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CHAPTER 30 (14)
AGGREGATE DEMAND POLICY IN
PERSPECTIVE

LAUGHER CURVE
Q. What do economists and computers have in common?
A. You need to punch information into both of them.
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CHAPTER OVERVIEW: What’s It All About?
The chapter focuses on how policymakers change the level of output in the economy by
influencing aggregate demand and relying on the multiplier to expand any policy-induced change
in aggregate demand. This is done through fiscal policy – raising or lowering spending and/or
taxes – and by monetary policy – a policy of influencing the economy through changes in the
banking system’s reserve that influence the money supply and credit available in an economy.
Both policy choices are used for an expansionary or contractionary policy.
CHAPTER OBJECTIVES: Students Should Be Able To …
1. List six problems with fiscal policy and explain how these problems limit its use. They
are: (1) financing the deficit doesn't have offsetting effects, (2) knowing what the
situation is, (3) knowing the level of potential income, (4) the government's flexibility in
changing taxes and spending, (5) size of the government debt doesn't matter, and (6)
fiscal policy doesn't negatively affect other governmental goals. In reality, it often does.
2. Describe how automatic stabilizers work. Built-in fiscal policies are called automatic
stabilizers -- any government program or policy that will counteract the business cycle
without any new government action.
3. Summarize the advantages and disadvantages of using monetary and fiscal policy. See
Figure 30-4.
4. List three alternatives to fiscal policy. Directed investment policies, autonomous
consumption policies, and trade policy and export-led growth.
5. State why economists often talk about policy regimes rather than simply policy. A
policy regime is a rule while a policy is a one-time reaction to a problem. It is chosen
without a predetermined framework.
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WHAT’S NEW? Revisions to This Edition
This chapter is a major revision and combines parts of 4th edition Chapters 27 and 34 (Chapters
11 and 18 in Macroeconomics). That latter chapter involving a summary of the course was
deleted with those parts that reflected modern policy issues integrated into this chapter. The
general analytics of fiscal policy that was in the fourth edition Chapter 27 (Chapter 11 in
Macroeconomics) was integrated earlier in the text to Chapters 25 and 26 (Chapters 9 and 10 in
Macroeconomics). The more technical and specific discussion of fiscal policy was moved to this
chapter.
So this new chapter discusses the problems with fiscal policy in more depth, describes the
use of automatic stabilizers, summarizes the advantages of monetary and fiscal policy, discusses
alternatives to fiscal policy and finally talks about credibility and regimes. The hope is that it ties
the various discussions together and updates students on recent changes in the economy.
DISCUSSION STARTERS: Get Your Class Rolling
1. How politically popular do you think it would be to raise taxes and/or reduce government
spending significantly even if there was unanimous agreement among economists that this
would be beneficial to the economy? How is this related to NIMBY?
2. Which is politically more popular: expansionary or contractionary fiscal policy? How might
this be related to government having a tendency to continuously incur deficits?
3. Which is more popular: reducing taxes or increasing government spending? Which would
have the greatest effect in stimulating the economy?
4. Why are we not able to “fine-tune” the equilibrium income level with the use of fiscal
policy?
5. What do you think determines the size of the crowding-out effect? Do you think it would
change over time? Why or why not?
ON THE WEB: Integrating New Media into the Classroom
Note: The following Web sites are for policy-oriented organizations, both liberal and
conservative. They can be used for any of the policy chapters.
http://www.heritage.org/research/features/index is the Web site of the Heritage Foundation, a
Washington think tank. This particular site features an excellent nine-page executive summary
of the 2000 Index of Economic Freedom, an analysis of economic freedom of 156 nations.
Politics: scholarly, mildly conservative.
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http://epinet.org is the Web site for the Economic Policy Institute. There are links to Living
Standards and Labor Markets; Government and the Economy; Trade and Globalization; Politics
and Public Opinion, and Sustainable Economics. Politics: conservative.
http://www.gao.gov is the Web site of U.S. General Accounting Office. “The GAO examines the
use of public funds, evaluates federal programs and activities, and provides analyses, options,
recommendations, and other assistance to help the Congress make effective oversight, policy,
and funding decisions.” Politics: bureaucratic, balanced.
http://www.ncpa.org is the Web site of the National Center for Policy Analysis, “a non-profit,
non-partisan public policy research institute organization.” There are links to: “My Social
Security, Women in the Economy, Debate Central, and Team NCPA. Politics: scholarly, slightly
conservative.
http://www-hoover.stanford.edu is the Web site of Stanford University’s Hoover Institution on
War, Revolution, and Peace. The Institution is a conservative think tank on the Stanford campus.
Politics: scholarly, conservative.
http://brookings.org is the Web site of Washington’s Brookings Institution, a liberal think tank
devoted to studying national policy issues. They publish books and videos. Politics: scholarly,
liberal.
http://www.urban.org is the Web site of Washington’s Urban Institute, “a nonpartisan economic
and social policy research organization.” Recent studies include “Letting Older Workers Work,
Housing Bias, Insuring Children’s Health, Taxing Families, and The Marital Edge.” Politics:
scholarly, liberal.
http://www.rand.org is the Web site of Santa Monica’s RAND Corporation, “a nonprofit
institution that helps improve policy and decision making through research and analysis.”
RAND was established during World War II as a top-secret advisory think tank to government,
especially the military. Since then they have branched out to take on policy research of all sorts.
Politics: scholarly, neutral.
http://www.aei.org is the Web site of the American Enterprise Institute for Public Policy
Research, a conservative think tank. Politics: scholarly, conservative.
http://www.hudson.org is the Web site of the Indianapolis-based Hudson Institute, founded in
1961 by the fabled Herman Kahn. It is an internationally recognized public policy research
organization that forecasts trends and develops solutions for governments, businesses, and the
public. Politics: scholarly, neutral.
http://www.cato.org is the Web site of the Cato Institute, a Washington think tank devoted to “26
years of promoting public policy based on individual liberty, limited government, free markets,
and peace.” This is also available in Spanish. Politics: scholarly, conservative.
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STUDENT STUMBLING BLOCKS: Common Areas of Difficulty
Fiscal Policy: An In-Class Exercise
Assume the nation is experiencing a recessionary gap and the mpe= 0.75. Also assume the price
level is constant and taxes are independent of income. For each of the following situations
determine:
a. whether the policy action is appropriate or inappropriate according to activist economics.
b. the effect on the AE curve and the AD curve.
c. the effect on the equilibrium income level.
d. the effect on the government’s budget deficit (assume it is already running a very large
deficit).
1. Government spending increases by $50.
ANS: (a) Appropriate. (b) Shifts the AE curve up = $50. (c) Increases income = $200 [∆Y =
(multiplier) (∆autonomous expenditures) = 4 X $50 = $200 and shifts the AD curve out by
$200]. (d) Increases the deficit = $50.
2. Government raises autonomous taxes by $50 (assume mpc = mpe).
ANS: (a) Inappropriate. (b) Shifts the AE curve down = $37.50 [an increase in taxes will
decrease spending = (∆taxes) (mpe) and shifts the AD curve in $150]. (c) Decreases income =
$150. (d) Decreases the deficit = $50.
3. Government increases autonomous taxes by $50 and spends the entire amount. That is,
government spending and taxes both increase by $50.
ANS: (a) Appropriate. (b) Shifts the AE curve up = $12.50 (the combined effect of parts 1 and
2 above and shifts the AD curve out $50. (c) Increases income = $50. (d) Has no effect on the
deficit. Note that we are taking the combined effects of parts 1 and 2 above. Moreover, we are
able to stimulate the economy without increasing the debt!
4. Government decreases autonomous taxes by $40.
ANS: (a) Appropriate. (b) Shifts the AE curve up = $40 and shifts the AD curve out $160. (c)
Increases income = $160 [∆Y = (multiplier) (∆autonomous expenditures) = 4 X $40 = $160]. (d)
Increases the deficit = $40.
Conclusion: appropriate fiscal policy during a recession:
1. Increase G.
2. Reduce T or increase transfer payments.
3. Increase G and reduce T simultaneously.
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4. Increase G and T by the same dollar amount and this will increase the income level (Y) by
the same dollar amount.
Note that the first three situations will increase the deficit while the fourth will not.
TIES TO THE TOOLS: Bringing the Boxes into the Classroom
Applying the Tools: Fighting the Vietnam War Inflation
While President Lyndon Johnson was firmly in the White House he would not hear of a tax
increase to tame looming inflation considering it to be political suicide. But when he lost heart
and decided not to run for reelection, a temporary tax increase was passed.
LECTURE OUTLINE: A Map of the Chapter
I. Introduction
A. All the problems of using monetary policy are also true for fiscal policy, with some
additional political problems added.
B. We will study which policy is better and how aggregate demand policy is thought of by
policy makers.
1. First, demand-side policies are contrasted with supply-side policies.
2. Second, the problems of fiscal policy are discussed and how some of these problems
have been circumvented by building desired fiscal policy into institutions.
3. And third, some additional policies that supplement monetary and fiscal policy are
discussed.
II. Supply side vs. demand side policies.
A. In the aggregate, supply and demand forces are interrelated. That relationship is captured
in the circular flow diagram introduced at the beginning of the book.
B. To clear up the messiness introduced by the circular flow diagram, the basic AS/AD model
was introduced.
1. In that model, long-term aggregate supply forces were separated from short-term
aggregate demand forces, that allowed us to the differentiate policies affecting supply
and growth from policies affecting demand.
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2. Demand-side policies such as monetary and fiscal policies shift the aggregate demand
(AD) curve, while supply-side policies shift the long-run aggregate supply (LAS) curve.
See Figure 30-1.
C. Every politician emphasizes the effect of a policy that support the policy he/she wants.
1. Each of the arguments has some validity since almost every policy has simultaneous
supply- and demand side effects.
2. Usually, the supply-side effects are long-run effects, while the demand-side effects are
short-run effects. These differences are clearly shown in the AD/AS model.
III. Problems with fiscal policy.
A. Activist government policy seems so simple: if the economy contracts, the government
runs an expansionary fiscal policy; if there's inflation, the government runs a contractionary
fiscal policy.
1. In real life, that is not the way it is.
2. That does not necessarily mean the model is wrong; only that the model must be
modified for it to work in the real world.
B. The model makes the following six assumptions (Chapter Objective 3):
1. Financing the deficit doesn't have offsetting effects.
2. Knowing what the situation is.
3. Knowing the level of potential income.
4. The government's flexibility in changing taxes and spending.
5. Size of the government debt doesn't matter.
6. Fiscal policy doesn't negatively affect other governmental goals. In reality, it often
does.
C. Financing the deficit doesn't have offsetting effects.
1. Some economists argue that government financing of deficit spending will offset the
deficit's expansionary effect.
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2. They object to the multiplier model assumption that savings and investment are
unequal. They believe that the interest rate equilibrates savings and investment, and that
borrowing will increase interest rates and crowd out private investment.
a. Crowding out is the offsetting of a change in government expenditures by a change
in private expenditures in the opposite direction (Chapter Objective 5). See Figure
30-2.
(1) In order to make government debt instruments attractive to investors, interest
rates must be higher than they would otherwise be.
(2) Interest rates in the economy are pushed up.
(3) Private businesses are loath to borrow when interest rates are high.
b. Thus, interest rate crowding out reduces the effect of increases in government
expenditures. Indeed, some economists argue that the effect is negative, since they
consider private spending to be more productive than government spending.
c. Crowding out also works in reverse in contractionary fiscal policy.
(1) Assume the government is running a surplus and it decides to buy back bonds
they have issued in the past.
(2) Interest rates drop, stimulating investment, thereby causing inflation.
D. Knowing what the situation is.
1. Getting reliable numbers on the economy takes time. We may even be in the middle of
a recession and not know it.
2. In order to deal with the problem, the government has large econometric models and
leading indicators to predict where the economy will be in the near future.
3. Alas, economic forecasting is still very much an art and not a science.
E. Knowing the level of potential income.
1. What is the level of potential income? No one knows for sure.
2. Any variation in potential income can make an enormous difference in the policy
prescription that could be recommended.
a. Potential income is also known as full-employment level of income.
b. According to Okun's rule of thumb, a 1 percentage point fall in the unemployment
rate is associated with a 2 percent increase in income.
3. Differences in estimates of potential income often lead to different policy
recommendations.
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4. In most cases, the U.S. economy is in an ambiguous state where some economists are
calling for expansionary policy and others are calling for contractionary policy.
F. The government's flexibility in changing taxes and spending.
1. Even if all economists agree that an expansionary policy is needed, putting fiscal policy
into place takes time and has serious implementation problems.
2. Numerous political and institutional realities in the U.S. today make it a difficult task to
implement fiscal policy.
3. The government’s budget process begins more than a year and a half before the
government’s fiscal year begins. In the meantime, something drastic could have
happened, as it did on September 11.
4. Another problem is that most of the government’s budget is not part of annual spending
bills.
a. About two-thirds of the government budget is mandated by programs such as Social
Security, Medicare, and interest payments on the debt.
b. Even the remaining one-third, called discretionary spending, is hard to change.
5. Squabbles between Congress and the President may delay implementing appropriate
fiscal policy for months, even years.
G. Size of the government debt doesn't matter.
1. These is no inherent reason why the adoption of activist policies should have caused the
government to run deficits year after year.
2. There are two reasons why activist policy of deficit spending has led to an increase in
government debt.
a. Early activists favored large increases in government spending as well as favoring the
government's using fiscal policy.
b. Politically, it is much easier for government to increase spending and decrease taxes
than vice versa.
3. If one believes that debt is harmful, then there might be a reason not to conduct
expansionary fiscal policy, even when the model calls for it.
H. Fiscal policy doesn't negatively affect other government goals.
1. An economy has many goals; achieving potential income is only one of those goals
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2. National economic goals often conflict.
I. Fiscal policy in practice: Summary of the problems.
1. While the six problems listed above do not necessarily eliminate fiscal policy
altogether, they severely restrict it.
2. Fiscal policy is a sledgehammer, not an instrument for fine-tuning.
IV. Building fiscal policies into institutions.
A. Economists were quick to realize the political realities of fiscal policy so they attempted to
create built-in fiscal policies.
B. How automatic stabilizers work.
C. These built-in fiscal policies are called automatic stabilizers -- any government program
or policy that will counteract the business cycle without any new government action.
These may include: (Chapter Objective 6)
1. Welfare payments.
2. Unemployment insurance.
3. The income tax system.
D. Automatic stabilizers have their problems too.
1. When the economy first starts climbing out of a recession, automatic stabilizers may
slow down the process.
2. As income increases, automatic stabilizers increase government taxes and decrease
government spending, and as they do, the discretionary policy's expansionary effects are
decreased.
E. Despite these problems, some economists believe automatic stabilizers have played an
important role in reducing fluctuations in the economy. See Figure 30-3.
F. State government finance and pro-cyclical fiscal policy.
1. Automatic stabilizers are sometimes offset by other institutional structures that work as
a type of automatic destabilizer. Examples include:
a. States’ constitutional provisions to maintain balanced budgets.
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b. The result is what economists call pro-cyclical fiscal policy – changes in
government spending and taxes that increase the cyclical fluctuations in the
economy, rather than reduce it.
c. In order to deal with this, economists have suggested states establish rainy-day funds
– reserves held in good times to offset declines in bad times.
d. Another way of doing this is to use a five-year rolling average budgeting procedure
as the budget they are required to balance.
2. The idea of using a five-year rolling average budgeting procedure is not only good for
state governments but would work at the federal level, reducing the need for
discretionary stimulus packages in the future.
V. Conventional wisdom about monetary and fiscal policy. See Figure 30-4.
A. Although monetary and fiscal policy are not tools to fine-tune the economy, they can be
useful toward achieving goals of high growth, low inflation, and low unemployment.
1. Of the two, monetary policy is the more important for short-term stabilization purposes.
2. Automatic stabilizers have built in an automatic fiscal response to fluctuations in the
economy and even more automatic responses could be built in.
3. Monetary policy has some of the same problems as fiscal policy, but is more flexible
and less influenced by politics.
B. Even if monetary and fiscal policies are working perfectly, there are limits to what they
can achieve.
1. If the economy is falling into a recession, the government can use expansionary policies.
2. If the economy is heading for inflation, the government can use contractionary policies.
3. If both are happening at the same time, they can choose between the two strategies and
hope for the best.
VI. Alternatives and supplements to monetary and fiscal policy (Chapter Objective 4).
A. Monetary policy works because it changes the interest-sensitive portions of consumption
and investment spending.
B. Monetary and fiscal policies are not the only policies that affect aggregate demand.
1. Any policy that affects any of the four components of autonomous spending without
having offsetting effects on other expenditures can achieve the same results.
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2. Since no expenditure is totally autonomous, if you push on one type of expenditure, you
pull on another – the net effect is often far more ambiguous than assumed.
C. Directed investment policies are those affecting expectations to increase investment.
1. Rosy scenario is government talking the economy well.
a. Almost invariably, government officials paint optimistic pictures as to where the
economy is headed.
b. Upbeat predications must be credible -- cf. President Bush and other politicians
urging the public to go about their business as before, following the September 11
attack.
2. Financial guarantees affect expectations regarding financial institutions. Another way
to influence investment is to protect the financial system by government guarantees or
promises of guarantees. Example: preventing bank failures.
D. Autonomous consumption policy is a second alternative. One example is increasing
consumer credit availability to individuals to increase consumption.
E. Trade policy and export-led growth is another alternative.
1. Any governmental policy that increases autonomous exports and decreases autonomous
imports (and thereby increases autonomous expenditures) will also increase aggregate
demand.
2. These policies are called export-led growth policies -- those designed to stimulate U.S.
exports and increase aggregate expenditures on U.S. goods, and hence have a multiplied
effect on U.S. income.
3. Alternatively, any policy that will lower imports, such as tariffs, will have the same
expansionary effect on income.
4. The global economy is interdependent.
a. Any time the U.S. is pushing an export-led growth policy, it is the same as getting
another nation to follow an import-led decline for its economy.
b. It can reasonably be expected that other nations will retaliate.
c. As a consequence, many economists support free-trade agreements such as NAFTA.
5. Exchange rate policies can affect new exports.
a. Trade balance can also be affected through exchange rate policy -- a policy of
deliberately affecting a nation's exchange rate in order to affect its trade balance.
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b. A low value of a nation’s currency relative to currencies of other nations encourages
exports and discourages imports; a high value of a nation’s currency relative to
currencies of other nations discourages exports and encourages imports.
F. A final comment.
1. Aggregate demand policy is more than monetary and fiscal policy.
2. For policymakers, keeping unemployment low and the growth rate high are generally a
prime objective of policy.
VII. Credibility in aggregate demand policy.
A. Expectations complicate models and policymaking enormously.
1. Changes in expectations can shift the AD curve.
2. Expectations of inflation can cause inflation.
B. Rational expectations.
1. People generally act rationally in the sense that they are forward looking.
a. Some economists define rational expectations to mean those consistent with
economic models, but that definition is a technical one.
b. We use a broader definition: rational expectations are forward-looking expectations
that use available information.
2. If, for example, the Fed convinces the public that it is deadly serious in its goal of
cooling down the economy, and if the public is convinced, the policy will work.
C. Uncertainty about the effects of policy.
1. The central role of expectations means that there is a great deal of uncertainty in the
economy.
2. The multiplicity of expectational strategies and the speed with which they can shift
undermine our ability to develop deterministic models of the economy and give the
economy an unpredictability that precludes fine tuning.
3. Depending on the beliefs that individuals have, monetary and fiscal policy will work in
different ways.
D. Policy regimes and expectations (Chapter Objective 5).
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1. A policy regime is a rule. It is a predetermined statement of the policy that will be
followed in various circumstances.
2. A policy is a one-time reaction to a problem. It is chosen without a predetermined
framework.
3. Policy regimes can help generate the expectations that make the government’s tools
work.
4. Policy statements coming out of the Economic Report of the President at various times
emphasize credibility as the primary effect modern theoretical work has had on
macroeconomic policy.
E. Rules vs. discretion and credibility.
1. Rather than giving policymakers wide discretion about what policy to implement, by
focusing on credibility, demands are made for policy rules.
2. In fiscal policy, this has meant changing how budgets are created and modified.
3. In monetary policy, it has meant pushing for feedback rules, like the Taylor Rule or an
inflation target, that specify what the policy response will be to an event that has
occurred.
4. Since no one can plan perfectly, rules are sometimes broken at the cost of losing a bit of
credibility.
CHAPTER SUPPLEMENTS: Other Classroom Aids to Use
 Classic Readings in Economics: "The Economic Steering Wheel: The Story of the People's
New Clothes," pp. 78-80. Abba Lerner, one of the greatest Keynesians, argues in this 1951
essay that government should adopt a policy of "functional finance" -- increasing government
spending when output was too low, and decreasing government spending when output was
too high. Directly opposed to this view is Milton Friedman's 1962 essay on fiscal policy
("Fiscal Policy," pp. 81-83).
 Economics: An Honors Companion. For a mathematical presentation of the
interdependence of the global economy, see Chapter 5, "The International Locomotive
Effect," pp. 59-66.
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POP QUIZ
NAME: __________________________________
COURSE: ________________________________
1. Which of the following statements concerning fiscal policy is true?
a. Fiscal policy is the manipulation of government spending and taxes in an effort to smooth
out the business cycle.
b. Expansionary fiscal policy is designed to reduce the income level in the economy.
c. Contractionary fiscal policy will shift the AE curve upward.
d. The automatic stabilizers destabilize the business cycle.
2. An assumption of fiscal policy is that:
a. financing the deficit has offsetting effects.
b. the government is not sure of the economy’s potential income level.
c. the size of the government's debt matters.
d. fiscal policy does not negatively affect other government goals.
3. An advantage of expansionary monetary policy is that:
a. inflation may worsen.
b. it decreases unemployment.
c. capital outflow will worsen.
d. the trade deficit may increase.
4. A disadvantage of contractionary monetary policy is that:
a. it helps fight inflation.
b. the trade deficit may decrease.
c. there may be a capital inflow.
d. it risks a recession.
5. Which of the following statements is true?
a. A decrease in taxes and/or an increase in government spending will shift the AE curve
downward.
b. An example of a built-in stabilizer is unemployment compensation.
c. Fiscal policy works better in the short run than in the long run.
d. Fiscal policy has no substitutes.
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6. A disadvantage of expansionary fiscal policy is that:
a. it may make the budget deficit worse.
b. it may increase output growth in the short run.
c. it may help solve short-term political problems.
d. it will decrease unemployment.
7. Which of the following statements is true?
a. Higher taxes and higher marginal propensities to import increase the size of the real world
multiplier.
b. Reducing the deficit during a recession would help keep the recession from getting worse.
c. The purpose of expansionary fiscal policy is to reduce inflationary pressures.
d. Contractionary fiscal policy involves raising taxes and/or reducing government spending –
moving in the direction of a budget surplus.
8. A disadvantage of a contractionary fiscal policy is that:
a. it may help fight inflation.
b. the trade deficit may decrease.
c. it may allow a better monetary/fiscal mix.
d. it risks a recession.
9. Which of the following would constitute a policy regime?
a. The reaction of the President and Congress after the September 11 terrorist attack.
b. The Fed lowers the Fed funds rate in order to stimulate the economy.
c. The Taylor Rule.
d. Congress raises the military appropriation in the face of a possible attack on Iraq.
10. The crowding out effect:
a. creates some inflation.
b. occurs because when the government runs a deficit, it must buy bonds to finance that
deficit.
c. states that deficit spending financed by borrowing will increase interest rates and thereby
crowd out private spending.
d. gets smaller the closer the economy comes to full employment.
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ANSWERS TO POP QUIZ
1. a 2. d 3. b 4. d 5. b 6. a 7. d 8. d 9. c 10. c
IN-CLASS EXERCISE: Learning Concepts through Practice
A general in-class pre-exam review.
1. According to the multiplier model, what are two key determinants to the level of economic
activity?
ANS: Aggregate expenditures or total spending and the multiplier.
2. a. What must happen to AE to create a recession? b. An expansion?
ANS: a. AE must decrease to create a recession. b. Spending must increase to create an
expansion in the income or output level.
3. a. What are the major economic problems associated with a recession or downturn in the
business cycle? b. An expansion or upturn?
ANS: a. The two major economic problems associated with a recession are (1) cyclical
unemployment and (2) slow rates of economic growth. b. The major economic problem
associated with an expansionary phase of the business cycle is demand-pull inflation.
4. What does government’s use of fiscal and monetary policies attempt to do to the business
cycle?
ANS: Fiscal and monetary policy attempts to smooth out the business cycle.
5. a. What is expansionary fiscal policy? b. Contractionary fiscal policy?
ANS: a. Expansionary fiscal policy is designed to increase total spending and therefore the
income or output level. It can consist of any one of the four following actions:
1. Increasing government spending alone.
2. Decreasing taxes alone.
3. Simultaneously increasing government spending and decreasing taxes.
4. Increasing taxes and government spending by the same dollar amount that will increase the
income or output level by the same dollar amount – in theory anyway. This occurs because
the multiplier effect of an increase in government spending is greater than the multiplier
effect of an increase in taxes.
b. Contractionary fiscal policy is designed to slow total spending because of a fear of inflation.
It can consist of any one of the following four actions:
1. Decreasing government spending alone.
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2. Increasing taxes alone.
3. Simultaneously decreasing government spending and increasing taxes.
4. Decreasing taxes and government spending by the same dollar amount that will decrease
the income or output level by the same dollar amount.
6. a. Is expansionary or contractionary fiscal policy appropriate to combat a recession? b. What
about the upturn in the business cycle?
ANS: a. Expansionary fiscal policy is appropriate to combat unemployment during a recession.
b. Contractionary fiscal policy is appropriate to combat inflation during an expansionary phase
of the business cycle.
7. Generally speaking, what are some alternatives to fiscal and monetary policy actions that
government could take to help smooth out the business cycle?
ANS: There are three alternatives to fiscal policy: (a) directed investment policies, (b) trade
policies, and (c) autonomous consumption policies.
CASE STUDIES: Real-World Cases of Textbook Concepts
Case Study 30-1: Ten Fiscal Myths
In response to speeches made by Senators Kennedy and Daschle, in which they called for
supplanting the next stage of the $1.35 trillion tax cut, passed in 2001, in favor of more spending
on existing and new programs, Cato Institute executive Chris Edwards identified 10 enduring
myths in both senators’ speeches.
1. Myth: Tax cuts cause budget deficits, but more spending does not. Reality: Spending is set to
increase at least $120 billion in fiscal 2002, much more than the Bush tax cut reduced 2002’s
revenues.
2. Myth: Any unmet “needs” in society demand government action. Reality: “Government big
enough to supply everything you need is big enough to take everything you have.”
3. Myth: Politicians should act like army generals directing the nation with “we should” and “we
must” commands. Reality: The U.S. has 280 million people with different needs, that they will
not be able to meet if the federal government keeps expanding.
4. Myth: The government’s interest is the same as society’s. Reality: “The size of the federal
budget and the size of private pocketbooks are inversely related.” Lowering taxes during a
recession can help families and businesses.
5. Myth: New spending programs make families better off since money grows on trees. Reality:
New spending makes families worse off. This is because every $1 of new spending costs
Americans about $1.40 due to higher compliance costs and inefficiencies of the tax system.
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6. Myth: Failing government programs need more reform, coordination, and consolidation.
Reality: Reforming old programs often makes them less effective.
7. Myth: Tax cuts cause high interest rates. Reality: Both short- and long-term interest rates are
low, not high.
8. Myth: Public/private partnerships combine private sector efficiencies with government
funding. Reality: Mixing public and private often leads to corruption and favoritism.
9. Myth: Any problem in the private sector is a “crisis” that will be worse without government
help. Reality: Private markets and companies are constantly solving problems for themselves
and the nation. Federal government help usually makes matters worse.
10. Myth: Centalization and universality in education and other sectors is the wave of the future.
Reality: Diversity and decentralization is the wave of the 21st century.
Source: Chris Edwards, “Top Ten Fiscal Myths of Sens. Kennedy and Daschle,” Cato Institute
News Release, January 17, 2002. See http://www.cato.org/new/01-02/01-17-02r/html. :
Questions:
1. Do you agree that “tax cuts cause budget deficits, but more spending won’t?
2. The airline industry is desperately trying to get government loan guarantees and other
benefits. How does Myth 9 relate to this?
3. Do you think new spending programs make families better off?
4. Do you believe that the government’s interest is the same as society’s?
5. Do you agree with all the points made by the Cato Institute?
Case Study 30-2: Fiscal Policy Effects of Grade Inflation
Grade inflation is defined as a situation when a student receives a grade for course work
unwarranted by the level of work or achievement demonstrated. Dozens of studies have
confirmed that grade inflation exists in both public and private colleges and universities and that
it is increasing.
Among the theories for the existence of grade inflation are:



Society tends to de-emphasize competition and make people feel better about themselves.
It is a response to the fears that stringent grading would damage the student’s selfconcept.
It is the process of devaluing an undergraduate degree.
What are the causes for grade inflation? These include:
 The current practice of student evaluation of faculty, especially untenured faculty, is
suggested. Giving poor grades is not in their economic self interest.
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

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The war in Viet-Nam accelerated grade inflation as students flocked to college campuses
in fear of the draft. Sympathetic teachers kept poor performers in class.
Administration policies and practices: reductions in rigorous core requirements,
movements toward more electives, removal of first-attempt grades from transcripts, and
pass/fail options.
The increasing use of part-time teachers played a role. These teachers, hired on a term-toterm basis, are hesitant to give low grades. It could create student complaints and as a
result the part-timer’s may not receive an offer to teach in subsequent terms.
There is an economic cause for grade inflation: fiscal and budgetary policy.
It is to this last cause we now turn.
According to the U.S. Department of Education “Finance FY 94” survey, publicly funded
colleges and universities received money from the following sources:
SOURCES OF MONEY FOR PUBLICLY FUNDED COLLEGES AND UNIVERSITIES
State governments
35.9 percent
Tuition
18.4 percent
Federal and local government, private sources, endowment income, and sales
and service revenue
45.7 percent
Each of the 50 states has devised its own plan for financing higher education. At least half use
some formula to determine at least part of their higher education budgets. Many of these
formulas use some measure linked to performance such as retention of students in programs.
The objective is not to allocate the same amount of funds to all institutions but rather to allocate
based on need as determined by formula.
The formula funding models reward public institutions of higher earning based on numbers of
students enrolled. In those states that allocate funds on the basis of enrollment (more than 50
percent do so) pressure to maintain enrollment levels in order to maintain funding levels must be
present. Given that pressure, it is easy to conclude that inflated grades will result.
Source: Richard C. Barndt, “Fiscal Policy Effects on Grade Inflation,” July 6, 2001. See
http://www.newfoundations.com/Policy/Barndt.html.
Questions:
1. Is this article an example of aggregate demand management?
2. Are there any elements of contractionary fiscal policy in this article?
3. If grade inflation skews state fiscal policies, why don’t the states do something about it?
4. Do you believe colleges promote grade inflation as a means of getting more money from state
legislatures?
5. Do you believe there is grade inflation in colleges, and if so, is state fiscal policy is causing
it?
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