Question

Consider the following linear version of the AA-DD model: consumption is given by C-(1- s)(YT) and the current account balance is given by CA aE-m(Y-T). (s is sometimes referred to as the marginal propensity to save and in is called the marginal propensity to import.) Then the condition of equilibrium in the goods market is Y=C+1+G+CA (1-s) (Y-T)+ I+G+aE-m(Y-T). We will write the condition of money-market equilibrium as M'/P = bYdR. Assume that the central bank can hold both the interest rate R and exchange rate E constant, and assume that investment I is also constant.

a) Consider the equilibrium in the output market. Other things equal, what is the effect of an increase in government spending G by 1 unit on output Y? (This number is often called the open-economy government spending multiplier, but as you can see it is relevant only under strict conditions.) How does a higher value of m affect the government spending multiplier? Explain your result intuitively.
b) Consider the equilibrium in the output market. Other things equal, what is the effect of an increase in taxes T by 1 unit on output Y? Under what conditions will higher taxes reduce output? Explain your result intuitively.
c) Suppose that the government decreases decreases both G and T by one unit, so the govern- ment balances its budget. From your analysis in parts a) and b), will this policy increase or decrease output Y? By how much?

Answer 1

An increase in government spending will increase output, and a higher value of the marginal propensity to import reduces the government spending multiplier. An increase in taxes will decrease output, but the magnitude of the decrease depends on the marginal propensity to consume. If the government decreases both government spending and taxes by the same amount, output will decrease if the decrease in government spending is larger.

Step-by-step explanation:

a) An increase in government spending G by 1 unit will have an effect on output Y known as the open-economy government spending multiplier. In this case, the equilibrium condition in the goods market is given by Y = C + I + G + CA(1-s)(Y - T) + G + aE - m(Y - T). When government spending increases, the equation becomes Y = C + I + G +1 + CA(1-s)(Y - T) + G + aE - m(Y - T). As a result, the output Y will increase by a value larger than 1 unit due to the multiplier effect.

A higher value of m, which represents the marginal propensity to import, will reduce the government spending multiplier. This is because a higher value of m means that a larger proportion of income is spent on imports, which reduces the impact of an increase in government spending on output.

b) An increase in taxes T by 1 unit will have a negative effect on output Y. This is because an increase in taxes reduces the amount of disposable income available for consumption, which in turn reduces consumption and output. Higher taxes will reduce output under conditions where the marginal propensity to consume (MPC) is less than 1. In this case, if the MPC is less than 1, an increase in taxes will lead to a decrease in consumption and output.

c) If the government decreases both G and T by one unit, so the budget is balanced, the effect on output Y will depend on the magnitudes of the changes in G and T and the values of the multipliers. If the magnitude of the decrease in G is larger than the magnitude of the decrease in T, then the decrease in G will have a larger negative impact on output than the decrease in T. As a result, output Y will decrease.