending A
– leave multiplier unchanged
– raise the equilibrium level of income Y0
• Imports (Z)
– act as leakage from circular flow
– reduce the level of aggregate spending on domestic production
– reduce the multiplier
– reduce the equilibrium level of income
Factors that influence the multiplier
• Marginal propensity to consume – the larger the MPC (c) the bigger
the multiplier
• Tax rate - the larger the tax rate (t) the smaller the multiplier
• Marginal propensity to import - the larger the marginal propensity to
import (m) the smaller the multiplier
Important: questions about change in
equilibrium
• Always remember to read the question carefully!
• Does it tell you by how much the autonomous spending changes or does it
tell you the new level of autonomous spending?
• Does it ask you to calculate by how much equilibrium income changes or
what the new level of income will be after the change?
• In addition to the exercises covered in these slides, remember to work
through the additional exercises uploaded on Ikamva. These exercises
provide clear examples of what you are expected to calculate and analyse
based on Chapter 7
• Additional worked examples: Page 82 – 88 of the ECO152 exercise book

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ECO152: Macroeconomics

Chapter 7: The Keynesian model with a government and a foreign sector

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