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Chapter 14: Fiscal Policy and Public Finance
Chapter 14: Fiscal Policy and Public Finance
Questions for Thought and Review
2.
According to the Ricardian equivalence theorem, government spending is offset by an
equal reduction in private spending because people would increase their savings in
anticipation of an increase in taxes in the future to pay for that deficit.
4.
Functional finance is difficult to implement because financing the deficit often has
offsetting effects, the government doesn’t always know how its policies will affect the
economy, potential output is not a known quantity, enacting spending and taxing policies
is time consuming, government debt can affect private spending, and taxing and spending
can negatively affect other government goals.
6.
If interest rates have no effect on investment, there would be no crowding out. Crowding
out occurs when the government’s sale of bonds to finance expansionary fiscal policy
causes interest rates to rise, choking off private investment.
8.
State balanced budget requirements are pro-cyclical because during downturns, tax
revenue generally falls, making it necessary for state governments to raise tax rates and
cut expenditures in order to maintain a balanced-budget. Such actions slow the economy
even further. The opposite is true during expansions: tax revenues rise so that states
accumulate surpluses. They cut tax rates and increase expenditures, contributing to a
greater expansion.
10.
Automatic stabilizers reduce taxes and raise expenditures during contractions without
additional government action. They therefore act to offset contractions. Likewise during
recoveries, automatic stabilizers increase taxes and reduce expenditures, which act to
slow the recovery.
12.
Increasing taxes shifts the aggregate demand curve in to the left, decreasing income,
increasing unemployment and making people less likely to vote for those in office. The
maxim holds because people tend to have short memories.
14.
While New Classicals do not believe that government spending will affect the economy,
they do believe that taxes reduce the incentive to work and produce. Therefore, they
promote a policy of reducing spending so that taxes can be cut and incentives to produce,
and therefore growth, can increase.
Chapter 14: Problems and Exercises
16. a. According to the Ricardian equivalence theorem deficit spending has no effect on the
interest rate because people increase their saving (supply of loanable funds) sufficiently
enough to offset the increase in the deficit (demand for loanable funds).
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b. According to the Ricardian equivalence
theorem, the aggregate demand curve does not
shift at all because the increase in government
spending is exactly offset by a decline in private
spending. This is shown in the graph on the
right.
Price level
Chapter 14: Fiscal Policy and Public Finance
SAS
A
P0
AD
Y0
Real output
18. a. If the economy is truly below potential output, a
nuanced functional finance view would be to increase spending enough to bring the
economy back to potential as shown in the graph below on the left, but always be careful
to monitor the economy to see that the policy is having the desired effect.
b. According to the New Classical view, there is no point to activist fiscal policy because it
will be ineffective. The only way for the economy to reach potential is for economic
forces (such as a decline in the price level) to do it. This is shown in the graph below on
the right.
LAS
SAS 0
Price level
Price level
LAS
SAS
B
P1
A
P0
SAS 1
A
P0
AD 1
B
P1
AD0
Y0
Y1
Real output
AD0
Y0
Y1
Real output
20. a. In the standard AS/AD model, a tax cut will shift the AD curve to the right, leading to an
increase in the price level and real output, as shown in the accompanying graph.
Congressman Stable’s views fit this model well.
Price
Le ve l
SAS
P
1
A
P0
AD1
AD 0
Y0
Y
1
Re al Output
2
Chapter 14: Fiscal Policy and Public Finance
b. If Congressman Growth is correct, the tax cut will shift
the LAS curve to the right. If the economy had
previously been in long-run equilibrium, the economy
will now be below potential and there will be pressures
for factor prices to decline. Assuming nothing else
happens in the meantime, the SAS curve will shift down,
leading to a lower price level and higher real output, as
shown in the accompanying graph.
c. In the short run, Congressman Stable is likely to be
correct.
LAS
Price
Leve l
0
LAS
1
SAS 0
SAS1
P
1
P0
AD 0
Y0
Y
Real Output
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d. The tax cut will require government to finance a higher budget deficit. This would lead to
higher interest rates and lower investment. If there is perfect crowding out, the decline in
investment will completely offset the expansionary effect of the tax cut. In this case, the
tax cut will have no effect on either the price level or real output.
22. a. In 1995 the unemployment rate fell below the target rate of 6 percent without generating
inflationary pressures. He was probably changing his estimates to reflect that reality.
b. It would shift the LAS curve out.
c. Using Okun’s rule of thumb—which says that for every 1 percentage point rise in the
unemployment rate, income falls by 2 percent—a 0.5 percentage point decline in the
target unemployment rate would imply a rise in potential income of 1 percent, or $100
billion.
Chapter 14: Web Questions
2. a. The process starts off by the formulation of the president’s budget for a fiscal year. The
budget documents are then prepared and transmitted to the Congress. The Congress, after
reviewing this budget, develops its own budget and accepts the expenditure and revenue
bills. The agency managers then execute the budget in the fiscal year, after which
information for the actual spending and receipts becomes available.
b. It takes about two years. For example, for Fiscal Year 2001 (begins October 1, 2000) the
President formulated the budget between February-December 1999, and the data on the
expenditures and receipts became available in October-November 2001.
c. The President and the Congress have to decide upon the discretionary spending, which
accounts for one-third of all federal spending. The remaining two-thirds of all federal
spending, called mandatory spending, is authorized by permanent laws.
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