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McGill University
Econ209
Professor Paul Dickinson
Conference Sheet #10:
Debt, Deficits & Fiscal Policy (Chap 32)
1. The figure below shows the budget deficit function for a country.
a. Explain why the budget deficit function is downward sloping.
b. If the government increases its level of purchases (G), what happens to the budget deficit at any level
of real GDP? Show this in the diagram.
c. If the government increases its level of net tax revenues (T), what happens to the deficit at any level of
real GDP? Show this in the diagram.
d. Explain why a rise in the actual budget deficit does not necessarily reflect a change in fiscal policy.
How would a fiscal expansion appear in the diagram? A fiscal contraction?
2.
The economy begins at Y*. Suppose the government in this closed economy decreases its budget deficit by
increasing T (and keeping G unchanged), thus causing the AD curve to shift to the left. (Let the initial long-run
equilibrium point be E0, the subsequent short-run equilibrium point be E1, and the final long-run equilibrium
point be E2)
a.
b.
c.
d.
e.
3.
How does the interest rate at E1 compare with that at E0? Explain.
Given your answer to part (a), how does investment at E1 compare to investment at E0?
Explain the economy’s adjustment toward E2. What happens to the interest rate and investment?
What is the long-run effect of the government deficit on the growth rate of Y*?
Comparing the short-run and the long-run effects of this policy, what dilemma does the government
face in reducing its deficit?
Evaluate each of the following proposals to “control the deficit” to avoid the long-run burden of the debt.
a. Maintain a zero cyclically adjusted deficit.
b. Keep the debt-to-GDP ratio constant.
c. Limit government borrowing in each year to some fixed percentage of national income in that year.
4. Explain why monetary and fiscal policy may be hampered in an economy that has a high Debt-to-GDP ratio.
5.
Take the following data for an hypothetical economy:
G=300
T=-50+0.2Y
Y*=2000
a. What is the cyclically-adjusted deficit for this economy?
b. What is the actual deficit when Y=1500? Would you advise the government to implement
expansionary or contractionary policy (whether fiscal or monetary)? Explain why.
c. Repeat (b) above, but for Y=1750.
d. Repeat (b) above, but for Y=2250.
e. Repeat (b) above, but for Y=2000.
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