aggregate demand, fiscal policy, and foreign trade

Chapter 22
Aggregate demand, fiscal policy,
and foreign trade
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
6th Edition, McGraw-Hill, 2000
Power Point presentation by Peter Smith
22.1
Some key terms
 Fiscal policy
– the government’s decisions about spending
and taxes
 Stabilization policy
– government actions to try to keep output close
to its potential level
 Budget deficit
– the excess of government outlays over
government receipts
 National debt
– the stock of outstanding government debt
22.2
Government
in the income-expenditure model
 Direct taxes
– affect the slope of the consumption
function
– and hence the slope of the AD
schedule.
 Government expenditure affects the
position of the AD schedule
22.3
Fiscal policy?

Income,
output
45
o
line
AD
0
Y
0
But this ignores some
important issues –
prices, interest rates,
and the need to fund
the government
spending.
AD
1
This seems to suggest
that the government
could influence aggregate
output in the economy
by raising AD from AD
0
to AD
1
,
Y
1
thus raising equilibrium
output from Y

0
to Y
1
.
22.4
but in surplus at high levels
then the budget will be in
deficit at low levels of
income
The government budget
The budget deficit equals total government spending
minus total tax revenue.
If government spending is
independent of income
G
Income, output
but net taxes depend on
income,
The balanced budget multiplier states that an increase in
government spending plus an equal increase in taxes leads
to higher equilibrium output.
Balanced
budget
22.5
Deficits and the fiscal stance
 The size of the budget deficit is not a good
measure of the government’s fiscal
stance.
 The structural budget shows what the
budget would have been if output had

been at the full-employment level.
 The inflation-adjusted budget uses real
not nominal interest rates to calculate
government spending on debt interest.
22.6
Automatic stabilizers
 mechanisms in the economy that
reduce the response of GNP to
shocks
– for example, in a recession:
– payments of unemployment benefits
rise
– and receipts from VAT and income tax
fall
22.7
Limits on active fiscal policy
 Time lags: it takes time
– to diagnose the problem
– to take action
– for the multiplier process to operate
 Uncertainty
– the size of the multiplier is not known
– aggregate demand is always changing
 Induced effects on autonomous demand
– changes in fiscal policy may induce offsetting effects in
other components of aggregate demand
Why can’t shocks to aggregate demand
immediately be offset by fiscal policy?
22.8
Limits on active fiscal policy (2)

 The budget deficit
– concern about inflation if the budget deficit
grows
 Maybe we’re at full employment!
– unemployment may be (at least partly)
voluntary
Why doesn’t the government expand fiscal
policy when unemployment is persistently high?
22.9
Foreign trade
and income determination
 Introducing exports (X) & imports (Z)
 TRADE BALANCE
– the value of net exports (X - Z)
 TRADE DEFICIT
– when imports exceed exports
 TRADE SURPLUS
– when exports exceed imports
 Equilibrium is now where
– Y = C + I + G + X - Z
22.10
At higher income levels, there is a trade deficit.
At relatively low income,
exports exceed imports – there is a trade surplus.
Exports, imports and the trade balance
Income
but that imports increase
with income
Imports
Assume that exports

are independent of
income,
Exports
There is trade balance at income Y*, but there is no
guarantee that this corresponds to full employment.
Y*
22.11
Foreign trade and the multiplier
 The marginal propensity to import
– is the fraction of additional income that
domestic residents wish to spend on
additional imports.
 The effect of foreign trade is to
reduce the size of the multiplier
– the higher the value of the marginal
propensity to import, the lower the
value of the multiplier.
22.12
Chapter 23
Money and modern banking
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
6th Edition, McGraw-Hill, 2000
Power Point presentation by Peter Smith
23.14
Some key questions
 Why does society need money?
 Why do governments wish to
influence money supply?
 How do financial markets interact
with the “real” economy?

 What is the relationship between
money and interest rates?
23.15
Money
 Any generally accepted means of
payment for delivery of goods or the
settlement of debt
 Legal money
– notes and coins
 Customary money
– IOU money based on private debt of the
individual
 e.g. bank deposit.
23.16
Money and its functions
 Medium of exchange
– money provides a medium for the exchange of goods
and services which is more efficient than barter
 Unit of account
– a unit in which prices are quoted and accounts are kept
 Store of value
– money can be used to make purchases in the future
 Standard of deferred payment
– a unit of account over time: this enables borrowing and
lending
23.17
Modern banking
 A financial intermediary
– an institution that specializes in bringing
lenders and borrowers together

 e.g. a commercial bank, which has a government
licence to make loans and issue deposits
 including deposits against which cheques can be
written
 Clearing system
– a set of arrangements in which debts between
banks are settled
23.18
A beginner’s guide to the financial markets
 Financial asset
– a piece of paper entitling the owner to a
specified stream of interest payments over a
specified period
 Cash
– Notes and coin, paying no interest
– the most liquid of all assets.
 Bills
– financial assets with less than one year until
the known date at which they will be
repurchased by the original owner
– highly liquid
23.19
A beginner’s guide to the financial markets
(continued)
 Bonds
– longer term financial assets – less liquid because there
is more uncertainty about the future income stream
 Perpetuities
– an extreme form of bond, never repurchased by the
original issuer, who pays interest forever

 e.g. Consols
 Gilt-edged securities
– government bonds in the UK
 Industrial shares (equities)
– entitlements to receive corporate dividends
– not very liquid
23.20
Credit creation by banks
 Commercial banks need to hold only
a proportion of assets as cash
reserves
– this enables them to create credit by
lending
 EXAMPLE:
– suppose the public needs a fixed £10m
for transactions
– and the commercial bank maintains a
10% cash reserve
23.21
Credit creation – example
Commercial bank :
Liabilities Assets
Deposits
Cash Loans Total
Cash
ratio
%
Public
cash
holding

Money
supply
Initial position:
100 10 90 100
Central bank issues £10m extra; the public deposits it
10
10
110
110 20 90 110
1
18.2 10 120
110 11 99 1102 10 19 129
119 20 99 1193 16.8 10 129
200 20 180 200
n
10 10 210
23.22
The monetary base and the
money multiplier
 The monetary base or stock of high-
powered money
– the quantity of notes and coin in private
circulation plus the quantity held by the
banking system
 The money multiplier
– the change in the money stock for a £1
change in the quantity of the monetary
base
23.23
The money multiplier

Suppose the banks wish to hold cash reserves R as
as fraction (c
b
) of deposits (D), and the private sector
wish to hold cash (C) as a fraction (c
p
) of bank
deposits (D).
Then R = c
b
D and C = c
p
D
Monetary base H = C + R = (c
b
+ c
p
) D
Money supply = C + D = (c
p
+ 1) D
So M =
(c
p
+ 1)
(c
p
+ c
b
)

H
Money supply = money multiplier × monetary base