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Factoring in government purchases
Government expenditure (G) is the second-largest component of aggregate demand and accounts for around 20 per cent of GDP in the UK. It refers to the government purchasing goods and services. The idea is that these goods and services are eventually provided to households in some shape or form. Examples of government purchases are spending on healthcare, education, defence, roads and so on.
Social security spending on benefits and welfare payments aren’t counted as part of government purchases. This is because they’re transfer payments from one group of people to another group: they don’t
involve the government purchasing any goods or services.
Government expenditure is usually exogenous in macroeconomic models, which means that the model doesn’t attempt to explain it. It just equals what it equals. This makes sense, because the level of government spending is a political decision taken by politicians – within certain constraints, of course. For this reason G is assumed to be fixed, unless it’s specifically changed by policy makers.
To show that a variable is fixed, you can put a ‘bar’ above it:
Of course, G does change over time depending on the particular preferences and constraints of the government at the time. But unless you’re explicitly told that government spending has changed, you can assume that it’s constant and unaffected by other macroeconomic variables.
Coming in, going out: Net exports
Net exports (NX) are exports (X) minus imports (M). The term represents the net demand from overseas for domestic goods. Imports need to be subtracted so their inclusion in C, I and G is taken out – this is to ensure that AD only includes demand for goods and services produced domestically.
The UK tends to import more than it exports, which means that net exports is
usually a negative component of aggregate demand and GDP. Net exports as
a whole tends to be only a few percentage points of total GDP. You may
think that this means that trade is insignificant, but in fact open economies
(countries that make it relatively easy to trade with others) such as the UK
engage in huge amounts of trade. In 2014, UK exports were worth around
£0.5 trillion, which is a substantial chunk of the country’s GDP. But because
UK imports of foreign goods was more than this (although not a huge amount
more), the overall trade balance is small compared to GDP.
The main macroeconomic variable that affects net exports is the exchange rate, which tells you the rate at which you can convert one currency into another. For example, if the exchange rate is £1 = $1.50, you can go to the foreign exchange market and convert £1 into $1.50 or alternatively $1.50 into £1. If the exchange rate changes to £1 = $2, it’s called an appreciation of the pound and a depreciation of the dollar. Basically, £1 now buys you more dollars.
If the pound appreciates, it becomes relatively cheaper for people in the UK to buy US goods; this causes an increase in imports (M). Equally, UK goods are now relatively more expensive to people in the US; this causes a decrease in UK exports (X). These effects lead to a fall in net exports (NX = X – M).
(Strictly speaking, something called the Marshall–Lerner condition needs to hold for a depreciation to increase net exports. In this book we always assume that the condition holds. (See the nearby sidebar ‘Delving into the Marshall– Lerner condition’ for more details.)
Mathematically, you can express the relationship between net exports and the exchange rate as follows:
In words, this expression says that net exports (NX) are a function of the exchange rate (e).
Figure 7-3 illustrates this situation graphically. You can see that, as the exchange rate depreciates, net exports increase. The dashed line at 0 (zero) represents the case of balanced trade, that is, imports are exactly matched by exports. To the right of the dashed line, net exports are positive and the economy has a trade surplus: exports are greater than imports. To the left of the dashed line, net exports are negative and the economy has a trade deficit: imports are greater than exports.
© John Wiley & Sons
Figure 7-3: Net exports (NX) and the exchange rate (e).
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