Download 837 b. Which type of fiscal policy—expansionary or

CHAPTER 28
FISCAL POLICY
837
b. Firms come to believe that a recession in the near
Aggregate
price
level
future is likely.
LRAS
SRAS
c. Anticipating the possibility of war, the government
increases its purchases of military equipment.
d. The quantity of money in the economy declines and
interest rates increase.
P1
E1
4. During an interview in 2008, the German Finance
AD1
Y1
YP
Potential
output
Real GDP
b. Which type of fiscal policy—expansionary or
contractionary—would move the economy of
Albernia to potential output, YP? What are some
examples of such policies?
c. Illustrate the macroeconomic situation in Albernia
with a diagram after the successful fiscal policy has
been implemented.
Minister Peer Steinbrueck said, “We have to watch out
that in Europe and beyond, nothing like a combination
of downward economic [growth] and high inflation
rates emerges—something that experts call stagflation.” Such a situation can be depicted by the movement
of the short-run aggregate supply curve from its original position, SRAS1, to its new position, SRAS2, with the
new equilibrium point E2 in the accompanying figure.
In this question, we try to understand why stagflation
is particularly hard to fix using fiscal policy.
Aggregate
price
level
LRAS
SRAS2
2. The accompanying diagram shows the current mac-
roeconomic situation for the economy of Brittania;
real GDP is Y1, and the aggregate price level is P1. You
have been hired as an economic consultant to help the
economy move to potential output, YP.
SRAS1
P2
E2
E1
P1
AD1
Aggregate
price
level
LRAS
SRAS
P1
Y2
YP
Real GDP
Recessionary gap
E1
a. What would be the appropriate fiscal policy response
AD1
Potential
output
YP
Y1
Real GDP
a. Is Brittania facing a recessionary or inflationary gap?
b. Which type of fiscal policy—expansionary or con-
tractionary—would move the economy of Brittania
to potential output, YP? What are some examples of
such policies?
c. Illustrate the macroeconomic situation in Brittania
with a diagram after the successful fiscal policy has
been implemented.
3. An economy is in long-run macroeconomic equilibrium
when each of the following aggregate demand shocks
occurs. What kind of gap—inflationary or recessionary—will the economy face after the shock, and what
type of fiscal policies would help move the economy
back to potential output? How would your recommended fiscal policy shift the aggregate demand curve?
a. A stock market boom increases the value of stocks
held by households.
to this situation if the primary concern of the government was to maintain economic growth? Illustrate
the effect of the policy on the equilibrium point and
the aggregate price level using the diagram.
b. What would be the appropriate fiscal policy response
to this situation if the primary concern of the government was to maintain price stability? Illustrate the
effect of the policy on the equilibrium point and the
aggregate price level using the diagram.
c. Discuss the effectiveness of the policies in parts a
and b in fighting stagflation.
5. Show why a $10 billion reduction in government pur-
chases of goods and services will have a larger effect
on real GDP than a $10 billion reduction in government transfers by completing the accompanying table
for an economy with a marginal propensity to consume (MPC) of 0.6. The first and second rows of the
table are filled in for you: on the left side of the table,
in the first row, the $10 billion reduction in government purchases decreases real GDP and disposable
income, YD, by $10 billion, leading to a reduction in
consumer spending of $6 billion (MPC × change in disposable income) in row 2. However, on the right side of
the table, the $10 billion reduction in transfers has no
effect on real GDP in round 1 but does lower YD by $10
838
PA RT 13
S TA B I L I Z AT I O N P O L I C Y
billion, resulting in a decrease in consumer spending
of $6 billion in round 2.
Decrease in G 5 2$10 billion
Decrease in TR 5 2$10 billion
Billions of dollars
Billions of dollars
Rounds
Change in
G or C
Change in
real GDP
Change in
YD
1
6G = <$10.00
<$10.00
<$10.00
2
6C =
<6.00
<6.00
<6.00
Change in
TR or C
Change in
real GDP
Change in
YD
6TR = <$10.00
$0.00
<$10.00
6C =
<6.00
<6.00
<6.00
3
6C =
?
?
?
6C =
?
?
?
4
6C =
?
?
?
6C =
?
?
?
5
6C =
?
?
?
6C =
?
?
?
6
6C =
?
?
?
6C =
?
?
?
7
6C =
?
?
?
6C =
?
?
?
8
6C =
?
?
?
6C =
?
?
?
9
6C =
?
?
?
6C =
?
?
?
10
6C =
?
?
?
6C =
?
?
?
a. When government purchases decrease by $10 billion,
what is the sum of the changes in real GDP after the
10 rounds?
b. When the government reduces transfers by $10 bil-
lion, what is the sum of the changes in real GDP
after the 10 rounds?
c. Using the formula for the multiplier for changes in
government purchases and for changes in transfers,
calculate the total change in real GDP due to the $10
billion decrease in government purchases and the
$10 billion reduction in transfers. What explains the
difference? (Hint: The multiplier for government purchases of goods and services is 1/(1 < MPC). But since
each $1 change in government transfers only leads to
an initial change in real GDP of MPC × $1, the multiplier for government transfers is MPC/(1 < MPC).)
6. In each of the following cases, either a recessionary or
inflationary gap exists. Assume that the aggregate supply
curve is horizontal, so that the change in real GDP arising
from a shift of the aggregate demand curve equals the size
of the shift of the curve. Calculate both the change in government purchases of goods and services and the change
in government transfers necessary to close the gap.
a. Real GDP equals $100 billion, potential output
equals $160 billion, and the marginal propensity to
consume is 0.75.
b. Real GDP equals $250 billion, potential output
equals $200 billion, and the marginal propensity to
consume is 0.5.
c. Real GDP equals $180 billion, potential output
equals $100 billion, and the marginal propensity to
consume is 0.8.
an inflationary or recessionary gap is larger. How can
you explain this apparent inconsistency?
8. The accompanying table shows how consumers’ mar-
ginal propensities to consume in a particular economy
are related to their level of income.
Income range
Marginal propensity to consume
$0–$20,000
0.9
$20,001–$40,000
0.8
$40,001–$60,000
0.7
$60,001–$80,000
0.6
Above $80,000
0.5
a. Suppose the government engages in increased purchas-
es of goods and services. For each of the income groups
in the table, what is the value of the multiplier—that is,
what is the “bang for the buck” from each dollar the
government spends on government purchases of goods
and services in each income group?
b. If the government needed to close a recessionary or
inflationary gap, at which group should it primarily
aim its fiscal policy of changes in government purchases of goods and services?
9. The government’s budget surplus in Macroland has
risen consistently over the past five years. Two government policy makers disagree as to why this has
happened. One argues that a rising budget surplus
indicates a growing economy; the other argues that
it shows that the government is using contractionary
fiscal policy. Can you determine which policy maker is
correct? If not, why not?
7. Most macroeconomists believe it is a good thing that
10. Figure 28-9 shows the actual budget deficit and the
taxes act as automatic stabilizers and lower the size
of the multiplier. However, a smaller multiplier means
that the change in government purchases of goods and
services, government transfers, or taxes needed to close
cyclically adjusted budget deficit as a percentage of
GDP in the United States from 1970 to 2010. Assuming
that potential output was unchanged, use this figure
to determine which of the years from 1990 to 2009 the
CHAPTER 28 APPENDIX
TA X E S A N D T H E M U LT I P L I E R
841
PROBLEMS
1. An economy has a marginal propensity to consume of
0.6, real GDP equals $500 billion, and the government
collects 20% of GDP in taxes. If government purchases
increase by $10 billion, show the rounds of increased
spending that take place by completing the accompanying table. The first and second rows are filled in
for you. In the first row, the increase in government
purchases of $10 billion raises real GDP by $10 billion,
taxes increase by $2 billion, and YD increases by $8 billion; in the second row, the increase in YD of $8 billion
increases consumer spending by $4.80 billion (MPC ×
change in disposable income).
Change
in G
or C
Rounds
Change
in real
GDP
Change
in
taxes
Change
in YD
(billions of dollars)
1
6G = $10.00
2
6C =
3
6C =
4
5
$10.00
$2.00
$8.00
4.80
4.80
0.96
3.84
?
?
?
?
6C =
?
?
?
?
6C =
?
?
?
?
6
6C =
?
?
?
?
7
6C =
?
?
?
?
8
6C =
?
?
?
?
9
6C =
?
?
?
?
10
6C =
?
?
?
?
a. What is the total change in real GDP after the 10
rounds? What is the value of the multiplier? What
would you expect the total change in real GDP to be,
based on the multiplier formula? How do your two
answers compare?
b. Redo the accompanying table, assuming the margin-
al propensity to consume is 0.75 and the government
collects 10% of the rise in real GDP in taxes. What
is the total change in real GDP after 10 rounds?
What is the value of the multiplier? How do your two
answers compare?
2. Calculate the change in government purchases of goods
and services necessary to close the recessionary or
inflationary gaps in the following cases. Assume that
the short-run aggregate supply curve is horizontal, so
that the change in real GDP arising from a shift of the
aggregate demand curve equals the size of the shift of
the curve.
a. Real GDP equals $100 billion, potential output
equals $160 billion, the government collects 20% of
any change in real GDP in the form of taxes, and the
marginal propensity to consume is 0.75.
b. Real GDP equals $250 billion, potential output
equals $200 billion, the government collects 10% of
any change in real GDP in the form of taxes, and the
marginal propensity to consume is 0.5.
c. Real GDP equals $180 billion, potential output
equals $100 billion, the government collects 25% of
any change in real GDP in the form of taxes, and the
marginal propensity to consume is 0.8.
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