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AK Macroeconomics – Chapter 7
CHAPTER SEVEN
Answers to Self-Test Questions
1. See the following graph:
NTR1
G & NTR
NTR2
G
Real
GDP
Budget
Surplus
Real
GDP
Budget
deficit
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AK Macroeconomics – Chapter 7
2. $80B. (The debt is $100B and there is a current budget surplus of $20B which will
reduce the debt to $80B)
3. a) See the following table:
0
20
– 30
Real GDP
Net tax revenues
Budget balance
40
30
– 20
80
40
– 10
120
50
0
160
60
+ 10
See the following graph:
Budget balance
30
20
BL
10
0
-10 0
40
80
120
160
-20
-30
Real GDP
4. a)
b)
c)
d)
shift to the left
shift to the left
shift to the right
shift to the left
5. Contractionary fiscal policy is used to close an inflationary gap. Aggregate demand
decreases causing price and national income to fall.
6. a) unemployment: rise (because GDP will fall with the drop in government
spending, or increased tax rates);
b) GDP: fall (because of the drop in government spending or increased tax rates);
c) NTR: may rise or fall (a lower GDP will reduce taxes but overall NTR might
rise or fall depending on whether tax rates were increased or government spending
reduced.)
d) deficit: smaller (but will not be eliminated)
Second set of circumstances:
a) unemployment: fall (because GDP has risen)
b) GDP: rise (because of the increase in government spending or cut in tax rates)
c) NTR: may rise or fall (a higher GDP will increase taxes but overall NTR might
rise or fall depending on whether tax rates were decreased or government spending
increased.)
d) deficit: may be larger or smaller (but will definitely persist).
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AK Macroeconomics – Chapter 7
7. $300 is the initial level of equilibrium income and is determined as follows:
C
C
I
G
Xn
AE
0.5Y
Y
=
=
=
=
=
=
=
=
20 + 0.75(Y  80)
 40 + 0.75Y
50
80
60  0.25Y
150 + 0.5Y = Y
150
300
After the increase in G and T of $20:
C
=
20 + 0.75(Y  100); therefore
C
=
 55 + 0.75Y
I
=
50
G
=
100
XN
=
60  0.25Y
AE
=
155 + 0.5Y
0.5Y =
155
Y
=
310
The new income level, therefore, is $310. The effect on the economy is not neutral,
i.e. the effect of a change in T does not entirely cancel out the effect of the change
in G.
8. If the economy is experiencing an inflationary gap, then a budget deficit would be
inappropriate.
Answers to Study Guide Questions
1.
2.
3.
4.
5.
True
True
False: both the price level and real GDP will rise.
True
False: only net tax revenues are a function of GDP; government spending is regarded
as autonomous.
6. True
7. False: it produces a parallel shift down.
8. False: the opposite way around.
9. False: the level of GDP will still increase.
10. True
11. c
12. b
13. a
14. d
16. a
17. b
18. d
19. b
21. b
22. c
23. c
24. b
26. a
27. b
28. e
29. a
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31. d
32. b
33. a
34. b
AK Macroeconomics – Chapter 7
15. d
20. e
25. c
30. d
35. d
36A. Key Problem
a) GDP = 1200; price level = 120
b) recessionary gap of 400
(since the intersection of the AS and AD curves occurs to the left of the Potential
GDP curve, there is a recessionary gap)
c) deficit of 200 (at a GDP of 1200, the BL line is below zero at – 200)
d) See the following figure:
Figure 7.10 (completed)
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AK Macroeconomics – Chapter 7
AD must increase by 600 which is 6 squares to the right
e) increase in government spending of 200
(200 times the multiplier of 3 equals the gap of 600)
f) See Figure 11.10 (completed)
The new GDP would be 1600 and the price level would be 140. (This where AD2
intersects AS.)
g) deficit of 200 (The increase in government spending of 200 will shift the BL
down by 200 or 4 squares);
h) G needs to be reduced by 200. (Since at equilibrium of 1200 that is the amount
of the government’s deficit.)
See Figure 11.10 (completed) The BL shifts up by 200 (4 squares).
i) See Figure 11.10 (completed); AD would decrease by 600 (3 X 200).
j) the AD curve would shift back by 6 squares, thus the new GDP would be 800 and
the new price level 100.
k) Since the decrease in government spending would shift the BL up by 4 squares, at
a GDP of 800 the budget would have a deficit of 200.
37A. a) NTR = 135.8 ( Tax revenues = 222.2; transfer payments = 52.6 + 33.8 =86.4)
b) 13.2 (NTR = 135.8; G = 40.8 + 81.8 = 122.6)
c) 46.7%
(103.7/222.2 x100)
d) 14.3%
(31.7/222.2 x 100)
e) 25.2%
(52.6/209 x 100)
f) 16.2%
(33.8/209 x 100)
38A a) deficit of $14B Balance = (0.35 x 360) – 140)
b) surplus of $35B Balance = (0.35 x 500) – 140)
c) GDP of $400B 0.35Y = 140, therefore Y = 140/0.35
39A. a) AD1 to AD2 and BL1 to BL3
b) AD1 to AD3 and BL1 to BL2
40A See the following table:
Table 7.9 (completed)
Year
2006
2007
2008
2009
2010
2011
Budget
Surplus
/
/
/
8
5
/
Budget
Deficit
/
14
29
/
/
6
National
Debt
280
294
323
315
310
316
61
GDP
Debt/GDP %
700
725
730
700
720
750
40.0
40.6
44.2
45.0
43.1
42.1
AK Macroeconomics – Chapter 7
41A. a) recessionary gap of $20B (Equilibrium of $520 is $20 less than potential GDP
of $405)
b) $40B ( the AD curve must be shifted right by 4 squares)
c) $10B (1/4 of $40)
d) deficit of $5B (T increases by 0.25 x increase in GDP ($20b) = $5b; G
increased by $10b.)
42A. Fiscal policy refers to the government’s approach to its own spending and taxation.
For instance, should the government make sure that its spending and tax revenues
always balance every year, or perhaps every business cycle or alternatively should it
deliberately over- or under- spend in order to correct problems in the economy?
43A. The federal government owes most of its debt to Canadians – to banks, insurance
companies, and other firms, institutions or individuals who buy Canadian government
bonds. Only 16 percent (in 2010) was foreign-owned.)
44A.
a) $100B (G = $300; NTR = $200)
b) $600B
(If G drops by $100 then GDP will drop by $200 from its present
level.)
c) deficit of $50B (The G line shifts down by 2 squares - $100).
45A. a) recessionary gap of 200 (Equilibrium GDP of 1300 is $200 less than potential
GDP of $1500)
b) increase AD 400 ( to get it to intercept at potential GDP of $1500)
c) 8.33% (Price index increases from 120 to 130.)
46A. a)
b)
c)
d)
e)
C
I
G
XN
AE
0.5Y
Y
=
=
=
=
=
=
=
25 + 0.6Y
60
160
55 - 0.1Y
300 + 0.5Y
300
600
multiplier = 2 (MPE = 0.5; MLR = 0.5; multiplier = 1/0.5
deficit of 20 (T = 20 + 0.2(600) = 140;
G = 160)
new equilibrium Y = 560 (If G falls 20 then Y will fall by 20 x multiplier 2)
deficit = 8 (T = 20 + 0.2(560) = 132;
G = 140)
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AK Macroeconomics – Chapter 7
47A.
a) Party A: down (using contractionary policy); Party B: up (using
expansionary policy)
b) Party A: down (because GDP will fall); Party B: may go up or down (GDP
will increase NTR but tax rates have been cut and will reduce NTR)
c) Party A: up (because GDP is down);
Party B: down (because GDP is up)
d) Party A: will remain though may be smaller (because NTR will fall);
Party B: : will remain and may even be bigger
e) Party A: down (because AD is lower); Party B: up (because AD is higher)
48A. a) and b) See the following figure:
Figure 7.14 (completed)
A
320
G Spending/NTR
NTR
240
G1
G2
160
80
0
0
100
200
300
400
500
600
Real GDP
B
BL2
Budget balance
80
BL1
0
0
100
200
300
-80
-160
Real GDP
63
400
500
600
AK Macroeconomics – Chapter 7
c) Surplus of $80.
49A.
First, there is a potential time lag problem in that it may take many months for
the full effect of a change in policy to take effect and in the mean time the
conditions of the economy might change so that the policy becomes inappropriate.
Second, some argue that fiscal policy is ineffective because of potential problems
of inflation (using expansionary fiscal policy) or the crowding out effect. Thirdly,
budget deficits might become habit-forming for a government leading to a higher
and higher national debt so that an increasing amount of government spending
is devoted to paying interest on the debt at the possible cost of reduced spending
on health care and education.
50A. The primary goal of counter-cyclical fiscal policy is to correct problems in the
economy. It does this by increasing spending (or decreasing taxes) when the
economy is in a recession and by decreasing spending (or increasing taxes) when
the economy is in an inflationary boom. Three criticisms of this policy are:
 it is subject to serious time lags
 it is ineffective because it may be inflationary, and may crowd out private
spending
 it can lead to serious budget deficits.
51A. In order to pay off the national debt, funds must be taken from citizens in the form
of taxation and used to redeem the bonds. However, while everyone pays taxes
(in one form or another); not everyone owns bonds. Since it is the wealthy who
are the biggest bondholders, such a repayment would represent a serious redistribution of incomes.
52A. a)
C
C
C
I
G
XN
AE
0.3Y
Y
=
=
=
=
=
=
=
=
=
40 + 0.8YD
40 + 0.8(Y – 340)
- 232 + 0.8Y
100
340
107 - 0.1Y
315 + 0.7Y
315
1050
b) no surplus or deficit
c)
C
C
C
I
G
XN
=
=
=
=
=
=
40 + 0.8YD
40 + 0.8(Y – 400)
- 280 + 0.8Y
100
400
107 - 0.1Y
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AK Macroeconomics – Chapter 7
AE
0.3Y
Y
=
=
=
327 + 0.7Y
327
1090
C = 60 + 0.8 (Y – (200 + 0.25Y))
53A. a)
C = – 100 + 0.6Y
I = 600
G = 200 + 0.25Y
XN = 700 – 0.2Y
(Y = AE = 1400 + 0.65Y
Y = 4000
b)
c)
d)
G = T = 200 + 0.25 (4000) = 1200
XN = 700 – 0.2(4000) = –100
multiplier = 2.86 (MPE = 0.65; MLR = 0.35; multiplier = 1/0.35)
54A. a) See the following table:
Table 7.11 (completed)
Year
1
2
3
4
5
6
GDP ($B)
600
580
560
612
620
608
Deficit/Surplus
0
-5
- 10
+3
+5
+2
b) Government spending: 145. After 6 years the government has an accumulated
deficit of – 5. Therefore to balance the budget over the 7-year cycle it needs a
surplus of 5 in year 7. Since its predicted revenues are $150 (25% x $600), it needs
to budget for spending of 145.
c) Change in tax rate: 0.8% (Alternatively, to produce a surplus of $5, its tax
revenues will need to be $155. 155/600 x 100 = 25.8%) So the MTR must
increase from 25% to 25.8%)
55A. Equilibrium income will increase by $50. Done separately, an increase of G of
$100 increases Y by 250 (2 ½ times). An increase of T of $100, reduces YD by $100,
which causes C to fall by $80. The drop of $80 causes Y to fall by $200 (2 ½ times).
Changing both at the same time will net out to an increase of $50.
56A. Generally speaking, when an economy is in a recession, the government finds it is
running a budget deficit. If the government were to try to balance the budget in these
circumstances (by reducing government spending or raising taxes) the effect will be to
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AK Macroeconomics – Chapter 7
reduce aggregate demand, thus decreasing GDP. In other words, the recession will get
worse, i.e. the action of the government pushes the economy further in the direction it
was heading.
Similarly, when an economy is experiencing an inflationary boom period, the
government generally finds that it has a budget surplus. If it attempts to reduce the
surplus by increasing government spending or reducing taxes the effect will be to
increase aggregate spending thus pushing up inflation higher.
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