ECS 1601

Learning Unit 7
Keynesian model including
the government and the
foreign sector

7.1 Fiscal policy

Recall from learning unit 3, fiscal policy concerns
decisions about the level and composition of
government expenditure, taxes and government
borrowing.
Expansionary fiscal policy is when the
government wants to give more petrol to the
economy. The government can either:
Increase government spending (G) (direct effect)
Decrease the tax rate (t) (indirect effect)

Contractionary fiscal policy is when the car

(economy) is going too fast and the government
wants to slow it down. The government can
either:
Decrease government spending (G) (direct effect)

7.1 Expansionary fiscal policy

What will happen when

government
expenditure (G)
increases?
Aggregate spending (A)
will increase.
This will lead to a decrease
in inventories, producers
will increase and this
results in an increase in
income.
G
The increase in income
results in an increase in
induced consumption,
0
which increases
aggregate spending
again (i.e. the multiplier
process).
Aggregate spending (A)

E1

E0

45

Y0
Y1
Total production, income (Y)

7.1 Expansionary fiscal policy

What will happen when the

tax rate decreases?
The slope of the aggregate
spending function
becomes steeper (a larger
part of an increase in
income can be spend due to
the smaller amount paid to
tax).
Induced consumption
increases (due to lower tax
rate) leading to an
increase in aggregate
spending.
This again results in a
multiplier process,
increasing income and

Aggregate spending (A)

E1

E0

45

Y0

Y1

Total production, income (Y)

What will happen when

government
expenditure (G)
decreases?
Aggregate spending (A)
will decrease.
This will lead to an
increase in inventories,
producers will decrease
production and this
results in a decrease in
income.
The decrease in income
results in a decrease in
induced consumption,
which decreases
aggregate spending
again (i.e. the multiplier

Aggregate spending (A)

7.1 Contractionary fiscal policy

E0

E1

0
45

Y0
Y1
Total production, income (Y)

7.1 Contractionary fiscal policy

What will happen when the

tax rate increases?
The slope of the aggregate
spending function
becomes flatter (a smaller
part of an increase in
income can be spend due to
the higher amount paid to
tax).
Induced consumption
decreases (due to higher
tax rate) leading to a
decrease in aggregate
spending.
This again results in a
reverse multiplier process,
decreasing income and

Aggregate spending (A)

E0

E1

45

Y1

Y0

Total production, income (Y)

Read section
18.2 in
textbook
pp348-354

7.2 Introducing the

foreign sector

Watch the 1601

DVD, for more on
the foreign sector
in the Keynesian
model.

Two important economic aspects of

the foreign sector are:
Exports (X)
Goods are produced in South Africa but
other countries buy it. It is thus a
injection into the production, income and
spending circular flow.
Imports (Z)
Goods are produced in other countries
and bought in South Africa. It is thus a
leakage out of the production, income

7.2 Exports

Exports are the same as investment and

government expenditure; it is a positive
(injection) that is autonomous.
Exports are not influenced by the income of
South Africa, it is rather influenced by the
economic condition of other countries in the
world, exchange rates and international
competitiveness. It is thus autonomous to
change in income:
Therefore we now also include other countries
in the model and they also spend money on
goods produced in our economy. Thus:

 See the expenditure line

with only households and
firms and the government.
As previously stated,
exports are not influenced
by income, it is
autonomous spending.
How do we show
autonomous spending on
the Keynesian diagram?
Think back to government
expenditure.

Aggregate spending (A)

7.2 Exports

45

Total production, income (Y

Aggregate spending (A)

Total expenditure in the

economy is now equal to what
households, firms, the
government and the foreign
sector spend.
Households (C), firms (I) and
government (G) are included
in the blue line A.
The purple line shows exports.
Now add these two lines
together to get total
expenditure (A=C+I+G+X).
Take note: The slope of the line
did not change, only the y-axis
intersect. That is because
exports are autonomous and
only influence the intersect
and NOT the slope of the
expenditure line.

45

Total production, income (Y

7.2 Imports
Think back to the consumption function:
Consumption includes at all goods
consumed, those produced in South Africa
and those produced abroad.
If I consume (C) the following items:
But we are only interested in the items that
are produced locally. Therefore we have to
subtract imported goods (minus Z).

7.2 Imports

Autonomous

Will import this

amount irrespective
of income

Another aspect that consumption and

imports have in common is that both have
Imports
(Z)
an autonomous
AND induced part.
Will import more if
income increases
Induced

Study Box
18.6 on
page 351 of
the textbook

7.2 Net exports

Net exports (NX) = Exports (X)

Imports (Z).
Net export (NX) is positive when
X>Z.
Net exports (NX) is negative when
X<Z.

7.2 Continue

Total income

Aggregate spending (A)

Net exports (NX)

What happens when NX is added to the

expenditure line?
Positive NX plus expenditure equals A1.
Negative NX plus expenditure equals A2.

45

Total production, income (Y)

7.2 Net exports

Net exports have two
parts: An autonomous
part () and an induced
part ()
Therefore, when you
add NX (lets assume it
is positive to keep it
simple) to the
expenditure line, the
following will happen
First, the intersect will
change because of the
autonomous spending.
Second, the slope will
change due to marginal

Aggregate spending (A)

45

Total production, income (Y)

Study Box
18.7 on
page 355 of
the textbook

7.2 Continue

Can
you also show net exports in numbers?

Take the following example:

C = 500 + 0.9Y
I = 450
G = 470
t = 20%
X = 300
= 150
m = 0.2
Calculate equilibrium income.

7.2 Continue
Y = A
Y=C+I+G+XZ

Y = 500+ 0.9(0.80)Y + 450 +

470 + 300 150 0.2Y
Y
+

Make sure you

understand
= 500+
0.72Y + why
450 +
these are
300 negatives
150
0.2Y
ask
your e-tutor if you
dont understand.

470

Y = 500+ 450 + 470 + 300

150 0.2Y + 0.72Y
Y = 1 570+ 0.52Y

There are two methods.

FIRST METHOD
State the equilibrium position.
Remember A = C + I + G + X Z.
Replace the given values.

Simplify inside bracket.

Simplify brackets.

Rearrange values on the right-hand side.

Simplify right-hand side.
Take the 0.52Y value to the left.
Simplify the left side.
Divide both sides by 0.48.
That is equilibrium income.

7.2 Continue

470 + 300 - 150

SECOND METHOD
Start by calculating the
multiplier.
Insert given values.
Simplify and calculate value of
multiplier.
Then calculate total
autonomous spending.
Insert given values.
Simplify .
To get equilibrium level of
income, multiply the multiplier
with autonomous spending.
That is the equilibrium level of
income. Compare with the
answer in method one.

7.2 Continue
There are two methods to
calculate equilibrium level
of income.
You have be able to do
both! But you will most
likely have a choice in what
method you would like to
use.
Do the following example
and decide NOW what
method you prefer.
The second method is
easier if it is a complex
question.

C = 9 800 + 0.7Y
I = 7 200
G = 6 000
t = 25%
X = 4 500
The answer is 36
Z = 4 600 -640.
0.15Y
Did you get
the same answer
with both
methods? Ask your
e-tutor how!

7.2 Impact of net exports (NX) on the

equilibrium level of income

A =C+I+G+(X-Z)

Aggregate spending (A)

Suppose there is an
increase in NX. The
expenditure line will
move upwards, there
will be an increase in
level of income,
equilibrium is now E.
Suppose there is an
decrease in NX. The
expenditure line will
move downwards, there
will be an decrease in
level of income,
equilibrium is now E.

A =C+I+G + (X-Z

Net exports E

A =C+I+G+(XZ)

45
Y

Total production, income

7.2 Impact of marginal propensity to import

(m) on the equilibrium level of income

Suppose there is an
decrease in m:
the slope of the Aspending line will be bigger,
such as A3.
equilibrium is now E3 at a
higher income level.

E3
Aggregate spending (A)

Suppose there is an
increase in m:
the slope of the Aspending line will be
smaller, such as A2.
equilibrium is now E2 at a
lower income level.

A3
A1

E1 A
2
E
2

45

Y2

Y1 Y3

Total production, income

(Y)

Read section
18.3 in
textbook
pp 355-356

7.3 Summary

Government spending increases

autonomous spending.
Proportional income tax reduces the
size of the multiplier.
Exports are an autonomous injection
into the economy.
Imports are an autonomous and
induced leakage out of the economy.

Are you able to:

Define fiscal policy?
Explain the impact of the government on aggregate spending,
the multiplier and equilibrium level of income?
Explain the impact of the proportional income tax on private
consumption expenditure, autonomous spending, the multiplier
and the equilibrium level of income?
Explain the difference between income and disposable income?
Show and explain any changes in the government spending, tax
rates, imports or exports on a graph?
Calculate autonomous spending?
Calculate the multiplier?
Calculate the equilibrium level of income?
Calculate the required change in government
spending to achieve full employment?

You are a
star! The
Keynesian model
is not easy to
understand and
youve managed
it.
Well done!

This is the end of learning unit

7.
A quiz on this work will be
available soon; make sure you
do it and discuss it
with your e-tutor!