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Chapter 30: Fiscal Policy and Public Finance Chapter 30: 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 30: 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). 1 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 30: 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 SAS0 Price level Price level LAS SAS B P1 A P0 SAS1 A P0 AD1 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 vel SAS P 1 A P0 AD1 AD 0 Y0 Y 1 Re al Output 2 Chapter 30: 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 1 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 30: 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. 3