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Chapter 21
Fiscal Policy
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
©2002 South-Western College Publishing
1
What is a discretionary
fiscal policy?
The deliberate use of
changes in government
spending or taxes to alter
aggregate demand and
stabilize the economy
2
What are examples of
expansionary fiscal policy?
• Increase government
spending
• Decrease taxes
• increase government
spending and taxes equally
3
What are examples
of contractionary
fiscal policy?
• Decrease government
spending
• Increase taxes
• Decrease government
spending and taxes equally
4
Government Spending to Combat a Recession
155
155
150
Price Level
AS
E2
E1
X
AD1
Real GDP
0
AD2
full employment
$6 $6.1 $6.2
5
Increase in
the price
level and the
real GDP
Increase in the
aggregate
demand curve
Increase in
government
spending
6
With an MPC of 0.75,
what is the spending
multiplier?
1/MPS = 1/1/4 = 4
7
How much will real
GDP increase by with
an increase in
government spending
of $50 bil?
4 x $50 bil = $200 bil
8
What is the
tax multiplier?
The change in aggregate
demand (total spending)
resulting from an initial
change in taxes
9
What happens when
government cuts
taxes by $50 bil?
The multiplier process is
less because initial
spending increases only by
$38 bil instead of $50 bil
10
What is the formula for
the tax multiplier?
1 – spending multiplier
11
How much does real
GDP increase by with a
cut in taxes of $50 bil?
3 x $50 bil = $150 bil
12
Can we assume that the
MPC will remain fixed?
No, it can change from one
time period to another
13
Can fiscal policy be
used to combat
inflation?
Yes, this would happen
when the economy is
operating in the
Classical or Intermediate
range of the aggregate
supply curve
14
What will happen to
AD with a cut in G
spending of 25 bil?
-$25 bil x 4 = -$100 bil
15
Price Level
Using Fiscal Policy to Combat Inflation
AS
E1
160
E´
155
E2
AD1
AD2
0 $6 $6.1
full
employment
Real GDP
16
Decrease in the
price level
Decrease in the
aggregate
demand curve
Decrease in
government
spending
17
What will happen
to AD with a cut in
taxes of 33.3 bil?
$33.3 x -3 = -$100 bil
18
What is the balanced
budget multiplier?
An equal change in
government spending
and taxes, which
changes aggregate
demand by the amount
of the change in
government spending
19
What is an
automatic stabilizer?
Federal expenditures and
tax revenues that
automatically change
levels in order to stabilize
an economic expansion
or contraction
20
What are examples of
automatic stabilizers?
• Transfer payments
• Unemployment compensation
• Welfare
21
What is a
budget surplus?
A budget in which
government revenues
exceed government
expenditures in a given
time period
22
What is a
budget deficit?
A budget in which
government
expenditures exceed
government revenues
in a given time period
23
$750
$500
$250
Automatic Stabilizers
T
Budget
deficit
$1,000
Government Spending and Taxes
$2,500
G
Real GDP
$4
$6
$8
24
Budget
offsets
inflation
Tax collections fall and
government transfer
payments rise
Increase
in real
GDP
25
Budget
offsets
recession
Tax collections fall and
government transfer
payments rise
Decrease
in real
GDP
26
What is supply-side
fiscal policy?
A fiscal policy that
emphasizes
government policies
that increase
aggregate supply
27
What is the purpose
of supply-side fiscal
policies?
To achieve long-run
growth in real output,
full employment, and a
lower price level
28
250
200
Price Level
Demand-Side Fiscal Policy
AS
E2
E1
full
employment
150
AD2
100
AD1
Real GDP
0
2
4
6
8
10
12
29
Increase in the aggregate
demand curve
Increase in
government spending;
decrease in net taxes
30
250
200
Price Level
Supply-Side Fiscal Policy
AS1
AS2
E1
150
E2
100
0
full
employment
AD
2
4
6
8
Real GDP
10
12
31
Increase in the aggregate
supply curve
Decrease in resource
prices; technological
advances; subsidies;
decrease in regulations
32
Supply-Side Policies Affect Labor Markets
Before tax-cut
labor supply
W2
E1
Wage rate
W1
After tax-cut
labor supply
E2
Labor
Demand
Q of Labor
0
L1
L2
33
Will an increase in
taxes lead to higher
government revenues?
That depends on
where the economy
is on the Laffer Curve
34
What is the
Laffer Curve?
Puts forth the idea that
increasing taxes from zero
will increase tax revenues
up to a certain point
35
What happens beyond
a certain point?
Tax revenues begin to
decline as the
economic pie begins
to shrink
36
Why does the economic
pie begin to shrink?
Workers have less
incentive to work and
investors have less of
an incentive to invest
37
R
Federal Tax Revenue
Rmax
A
0
The Laffer Curve
B
C
Federal Tax Rate
Tmax
D
T 100%
38
Key Concepts
39
Key Concepts
• What is a discretionary fiscal policy?
• What are examples of expansionary fiscal
policy?
• What are examples of contractionary fiscal
policy?
• With an MPC of 0.75, what is the multiplier?
• How much will real GDP increase by with an
increase in government spending of $50 bil?
40
Key Concepts cont.
• What is the tax multiplier?
• What is the formula for the tax multiplier?
• Can fiscal policy be used to combat
inflation?
• What will happen to ad with a cut in g
spending of 25 bil?
• What is the balanced budget multiplier?
41
Key Concepts cont.
•
•
•
•
•
What is an automatic stabilizer?
What is a budget surplus?
What is a budget deficit?
What is supply side fiscal policy?
What is the Laffer Curve?
42
Summary
43
Fiscal policy is the use of
government spending, taxes,
and transfer payments for the
purpose of stabilizing the
economy.
44
Discretionary fiscal policy follows
the Keynesian argument that the
federal government should
manipulate aggregate demand in
order to influence the output,
employment, and price levels in
the economy.
45
Discretionary fiscal policy requires
either new legislation to change
government spending or taxes in
order to stabilize the economy.
46
Expansionary fiscal policy is a
deliberate increase in government
spending, a deliberate decrease in
taxes, or some combination of
these two options.
47
Contractionary fiscal policy is a
deliberate decrease in government
spending, a deliberate increase in
taxes, or some combination of
these two options.
48
Using either expansionary or
contractionary fiscal policy, the
government can shift the
aggregate demand curve in
order to combat recession, cool
inflation, or achieve other
macroeconomic goals.
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Discretionary Fiscal Policies
Expansionary
Contractionary
• Increase government
spending
• Decrease taxes
• Increase government
spending and taxes
equally
• Decrease
government spending
• Increase taxes
• Decrease
government spending
and taxes equally
50
The tax multiplier is the multiplier
by which an initial change in taxes
changes aggregate demand (total
spending) after an infinite number
of spending cycles.
51
Expressed as a formula, the tax
multiplier = 1 - spending multiplier.
52
A balanced budget multiplier is not
neutral. A dollar of government
spending increases real GDP more
than a dollar cut in taxes. Thus, even
though the government does not
spend more than it collects in taxes,
it is still stimulating the economy.
53
Combating recession and inflation
can be accomplished by changing
government spending or taxes.
54
The total change in aggregate
demand from a change in
government spending is equal to
the change in government
spending times the spending
multiplier. The total change in
aggregate demand from a change
in taxes is equal to the change in
taxes times the tax multiplier.
55
Increase in
the price
level and the
real GDP
Increase in the
aggregate
demand curve
Increase in
government
spending
56
Decrease in the
price level
Decrease in the
aggregate
demand curve
Decrease in
government
spending
57
A budget surplus occurs when
government revenues exceed
government expenditures.
58
A budget deficit occurs when
government expenditures
exceed government revenues.
59
Automatic stabilizers are
changes in taxes and
government spending that
occur automatically in
response to changes in the
level of real GDP.
60
The business cycle creates
braking power. A budget
surplus slows down an
expanding economy. A
budget deficit reverses a
downturn in the economy.
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$750
$500
$250
Automatic Stabilizers
T
Budget
deficit
$1,000
Government Spending and Taxes
$2,500
G
Real GDP
$4
$6
$8
62
According to supply-side fiscal
policy, lower taxes encourage
work, saving, and investment,
which shift the aggregate supply
curve rightward. As a result,
output and employment increase
without inflation.
63
The Laffer curve represents the
relationship between the income
tax rate and the amount of
income tax revenue collected by
the government.
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Chapter 21 Quiz
©2002 South-Western College Publishing
65
1. Contractionary fiscal policy is deliberate
government action to influence aggregate
demand and the level of real GDP through
a. expanding and contracting the money
supply.
b. encouraging business to expand or
contract investment.
c. regulation of net exports.
d. decreasing government spending or
increasing taxes.
D. The money supply is under control of
the Federal Reserve and not Congress.
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2. The spending multiplier is defined as
a. 1 / (1 - marginal propensity to
consume).
b. 1 / (marginal propensity to
consume)
c. 1 / (1 - marginal propensity to save).
d. 1 / (marginal propensity to consume
+ marginal propensity to save.
A. The spending multiplier is also
defined as 1/MPS.
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3. If the marginal propensity to consume
is 0.60, the value of the spending
multiplier is
a. 0.4
b. 0.6
c. 1.5
d. 2.5.
D. Spending multiplier = 1 / (1 - MPC) =
1 / (1 - 0.60) = 1 / 40/100 = 5 / 2 = 2.5
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4. Assume the economy is in recession and real
GDP is below full employment. The marginal
propensity to consume is 0.80, and the
government increases spending by $500 billion.
As a result, aggregate demand will rise by
a. zero.
b. $2,500 billion.
c. more than $2,500 billion.
d. less than $2,500 billion.
B. Change in aggregate demand (Y) = initial
change in government spending (G) x spending
multiplier.
Spending multiplier = 1 / 1 - MPC) = 1 / (1 - 0.80) = 1
/ 20/100 = 5
Y = $500 billion x 5
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Y = $2,500 billion
5. Mathematically, the value of the tax
multiplier in terms of the marginal
propensity to consume (MPC) is given by
the formula
a. MPC  1.
b. (MPC  1) MPC
c. 1 / MPC
d. 1  [1 / 1  MPC)].
D. The tax multiplier is also stated as Tax
multiplier = 1 - spending multiplier.
70
6. Assume the marginal propensity to
consume (MPC) is 0.75 and the
government increases taxes by $250
billion. The aggregate demand curve will
shift to the
a. left by $1,000 billion.
b. right by $1,000 billion.
c. left by $750 billion
d. right by $750 billion.
A. The tax multiplier is -3 (1 - spending
multiplier) and -3 times $250 equals a $750
billion decrease. The movement is left
because consumers have less money to
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spend.
7. If no fiscal policy changes are made, suppose
the current aggregate demand curve will
increase horizontally by $1,000 billion and cause
inflation. If the marginal propensity to consume
is 0.80, federal policy-makers could follow
Keynesian economics and restrain inflation by
a. decreasing government spending by $200
billion.
b. decreasing taxes by $100.
c. decreasing taxes by $1,000 billion.
A. Change in government spending (G) x spending
multiplier = change in aggregate demand,
rewritten:
G = change in aggregate demand / spending
multiplier
Spending multiplier = 1 / (1-MPC) = 1 / (1-0.80) = 1 /
20/100 = 5
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G = -$1,000/5, G = -$200 billion.
8. If no fiscal policy changes are implemented,
suppose the future aggregate demand curve will
exceed the current aggregate demand curve by
$500 billion at any level of prices. Assuming the
marginal propensity to consume is 0.80, this
increase in aggregate demand could be
prevented by
a. increasing government spending by $500
billion.
b. increasing government spending by $140
billion.
c. decreasing taxes by $40 billion.
d. increasing taxes by $125 billion.
D. Change in taxes (T) x tax multiplier = change in
aggregate demand, rewritten:
Tax multiplier = 1 - spending multiplier
Spending multiplier = 1 / (1-MPC) = 1 / 1-0.80) = 1 / 20/100 = 5
Tax multiplier = 1 - 5 = -4, T = $600 billion/5, T = -$20073
billion
9. Suppose inflation is a threat because the
current aggregate demand curve will
increase by $600 billion at any price level.
If the marginal propensity to consume is
0.75, federal policy-makers could follow
Keynesian economics and restrain
inflation by
a. decreasing taxes by $600 billion.
b. decreasing transfer payments by $200
billion.
c. increasing taxes by $200 billion.
d. increasing government spending by
$150 billion.
C. 3 x $200 billion = $600 billion.
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10. If no fiscal policy changes are implemented,
suppose the aggregate demand curve will
exceed the current aggregate demand curve by
$900 billion at any level of prices. Assuming the
marginal propensity to consume is 0.90, this
increase in aggregate demand could be
prevented by
a. increasing government spending by $500
billion.
b. increasing government spending by $140
billion.
c. decreasing taxes by $40 billion.
d. increasing taxes by $100 billion.
D. The multiplier here is 10 (1 divided by 1/10 =
10). If taxes are increased by $100 billion
spending will go down by $90 billion. Ten
75
times $90 equals $900.
11. Which of the following is not an
automatic stabilizer?
a. Defense spending.
b. Unemployment compensation benefits.
c. Personal income taxes.
d. Welfare payments.
A. Defense spending does not
automatically change levels as real GDP
changes.
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12. Supply-side economics is most
closely associated with
a. Karl Marx.
b. John Maynard Keynes.
c. Milton Friedman.
d. Ronald Reagan.
D. The most familiar supply-side
economic policy of the Reagan
administration was the tax cuts
implemented in 1981.
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13. Which of the following statements is true?
a. A reduction in tax rates along the
downward-sloping portion of the Laffer
curve would increase tax revenues.
b. According to supply-side fiscal policy,
lower tax rates would shift the aggregate
demand curve to the right, expanding the
economy and creating some inflation.
c. The presence of the automatic stabilizers
tends to destabilize the economy.
d. To combat inflation, Keynesians
recommend lower taxes and greater
government.
A.
78
R
Federal Tax Revenue
Rmax
A
0
The Laffer Curve
B
C
Federal Tax Rate
Tmax
D
T 100%
79
END
80