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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