Download Chapter 12 - Fiscal Policy

Even if I have to dig a
hole and cover it back
up, I do have a job.
FISCAL POLICY
[“G” and “T”]
John Maynard Keynes
“Father of Fiscal Policy”
Introduction
• This chapter confronts the following questions:
1. Can government spending and tax policies
help ensure full employment?
2. What policy actions will
help fight inflation?
3. What
are the roles of
government intervention?
Taxes (“T”) and “G”Spending
• Up until 1915, the federal government
collected few taxes and spent little.
• In 1902, it employed fewer than
350,000 people and spent $650
million.
• Today, it employs nearly 4.3 million
people and spends more than $3.4 trillion.
Government Revenue
• Government expansion started with the 16th
Amendment to the U.S. Constitution (1913)
which extended the taxing power to incomes.
• Today, the federal government collects over
$2.7 trillion a year in tax revenues.
Let’s say the German government decides to connect East
Germany to West Germany by constructing a water bridge
over the Elbe River. They did this, spending 500 million euros.
The next picture is a kilometer-long “concrete bathtub” water
bridge near the town of Magdeburg.
Loanable Funds Market
[*Use this graph if there is a chg in savings by consumers or chg in fiscal policy]
Real Interest Rate, (percent)
[*Use
the Money Market graph when there is a change in MS]
D
Borrowers
1
D
S
2
Lenders
IR=10%
E2
IR=8%
E1
Use the “real interest rate” with
LFM, because it is long-term.
Use “nominal interest rate” with
money market, as it is short-term.
Starting from a balanced budget, if the
G incr spending or decr T to get out of
a recession, they would now be running
a deficit and have to borrow, pushing
up demand in the LFM and increasing
the interest rate.
$2
F1
F
Quantity of Loanable
Funds
2
T
$2 T
G
T
Balanced Budget [G&T=$2 Tr.]
Demand for Loanable Funds Market
(b)
(a)
Demand for Loanable
Funds at 3%
Business firms demand for
[no G borrowing]
[a lot of investment]
Loanable Funds at
3%
DI
Real
Interest
Rate
S
D1[no G]
3%
A
3%
A
Businesses
LFM
1.5
QID
Trillions of Dollars Trillions of Dollars
Low interest rates, so
- a lot of investment
Demand for Loanable Funds Market
(b)
(a)
With “G” borrowing, the
demand for LF at 5%
Government Demand for Funds
D2(G)
Real
Interest
Rate
5%
S
D1[no G]
3%
B
A
LFM
Business firms demand for
Loanable Funds at 5%
[not as much investment]
Business Demand for Funds
DI
5%
B
3%
A
1.0
1.5
QID2 QID1
Trillions of Dollars Trillions of Dollars
Higher interest rates, so
not as much investment
Balanced Budget [$2 Tril. “G” = $2 Tril. “T”]
Recession $2 Trillion
Incr G to $2.2
$2 Trillion
Deficit so
higher I.R.
or
Decr T to $1.8
So expansionary fiscal policy
leads to higher interest rates.
G
Gonna have
to borrow
T
Inflation
Decr G to $1.8
or
Incr T to $2.2
So, contractionary fiscal policy
leads to lower interest rates.
Deficit
Surplus so
Lower I.R.
Budget
Wow! A
surplus
[Incr G; Decr T]
PL
AD2 LRAS
AD1
Start from a
Balanced Budget
G & T = $2 Trillion
$2
T
G
$2 T PL2
T
SRAS
“I can’t
get a job.”
PL1
E1
E2
YR YF
G
T
AD
DI
Y/Empl./PL;
C
“Now, this is better.”
AD
Real
GDP
G
Y/Emp/PL; T
LFM
LFM
I.R.
IR
[Decr G; Incr T to close a contractionary gap]
PL
Start from a
Balanced Budget
G & T = $2 Trillion
AD2
SRA
LRAS
S
PL1
$2T
G
E1
$2T PL
2
T
E2
AD1
YF YI
G
T
AD
DI
Y/Empl./PL;
C
AD
Real
GDP
G
Y/Emp/PL;
[like we have
“money trees”]
LFM
T
LFM
I.R.
IR
Everyone Wants To Go To Heaven
But
No
One Wants To Die.
Everyone Wants Government Spending
But No One Wants To Pay Taxes.
Recessionary Gap
SRAS
AD2 LRAS
AD1
YR Y*
Expansionary
Fiscal Policy
Keynes and Lydia Lopokova
G
T
Inflationary Gap
SRAS
LRAS
AD2
AD1
Y* YI
Expansionary Contractionary
Fiscal Policy
Fiscal Policy
G
T
G
T
The automatic stabilizers may be called the automatic pilot
of our economy, not very well suited for takeoffs and landings,
but fine for the smooth part of the flight. But when the going gets
rough, the economy must use manual controls. [discretionary G&T]
1. Transfer Payments
A. Welfare checks
C. Food Stamps
E. Corporate dividends
2. Progressive Income Taxes
Automatic stabilizers
take 33-50% out.
Stabilizers are like a thermostat
maintaining temperature.
They are shock absorbers.
Nondiscretionary Fiscal Policy (Automatic stabilizers)
B. Unemployment checks
D. Social Security
F. Veteran’s benefits
AS
Y*
YI
AD2
AD3
YR
33%-50%
AD2
YR ; T
; AD2
YI ; T
; AD3
A pilot may take a stroll thru & let the co-pilot cruise. If there is
turbulence, the pilot will rush back to the cockpit
[President & Congress] and use manual
controls to correct economic turbulence. Discretionary
fiscal policy is our manual control system.
More vertical [more progressive],
the more stability for the economy.
Taxes
Government Expenditures,
G, and Tax Revenues, T
12-31-65
Taxes
Transfers
More
Transfers
Deficit
Less Tax
Money
More tax
money
Surplus
G
ov.
Fewer
Fewer purchases
Transfers by Fed, state
Transfers
and local
governments
GDP1
GDP2
GDP3
YR
YI
Y*
Real Domestic Output, GDP
Keynesian
Model
Recess.
Gap
Inflat.
Gap
Discretionary
Fiscal Policy
Nondiscretionary
Fiscal Policy
Unempl. check
Deliberate use of government
spending and/or taxing.
“G” and “T”
Discretion of Congress
Automatic Stabilizers
1.Welfare & food stamps
2. Unemploy. insurance
3. Social security
4. Corporate Dividends
5. Progressive Tax System
Fiscal Policy
Automatic stabilizers.
Suppose the economy is in recession:
Real GDP
AD1
AS
AD2
PL
YR Y*
“Recession”
Tax
collections
Transfer
payments
G>T
The deficit grows
Fiscal Policy
Automatic stabilizers.
If the economy has an inflationary gap:
Tax
collections
Real GDP
PL
AS
AD2
AD1
Transfer
payments
G<T
Y* YI
“Inflationary Gap”
The surplus grows
Discretionary Fiscal Policy
Discretionary
Contractionary Fiscal Policy
1. Decrease “G”
2. Increase “T”
Expansionary Fis. Policy
1. Increase “G”
2. Decrease “T”
The Kennedy/Johnson $10 Billion Tax Cuts of 1964
The “Golden Age of Fiscal Policy”
When Kennedy came into office:
1. The top marginal tax rate was 91%
& drops to 52% [35% today]
2. The unemployment rate was
6.7% & drops below 5%.
3. A recession becomes
a very good low
unemployment - low
inflation (2%) economy.
4. The expansion
continued to 1969.
Kennedy had been hesitant
about a $10 billion tax cut but
finally saw the Keynesian Light.
12/31-65
Keynesian Policy:
“Balance the Economy, not the Budget.”
“Even if the jobs
are digging holes
and filling them up.”
Deficits
Surpluses
FINANCING OF DEFICITS
[Is borrowing or printing the money more expansionary?]
1. Government borrows from the public
[results in higher interest rates
which crowds out investment]
Higher
I.R.
MS1 MS2
2. Just print the money
[Money creation – lower interest rates
so this would be more expansionary]
But the LR increase in MS results
in an increase
in inflation
PL2
7%
4%
Lower I.R.
AD2 AS
AD1
PL1
Y* Y
How To Dispose of Surpluses
[Should we hold the surplus or give it back]
1. Debt Retirement
[Give the surplus back during recessions to get
lower interest rates and expand the economy]
2. Impound The Surplus
[Keep the surplus during inflations and give it back
during recessions]
AD2 AS
AD1
PL
Y* YI
“CROWDING OUT” EFFECT [Incr G
AS
AD2
AD1
4%
2%
16
12
Friedman
Just follow the
“monetary rule.”
1. Borrowing - this raises interest rates in
the LFM and “crowds out” investment.
2. Money Creation - no “crowding out” so is
more expansionary than borrowing.
10
Real interest rate (%)
YR
IG
Y*
Decr Ig]
G can finance a deficit by:
14
G
incr I.R.
8
6
4
2
Crowding
Out
Effect
DI
0
5
10
15
20
25
30
35
Investment (billions of dollars)
40
Negative Net Export Effect of Fiscal Policy
“Negative Xn”
Expansionary Fiscal Policy
Due to higher interest rates, dollar appreciates
LRAS SRAS
AD
AD+G +C +Ig
-Xn
YR
Y*
Negative Net Export Effect of Fiscal Policy
“Negative Xn” of
“Negative Xn” of
Expansionary Fiscal Policy
Contractionary Fiscal Policy
Due to higher interest
rates, dollar appreciates
Due to lower interest
rates, dollar depreciates
LRAS SRAS
LRAS SRAS
AD
-Ig -C -G
+Xn
+G +C +Ig
-Xn
YR
Y*
Y* YI
Liberal (“G”) or Conservative (“G”)
G
G
Liberals
Recession: Increase “G”; Inflation: Increase “T”
Conservatives
Recession: Decrease “T”; Inflation: Decrease “G”
Fiscal Policy Lags
“The shower starts out too cold, because the pipes have
not yet warmed up. So the fool turns up the hot water.
nothing happens, so he turns up the hot water further.
The hot water comes on and scalds him. He turns up the
cold water. Nothing happens right away, so he turns up
the cold further. When the cold finally starts to come up,
he finds the shower too cold, and so it goes.”
Fiscal Policy lags
1.
2.
3.
4.
Data (recognition) lag
“Wait-and-see” lag – short run
Legislative lag (political)
Effect lag [takes months]
E4
LRAS
SRAS1
AD1
AD2
SRAS2
E1
E2
E4
E3
YR YF Y I
E2
Traditional Fiscal Policy [“G” & “T”]
will not work with Stagflation
AD2 LRAS
SRAS2
AD1
15%
10%
4%
AD3
15%
10% 5%
YR YR YF
Stagflation
Was Reagan a “closet Keynesian” with all the “G” & “T”?
Perhaps he was a “Keynesian in drag.”
Tax rate (percent)
100
l
0
Tax revenue (dollars)
Tax rate (%)
100
m
l
0
Tax revenue (dollars)
100
Tax rate (percent)
n
m
l
0
Tax revenue (dollars)
100
Tax rate (%)
n
m
m
Maximum
Tax
Revenue
l
0
Tax revenue (dollars)
Ben Stein’s part in this
movie as a boring econ
prof was voted one of the
50 most famous scenes
in American film.
Ben Stein [from “Ferris Bueler’s Day Off”] graduated from
Columbia University in 1966 with a degree in economics
and from Yale Law School in 1970 as valedictorian. He was
a speech writer for Nixon. He has written 16 books, including
his latest humor book, “How To Ruin Your Life”.
President Reagan said he was on the Laffer curve. He said that after WWII,
when he started making big money, that he could do 4 movies before hitting
the top marginal tax rate of 90%. After 4, because he could only keep 10%,
he would quit making movies until the next year.
“Yes, I was on the
Laffer cuve. I couldn’t
shoot my way out”
Tax revenue (dollars)
m
0
Maximum Tax Revenue
n
l
Reagan
The “Gipper”
m
Tax rate (percent)
100
Bonzo
For rich people, there would be a disincentive to quit working when
they hit the top marginal tax rate. For most workers, this was not the case.
Emphasis on Expansionary Tax Cuts
[which shifts AD to the right, increasing Y & PL]
Impact upon...
•Saving and Investment
[Lower taxes increase DI & S; less business taxes will
increase investment. Our “national factory” will increase.]
• Work Incentives
We will have
Economic
[Keeping more of our money makes us work harder and longer] Heaven.
• Risk Taking
[Lower tax rates promise a larger potential after-tax reward]
So, the AS Curve will shift right bringing prices down.
SUPPLY-SIDE FISCAL POLICY
Can sustain a much greater increase in AD if the
AS curve is also shifting to the right.
Price level
AD1 AD2
AS1
AS2
PL2
10% PL1
PL3
0
Q1 Q2
10%
Q3
Real GDP
MULTIPLIER WITH PRICE-LEVEL CHANGES
Inflation and the Multiplier [4]
AS
Price Level
Full Multiplier Effect
AD1
AD2
Reduced
Multiplier
Effect Due
to Inflation
AD3
+20
+20
P2
P1
+ 80 bil.
M(4)=chg.Y/chg.E
[80] [20]
GDP1
+ 40 bil.
GDP2
GDP3
M(2)=chg.Y/chg. E
[40] [20]
EXPANSIONARY FISCAL POLICY
[MPS=.25] the multiplier at work...
$5 billion initial direct increase in spending
AS
Price level
AD1
AD2
Full $20 billion
increase in AD
+5
P1
$485
$505
Real GDP (billions)
CONTRACTIONARY FISCAL POLICY
[MPS=.25] the multiplier at work...
AD2 AD1AS
Price level
P1
P2
$5 billion initial
direct decrease in
spending
Full $20 billion
decrease in AD
$515
Real GDP (billions)
LEGISLATIVE MANDATES
Employment Act of 1946
Council of Economic Advisors(CEA)
Joint Economic Committee (JEC)
Legislative Mandates for Remedial Fiscal Measures
1. Employment Act of 1946 – a law promoting economic stability
(by promoting “maximum employment, production, and
purchasing power”) through monetary and fiscal policies.
This act was a government commitment to ensure prosperity
after WWII. [not only “could” but “would” – no more laissez faire]
This act gave the Keynesians economists the theoretical and
legal justification to use fiscal policy to stabilize the economy.
2. Council of Economic Advisers (CEA)
[for the President] – 3 distinguished economists (on leave from
universities) who assist and advise the President on economic
matters. Their staff is made up of 11 senior and 6 junior economists.
They forecast and project the deficit, inflation, GDP growth,
foreign exchange rates, immigration, & antitrust legislation.
The President must submit an annual economic report
describing the current economic state with recommendations.
“The President’s intelligence arm in the war against the business cycle.”
Greg Mankiw of Harvard has ridiculed
supply-side tax cuts as “fad economics”
conceived by “charlatans and cranks,”
in his textbook.
Head of the CEA
Edward Lazear
PHD in Econ, Harvard
Matt
Slaughter
of
Dartmouth
Ben Bernanke,
Former Board Governor,
succeeded Maniew.
[scored 1590 on SAT]
[Now Chairman of Fed]
Katherine Baicker
U.C.L.A.
Joint Economic Committee of Congress
and Humphrey-Hawkins Act of 1978
3. Joint Economic Committee(JEC) of Congress – an advisory group or
intelligence arm in the war against contractions in the business cycle. After
gathering and analyzing economic data, they make forecasts and formulate
programs to improve employment.
4. Humphrey-Hawkins Act of 1978 – (Full Employment & Balanced Growth Act)
- requires the government to establish 5-year economic goals and formulate plans
to achieve it. The goals were to seek 4% unemployment and zero inflation.
If you look at my “C”
average college grades, the
CEA can help me.
AE & Fiscal Policy Questions on 2000 AP Exam
If MPS incr from .10 to .20, the ME would decrease from 10 to 5.
1. (81%) The value of the spending multiplier (ME) decreases when
a. tax rates are reduced
b. exports decline
c. imports decline
d. government spending increases
e. the marginal propensity to save increases
2. (75%) Which of the following policies would a Keynesian recommend during
a period of high unemployment and low inflation?
a. decreasing the MS to reduce AD
b. decreasing taxes to stimulate AD
c. decreasing government spending to stimulate AS
d. balancing the budget to stimulate AS
3. (47%) Which of the following best explains why equilibrium income will
increase by more than $100 in response to a $100 increase in G?
The Multiplier ensures more C
a. Incomes will rise, resulting in a tax decrease.
b. Incomes will rise, resulting in higher consumption. with each round.
c. The increased spending raises the aggregate price level.
d. The increased spending increases the money supply, lowering interest rates.
e. The higher budget deficit reduces investment.
4. (56%) Unexpected increases in inventories usually precede
a. increases in inflation
b. increases in imports
c. stagflation
d. decreases in production
e. decreases in unemployment
S
Full.Employ.
AE
5. (63%) The economy on the right is
currently experiencing
C+Ig
E
a. inflation b. recession c. expansion
$500
C
A
d. stagflation e. rapid growth
$400
6. (77%) Correct monetary policy to
reach FE GDP is to increase
a. the MS b. the RR c. discount rate
45°
d. taxes e. exports
0
$800 $1,000 $2,000
7. (36%) The minimum increase in government
spending to reach full employment is
Determine what the “M” is going
a. $2,000 b. $1,000 c. $500
from A to E; then M X ? = $1,000
d. $200 e. $100
8. (58%) In the simple Keynesian AE model [not AD/AS] of an economy,
changes in Ig or G will lead to a change in which of the following?
a. the price level b. the level of output and employment c. interest rates
d. the AS curve
9. (83%) In a closed-private in which the APC is .75, which of following is true?
a. If income is $100, then saving is $75.
b. If income is $100, then “C” is $50
c. If income is $200, then saving is $50
d. If income is $200, then “C” is $75
e. If income is $500, then saving is $100
10. (63%) Suppose that DI is $1,000, consumption is $700, and the MPC is .6.
If DI then increases by $100, consumption and savings will equal which of
the following?
If $700 of $1,000 DI is consumed, then
Consumption
Savings
saving is $300. MPC of .6 means if DI
a. $420
$280
increases by $100, then $60 more will be
b. $600
$400
consumed & $40(.4) more will be saved(40%).
c. $660
$320
The $60 added to the $700 already consumed
d. $660
$440
= $760 consumed and the additional $40
e. $760
$340
saved = $340 saved.
Fiscal Policy Questions from 2000 Exam
11. (73%) An inflationary gap can be eliminated by all of the following EXCEPT
a. an increase in personal income taxes
d. a decrease in G
b. an increase in the MS
e. a decrease in Xn Which answer does
not slow the economy?
c. an increase in the interest rate
12. (56%) A major advantage of automatic stabilizers in fiscal policy is that they
a. reduce the public debt
b. increase the possibility of a balanced budget
c. stabilize the unemployment rate
d. go into effect without passage of new legislation
e. automatically reduce the inflation rate
13. (70%) In the short run, a contractionary fiscal policy will cause AD,
output, and the price level to change in which of the following ways?
AD
Output
Price level
a. decrease
decrease
decrease
b. decrease
increase
increase
c. increase
decrease
decrease
d. increase
increase
increase
14. (52%) Crowding out due to government borrowing occurs when
a. lower interest rates increase private sector investment
b. lower interest rates decrease private sector investment
c. higher interest rates decrease private sector investment
d. a smaller money supply increases private sector investment
15. (41%) If, at FE, the G wants to increase its spending by $100 billion
without increasing inflation in the short run, it must do which of the following?
a. raise taxes by more than $100 billion c. raise taxes by less than $100
b. raise taxes by $100 billion
d. lower taxes by $100 billion
16. (42%) Compared to expansionary monetary policies adopted to
counteract a recession, expansionary fiscal policies tend to result in
a. less public spending
c. a high rate of economic growth
b. higher interest rates
d. lower prices
1995 AP Exam
17. (71%) An increase in which will increase the value of the ME?
a. The supply of money
d. The marginal propensity to consume
b. Equilibrium output
e. The required reserve ratio
c. Personal income tax rates
18. (61%) An AS curve may be horizontal over some range because within that range
a. a higher PL leads to higher interest rates, which reduces the MS & “C”
b. changes in the aggregate PL do not induce substitution
c. output cannot be increased unless prices and interest rates increase
d. rigid prices prevent employment from fluctuating
e. resources are underemployed & an increase in AD will be satisfied without any pressure on the PL
19. (45%) What could cause simultaneous increases in inflation & unemployment
a. a decrease in government spending
d. An increase in inflationary expectations
b. A decrease in the money supply
e. An increase in productivity
c. A decrease in the velocity of money
20. (85%) Which of the following will result in the greatest increase in AD?
a. A $100 increase in taxes
b. A $100 decrease in taxes
c. A $100 increase in government expenditures
d. A $100 increase in government expenditures, coupled with a $100 increase in taxes
e. A $100 increase in government expenditures, couples with a $100 decrease in taxes
21. (65%) Which of the following will result from a decrease in government spending?
a. An increase in output
d. A decrease in AS
b. An increase in the price level
e. A decrease in AD
c. An increase in employment
Expenditures
Questions 22-23 refer to the diagram(rt),
which depicts an economy’s “C” function.
22. (56%) If the MPC increases, the equilibrium
S C+Ig
C
C2
levels of income and consumption will
change in which of the following ways?
C1
Equil. Level
Equil. Level
$700
of Income
of Consumption
a. No change
No change
45°
b. No change
Increase
0
$1,500 $2,000 Real Income
c. Increase
No change A larger MPC means a smaller MPS, and a larger M.
d. Increase
Increase
this will increase income and result in more “C” at
e. Decrease
Decrease the new level of equilibrium income (GDP).
23. (48%) If private investment of $100 is added to the economy, the equilibrium levels
of income and consumption will change in which of the following ways?
Equil. Level
Equil. Level
of Income
of Consumption
a. Increase
Decrease
b. Increase
Increase
c. Increase
No change
d. No change
Increase
e. No change
No change
AE
F
22. (61%) The graph indicates equilibrium at E
for a closed economy without G. If the
addition of G results in equilibrium at F,
which of the following is true?
a. G is $300 and the multiplier is 5.
b. G is $100 and the multiplier is 5.
c. G is $100 and consumption increased by $500.
d. G and Ig increase by $500.
e. Consumption and GDP increase by $500 each.
C+Ig+G
C+Ig
E
$300
$200
45°
0
$1,000 $1,500
GDP
23. (84%) According to Keynesian theory, decreasing taxes and increasing G will
most likely change consumption and unemployment in which of the following ways?
Consumption
Unemployment
a. Decrease
b. Decrease
c. Increase
d. Increase
e. No change
24. (79%) In an economy
No change
No change
Decrease
Increase
Decrease
at full employment, a presidential candidate proposes cutting
the government debt in half in 4 years by increase T and reducing G. According to
Keynesian theory, implementation of these policies is most likely to increase
a. unemployment
b. consumer prices
c. aggregate demand
d. aggregate supply
e. the rate of economic growth
25. (79%) If the economy is in a severe recession, which of the following is the
fiscal policy most effective in stimulating production and employment?
a. Government spending increases.
b. Government spending decreases.
c. Personal income taxes are increased.
d. The Fed sells bonds on the open market.
e. The Fed buys bonds on the open market.
26. (27%) Faced with a large federal budget deficit, the government decides to decrease
expenditures and tax revenues by the same amount. This action will affect
output and interest rates in which of the following ways?
Output
Interest Rates
a. Increase
b. Increase
c. No change
d. Decrease
e. Decrease
Increase
Decrease
Decrease
Increase
Decrease
An equal decrease in G & T [Let’s say by $10 billion] would
decrease GDP by $10 billion. The decrease in GDP would
decrease PL which would cause a decrease in interest rates.
27. (28%) If crowding out only partially offsets the effects of a tax cut, which of the
following changes in interest rates and GDP are most likely to occur.
Interest Rates
GDP
a. Increase
b. Increase
c. Increase
d. Remain unchanged
e. Decrease
Increase Partially means GDP increases. Starting from a
Remain unchanged
balanced budget, the tax cut would put the G in deficit
Decrease and the G borrowing would increase demand for money
Increase in the LFM and push up interest rates.
Decrease
28. (62%) According to the Keynesian saving schedule, when
aggregate income increases by a given amount, savings will
a. remain the same
b. decrease by the amount of the change in income
c. increase by the amount of the change in income
d. increase by less than the amount of the change in income
e. increase by more than the amount of the change in income
President Bush’s College Transcript
And – What did President Bush have
to say about “power pants”?
1. With the Employment Act of 1946, the federal government committed
itself to accept (total/some) degree of responsibility for employment/prices.
2. Fiscal policy is carried out primarily by the (local/state/federal) government.
3. Discretionary fiscal policy [G & T] (does/does not) require congressional action.
4. In a mixed [private & public) closed economy, taxes & (savings/government spending)
are leakages, while Ig and (savings/government spending) are injections.
5. In a mixed economy, the equilibrium GDP exists where (C+Ig/C+Ig+G+Xn)=GDP.
6. The balanced budget multiplier indicates that equal increases in G&T tend to
(decrease/increase/not change) the equilibrium GDP. [MBB is “1”]
7. Assume in a private economy that equilibrium GDP is $400 billion & the MPC is
.80. Suppose the G collects new taxes of $50 bil. & spends the entire amount on
our infrastructure. As a result equilibrium GDP will be ($400/$450/$500) bil.
8. Suppose a constitutional amendment requires that the G always balance
its budget. If it desired to increase GDP by $40 billion, G should
(increase/decrease) government spending & taxes by ($30/$40/$50) billion.
9. In a severe recession, Keynesians
would favor a(n) (increase/decrease) in
taxes.
PL
AE2
AE1
YR
Y*
800
?
10. If the government tries to eliminate a budget deficit during a depression,
these efforts will (help/hurt) the depression.
11. A conservative economist who advocates an active fiscal policy
would recommend tax (increases/decreases) during a recession and
(increases/decreases) in government spending during inflation.
S
AE
PL
C YRI A
12. If the F.E. GDP is OC, then it would be appropriate fiscal policy for
O
government to (increase/decrease) “G” and (increase/decrease) “T”.
13. If the F.E. GDP is OA, then it would be appropriate fiscal policy for
government to (increase/decrease) “G” and (increase/decrease) “T”.
14. If G increases its spending during a recession to assist
the economy, the funds must come from some source.
(Additional taxes/Borrowing from the public/Creating new money)
would tend to be the most expansionary.
15. The following fiscal actions, (incurring a budget surplus
and allowing it to accumulate as idle Treasury balances/
incurring a budget surplus which is used to retire debt held
by the public) is likely to be most effective in curbing inflation.
16. The greatest anti-inflationary impact of a budget
surplus will occur when the G (impounds/uses) the surplus
funds & lets them (stand idle/pay off the debt). Should I give
it back?
17. In describing the built-in stabilizers, we can say that
personal & corporate income tax collections
automatically (incr/decr) as GDP increases & transfers
& subsidies (incr/decr) as GDP increases.
Recognition, Action, & Effect Lags of Fiscal Policy
Recognition Lag
Action Lag
Effect Lag
FISCAL POLICY – Pure and Simple
There are 3 things that could “diminish AD.”
Price level
AD1
AD2 AS
Fiscal Policy:
No Complications
P1
$490
YR
$510 Real GDP (billions)
Y*
Three things that could “diminish AD.”
1. Crowding-out Effect
2. Net Export Effect
AD1 AD’2 AD2 AS
Net Export Effect
Expansionary fiscal policy
leads to more government
borrowing, increasing the
interest rate, & decreasing Ig
PL1
Crowding-out Effect
Higher interest rates
decrease investment]
and the . . .
$490 $503 $510
Real GDP (billions)
3. Inflation would be a third factor
That could reduce aggregate demand
AD2
Price level
AD1
AS
P1
$495 $505 $515
Real GDP (billions)
NS 18-21
T2
1
Answer the next 3 questions(18-21) based on the diagram.
18. Deficits will be realized at GDP levels (below/above) C, and
surpluses (below/above) C.
19. If the F.E. GDP for the economy is at D, the F.E. budget will
entail a (deficit/surplus).
20. If the tax line had a greater slope [more progressive tax system],
stability would be (less/greater).
21. If government adhered strictly to an annually balanced budget
then the government’s budget would tend to
the economy.
(destabilize/stabilize)
For Questions 22-24 [graph]
22. (T1/T4) tax system is characterized
by the least built-in stability.
23. (T1/T4) tax system is characterized
by the most built-in stability.
24. (T1/T4) tax system will generate the
largest cyclical deficits.
25. Nondiscretionary Fiscal Policy
NS 22-30
(does/does not) require congressional action.
26. If the MPC is .5, a $10 B increase in “G” will increase “C”
[not income] by ($20/$10/$5) billion.
[G increase in spending of $10 B increases income (Y) by $20 B. With MPC of .5, C increases $10 B]
27. If government tries to give back a surplus during an inflationary
FE year, this will be (pro-cyclical/counter-cyclical).
28. When politicians use fiscal policy to cause an improvement
in the economy just prior to an election, this is called a
(presidential/Congressional/political) business cycle.
29. When G incurs a deficit which is financed by borrowing,
causing interest rates to increase which decreases Ig, this is
called the (crowding-in/crowding out) effect.
30. Supply-siders argue that the primary effect of tax cuts is to
shift the AS curve (leftward/rightward).
NS 31-34
31. If the MPC is .8, a $2 billion increase in “G” will increase
“consumption” by ($10/$8/$6) billion.
[When G increases by $2 billion, Y does increase by $10, but *8 (80%) is consumed, or $8 billion]
32. If the MPC is .9, a $1 billion increase in “G” will increase
“consumption” by ($10/$9/$8) billion.
AE
33. In a private-closed economy, the MPS is .2,
consumption equals income at $200
billion, and the level of investment is $10
billion. The equilibrium level of income at the
“C”
200
45°
200
new level is ($200/$250) billion.
34. If the MPS is .2 and the economy has a
?
AE
S
AE2
AE1
recessionary spending gap of $5
billion, we may conclude that the equilibrium
level of GDP is ($5/$20/$25) below the FE GDP.
S
C+Ig
45°
YR
?
NS 35 - 38
35. If the MPS is .5 and the economy has an
S
AE1
AE2
AE
inflationary spending gap of $6 billion,
we may conclude that the equilibrium level
of GDP is ($6/$12/$18) billion above the
FE GDP.
45°
Y*
YI
36. If the government decreases G&T by $10 billion, then a
MPS of .10, the equilibrium GDP would (increase/decrease) by
($5/$10/$100) billion.
37. With a MPC of .75, Government increases G&T by $8 billion.
The equilibrium GDP (increases/decreases) by ($75/$32/$8) billion.
38. If the government runs a budget surplus and desires to
curb inflation, it should (give the surplus back/keep it in storage).
1. Expansionary fiscal policy
will be most effective
AS curve is (vertical/horizontal)
& (incr/decr) “C” and (incr/decr) unemployment.
[increase GDP] when the
2. The paradox of thrift indicates that an increase in saving (matched/
unmatched) by an increase in investment will lower equilibrium GDP.
[On #3, start from
a balanced budget] G $2 Tr.
T $2 Tr.
[G
; LFM
; In. Rates
]
3. A contractionary fiscal policy [decr G, incr T] would cause a[an]
(incr/decr) in output[GDP] and a[an] (incr/decr) in interest rates.
An expansionary fiscal policy [incr G, decr T] would cause a[an]
(incr/decr) in output[GDP] and a[an] (incr/decr) in interest rates.
[G
; LFM
; In. Rates
]
4. In the AE model, if AE[AD]doesn’t buy up FE output(GDP), then the
equilibrium output is (less than/more then) full employment output.
“Recessionary Gap”
“Inflationary Gap”
5. To decrease AD the greatest amount, the government should:
(decrease “G” only/increase “T” only/both decr G & incr T)
6. To increase AD the greatest amount, the “G” should:
(increase “G” only/decrease “T” only/both incr G and decr T)
7. In a recessionary gap (AE model) at the equilibrium point[actual GDP]
planned investment is (greater than/equal to/less than) saving, but at the FE
GDP level, planned investment[backup] is (greater than/equal to/less than) saving.
8. In an inflationary gap(AE model), at the equilibrium point [actual GDP]
planned investment [backup] is (greater than/equal to/less than) saving, but at
the FE level, planned investment is (greater than/equal to/less than) saving.
9. If businesses are experiencing an unplanned increase in inventories, AE is
(less than/greater than) FE output & spending will (increase/decrease).
10.
If businesses are experiencing an unplanned decrease in inventores [disinvestment]
AE is (less than/greater than) FE output & spending will (increase/decrease).
500
500
11. If “C” equals income at $500 billion, & MPC is .9, then an
increase in Ig of $10 billion will change equilibrium GDP to
($400/$490/$510/$600) billion.
12. A conservative economist would want tax (incr/decr) during
a recession & (incr/decr) in “G” during inflationary times.
13. A liberal economist would want tax (incr/decr) during an
inflation & (incr/decr) in “G” during recessionary periods.
14. An inflationary gap indicates AE[actual GDP] (exceeds/falls short of) FE GDP.
15. A recessionary gap indicates AE[actual GDP] (exceeds/falls short of) FE GDP.
16. To increase GDP[but reduce military spending], we would combine two
(domestic/overseas) bases into one (domestic/overseas) base.
17. A tax cut to expand the economy would (incr/decr) Y & (incr/decr) in. rates.
18. A tax increase to contract the economy would (incr/decr) Y & (incr/decr) IR.
19. To increase equilibrium GDP by $400,000,
with a MPC of .5, a Keynesian economist
would (decrease “T”/increase “G”) by $200,000.
20. Assume equilibrium GDP is $500 billion & MPS is .4.
Now “G” collects taxes of of $22 billion and spends
the entire amount. As a result, equilibrium GDP
will change to: ($445/$478/$522/$555).
21. With a MPC of .5, a $12 billion increase
in “G” will increase “C” by ($12/$24/$36) bil.
22. With a MPC of .5 and the economy in a
recessionary spending gap of $12 billion,
we may conclude that the equilibrium is
($12/$24/$36) billion short of FE GDP.
23. An increase in Ig of $25 billion results in an increase
in equilibrium income(GDP) of $50B, so the MPS is? .5
24. A contractionary fiscal policy results in a(n) (incr/decr)
in output, and a(n) (incr/decr) in interest rates. [Incr T or Decr G]
25. Increasing T or decreasing G will (increase/decrease)
consumption, and (increase/decrease) unemployment.
26. With a MPC of .5, and the economy with an inflationary GDP
Gap of $50B, G could eliminate this inflationary GDP Gap by
reducing government spending by? $25 bil.
27. With a MPC of .5 and current output at $500 bil. but FE
output is $700 bil., correct fiscal policy would be to
(increase G/decrease T) by $100 billion.
28. An increase in Ig in an economy
(increase)/decrease) GDP & (increase/decrease) C.
29. In a recessionary economy, at
FE GDP, saving is (less than/more than) Ig.
30. In a recessionary economy,
(actual Y/potential Y) exceeds (actual Y/potential Y).
31. In a mixed-closed economy (no Xn), the leakages are?
[S & T] and the injections are? [G & Ig]
32. If the economy has an inflationary Gap, at
FE GDP, saving (exceeds/is less than) Ig.
33. If there is an equal increase in G&T of $25 bil.,
then output will
(increase/decrease) &
interest rates
[based on PL] will
(increase/decrease).
E-con
E-con
The End
“Econ, econ”
Review for
AE & Fiscal Policy