Download ch 18 end of chapter answers

Chapter 18: The Modern Fiscal Policy Dilemma
Chapter 18: The Modern Fiscal Policy Dilemma
Questions and Exercises
1. 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). This is shown in the graph on the left below.
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 below.
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.
3.
Sound finance does not depend on the Ricardian equivalence theorem because
sound finance is based on political grounds. Those who held this belief were
suspicious of government.
4.
Functional finance is the theoretical proposition that government should make
spending and taxing decisions on the basis of their effect on the economy rather
than concern itself with balancing the budget.
5.
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.
According to crowding out, government spending increases the demand for
loanable funds and increases the interest rate. An increase in the interest rate
Colander’s Economics, 8e. McGraw Hill © 2010
1
Chapter 18: The Modern Fiscal Policy Dilemma
reduces private investment spending, which offsets the effect of increases in
government spending on aggregate demand.
7.
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. a
According to sound finance theory, there is no room for activist fiscal policy
because government cannot be trusted to implement the right policies.
b. According to the functional finance theory, there is room for activist fiscal policy.
The economy is subject to fluctuations in output and if it is believed that fiscal
policy will smooth out those fluctuations, it should be used to do so.
9.
The budget process begins a year and a half before the budget is implemented,
making it difficult to know what type of fiscal policy will be needed. In addition,
many budget decisions are made for political reasons (few politicians would vote
for a tax increase in an election year even if such an increase were needed).
Finally, nearly two-thirds of the budget is mandated by federal programs and
cannot be easily changed.
10.
Increasing government spending shifts out aggregate demand and thereby
increases income and reduces unemployment. This makes people better off in the
short run and more likely to vote for the incumbent president. The exception
would be if the economy is already above potential income and there is a
significant inflation threat.
11.
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.
12. a. With full crowding out, the AD curve shifts back to its original position and fiscal
policy has no effect on the economy. The effect in the loanable funds market is
shown in the graph below on the left. Expansionary fiscal policy shifts the
demand for loanable funds to the right and the interest rate rises enough so that
private investment declines sufficiently to shift the AD curve back to its original
position as shown in the graph below on the right.
Colander’s Economics, 8e. McGraw Hill © 2010
2
Chapter 18: The Modern Fiscal Policy Dilemma
b. With partial crowding out, the AD curve shifts back partway to the left, but not
back to its original position and fiscal policy has less of an effect on the economy
compared to if there were no crowding out. The effect in the loanable funds is
shown below on the left. Expansionary fiscal policy shifts the demand for
loanable funds to the right and the interest rate rises so that private investment
declines, but not by as much as the increase in government spending.
c. With full crowding out, the AD curve shifts back to its original position and fiscal
policy has no effect on the economy. The effect in the loanable funds is shown
below on the left. Expansionary fiscal policy shifts the demand for loanable funds
to the right and the interest rate rises enough so that private investment declines
sufficiently to shift the AD curve back to its original position (AD0) as shown in
the graph below on the right. If private investment is more productive, however,
in the long run the LAS curve shifts in to the left (from LAS0 to LAS1) which
causes the SAS curve to shift up (from SAS0 to SAS1) and the economy ends up
at a lower level of output and a higher price level as shown below on the right.
Colander’s Economics, 8e. McGraw Hill © 2010
3
Chapter 18: The Modern Fiscal Policy Dilemma
13. a. In the standard model, an increase in the tax
rate will shift the AD curve to the left as
shown in the accompanying graph. This will
lead to a lower price level and lower real
output.
b. If there were partial crowding out, the
increase in taxes will require government to
finance a lower budget deficit. This would
lead to lower interest rates and higher
investment. If there were partial crowding
out, the AD curve would shift to the left by
an amount that is less than shown in a. The
price level and real output will not decline
by as much as shown in the answer to a.
c. If there is complete crowding out, the rise in investment will completely offset the
contractionary effect of the tax increase and the tax increase will have no effect on
either the price level or real output. The AD curve will shift right back to its
original position.
14.
A 1 percentage point difference in one’s estimate of the target rate of
unemployment is equal to a 2 percentage point difference in the estimate of
potential output. So, in a $10 trillion dollar economy, this amounts to a difference
of $200 billion in their estimates of potential output.
15.
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 likely cut tax rates and
increase expenditures, contributing to a greater expansion.
Colander’s Economics, 8e. McGraw Hill © 2010
4
Chapter 18: The Modern Fiscal Policy Dilemma
16.
Automatic stabilizers reduce taxes and raise expenditures during contractions
without additional government action. In an expansion automatic stabilizers raise
taxes and decrease expenditures. They therefore act to offset shifts in the
economy, giving them their "stabilizing" quality.
17.
Automatic stabilizers increase taxes and reduce expenditures during an expansion,
which act to slow the recovery.
18. 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.
b. Congressman Stable’s views fit this model
well.
c. If Congressman Growth is correct, the tax
cut will shift the LAS curve to the right. If
the economy had previously been in longrun 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.
d. In the short run, Congressman Stable is
likely to be correct.
e. 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. So, with significant crowding out Congressman Growth is likely to be
correct.
Issues to Ponder
1. a. If the mpe is .8, the multiplier is 5. Every one-dollar increase in autonomous
expenditures will raise income by five dollars. To close a recessionary gap of
$400 the government needs to generate $80 of additional autonomous spending. It
Colander’s Economics, 8e. McGraw Hill © 2010
5
Chapter 18: The Modern Fiscal Policy Dilemma
b.
c.
d.
e.
(a)
can accomplish this by increasing government expenditures by $80 as shown in
graph (a) below.
If the government wishes to achieve the same end by changing taxes, it should
decrease taxes by $100. This will generate $80 of additional autonomous
spending. Again, with a multiplier of 5, this will cause a $400 increase in
aggregate income.
If there is a marginal tax rate of 0.2 (instead of taxes being exogenous), the
multiplier is [1/(1 - c + (c ( t))] or [1/(1 - .8 + (.8)(.2))], which is equal to 2.78
With regard to your answers to parts a and b, the government must generate added
expenditures of $143.88 to close the recessionary gap, either through an increase
in government spending of that amount (part a) or a decrease in taxes of $179.85
(part b). This is shown in graph (c) below.
With a marginal propensity to import of .2 the multiplier changes to [1/(1 - c + ct
+ m)] or [1/(1 - .8 +.16 +.2)], which is equal to [1/.56] or 1.79. With this
multiplier, to close a recessionary gap of $400 the government would have to
generate $224 in new expenditures, either through an increase in government
spending of that amount or a cut in taxes of $280. This is shown in graph (d)
below.
The graph (a) below shows the shift in the AE curve resulting from an increase in
government expenditures of $80 or a reduction of taxes of $100 when the mpe
and mpc are .8. Graph (c) shows the shift in the AE curve necessary to close the
recessionary gap when the marginal tax rate is .2. Notice that the slope of the AE
curve is smaller (.64). The AE curve must shift up by more to achieve the same
increase in output. Finally, the AE curve for part d has an even smaller slope (.44)
shown below in graph (d). Here the AE curve must shift up by even more.
(c)
(d)
2. a. In 1995 the unemployment rate fell below the
target rate of 6 percent without generating
Colander’s Economics, 8e. McGraw Hill © 2010
6
Chapter 18: The Modern Fiscal Policy Dilemma
inflationary pressures. He was probably changing his estimates to reflect that
reality.
b. It would shift the LAS curve out. Eventually the price level will fall and output
will rise.
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 $73 billion.
3. a. President Clinton's policy does not fit well with the multiplier model because with
that model the two goals are inconsistent with one another in the short run. To
increase output and employment using stimulative fiscal tools requires an increase
in the deficit.
b. His policy might have the desired effect if a reduction in government expenditures
to reduce the deficit reduces the interest rate so much and affects expectations
positively to such a degree that their effect on investment and consumption
expenditures offsets the decline in government spending.
c. The reduction in the deficit shifts the AD
curve to the left, but the increase in
investment expenditures resulting from the
reduction in interest rates shifts the AD
curve to the right by so much that, on net,
output rises as shown in the accompanying
graph.
d. I would look at interest rates and investment
expenditures to see if the explanation is
correct.
Colander’s Economics, 8e. McGraw Hill © 2010
7