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CHAPTER 12
1a. Unemployment is below its natural rate and inflation is an increasing
problem, so that real output must be above its potential level, and the
economy faces an inflationary gap. To diminish this gap, the government can
reduce its purchases, raise taxes, or pursue both actions simultaneously. Any
of these actions results in a leftward shift in the AD curve.
b. With declining output and unemployment above its natural rate, real output
falls short of its potential level and the economy is experiencing a
recessionary gap. This gap can be lessened by increasing government purchases,
cutting taxes, or combining these two actions. Each of these actions results
in a rightward shift in the AD curve.
c. Because unemployment is at or close to its natural rate, equilibrium real
output approximates its potential level. Therefore, no fiscal policy is
required.
2a. The MPC is 0.35 (= $350 000/$1 000 000), the MPW is 0.65 (= 1 - 0.35), and
the spending multiplier is 1.54 (= 1/0.65).
b. The MPC is 0.25 (= -$1 000 000/-$4 000 000), the MPW is 0.75 (= 1 - 0.25),
and the spending multiplier is 1.33 (= 1/.75).
c. The MPW is 0.60 (= -$3 000 000/-$5 000 000), the MPC is 0.40 (= 1 - 0.60),
and the spending multiplier is 1.67 (= 1/.60).
3. With a regressive tax system, changes in income cause only a small change
in tax revenues. This dampens decreases in net tax revenues during periods of
falling incomes and also dampens increases in net tax revenues when incomes
are rising. Therefore, automatic stabilizers become less effective and the
statement is true.
4a. MPW = .40 + .30(.60) + .05(.60) = .40 + .18 + .03 = .61
b. Because MPW is .61, MPC is .39 (= 1 - .61). This means that 39 cents of
each new dollar of income is spent on domestic consumption items.
c. The spending multiplier is 1.64 (= 1/.61).
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Chapter 12
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5.
FIGURE 12A–1 The Effects of a Rise in Government Purchases
With MPC equal to 1/3, MPW equals 2/3 (1 - (1/3)). In the first spending
round, the full increase in government purchases is spent, giving a $810 rise
in real output and no increase in withdrawals. In the second spending round,
real output rises by a further $270 (= (1/3) x $810), as sellers of the goods
and services that were exchanged in the first round spend one-third of their
$810 in new income on domestic consumption items. The remaining $540 (= (2/3)
x $810) is used for withdrawals. In the third spending round, real output
jumps by a further $90 (= (1/3) x $270), as sellers of the goods and services
that were exchanged in the second round spend one-third of their $270 in new
income on domestic consumption items. The remaining $180 (= (2/3) x $270) is
used for withdrawals.
6a. Given an MPW of 0.65, the spending multiplier is 1.54 (= 1/0.65), so that
the AD curve finally shifts to the right by $3.08 billion (= 1.54 x $2
billion).
b. With an MPC of 0.45, MPW is .55 (= 1 - 0.45). The spending multiplier is
therefore 1.82 (= 1/.55), so that the AD curve finally shifts to the left by
$9.09 billion (= 1.82 x $5 billion).
c. Given an MPW of 0.7, the MPC is 0.3 (= 1 – 0.7), and the spending
multiplier is 1.43 (= 1/0.7). The AD curve finally shifts to the left by -$1.3
billion (= -(0.3 x $3 billion) x 1.43).
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Chapter 12
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d. A $4 billion tax cut causes spending to rise initially by $1.5 billion, MPC
is .375 ($1.5 billion/$4 billion), which means MPW is .625 (= 1 - .375). The
spending multiplier is therefore 1.6 (= 1/.625), so that the AD curve finally
shifts to the right by $2.4 billion (= 1.6 x $1.5 billion).
7a. MPW is .55 (= $4.4 billion/$8 billion) and MPC is .45 (= 1 - .55). The
multiplier is therefore 1.818 (= 1/.55).
b. The AD curve shifts to the left by $14.5 billion (= 1.818 x $8 billion).
c.
Price Level (GDP deflator, 1997 = 100)
FIGURE 12-A2 Contractionary Fiscal Policy
Real GDP (1997) $ billions)
Because a contractionary policy is being applied, the economy’s initial
equilibrium real output must be above potential output. This means that the AS
curve is steep, so that the decrease in the equilibrium price level (for
example, from 130 to 120, as shown in the graph) is proportionally greater
than the drop in equilibrium real output (for example, from $650 billion to
$645 billion as shown in the graph). Because of price-level changes, the fall
in equilibrium real output is less than the $14.5 billion leftward shift in
the AD curve.
8a. Higher tax rates lead to a rise in tax revenues, causing a leftward shift
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Chapter 12
82
in the AD curve, and pushing down the equilibrium real output and price level.
b. Higher tax rates cause a rise in the marginal propensity to withdraw. This
means that more funds are withdrawn in every spending round, which reduces the
size of the spending multiplier.
c. Higher tax rates mean that changes in income lead to larger changes in net
tax revenues. Because tax revenues decrease more during periods of falling
incomes and increase more when incomes are rising, automatic stabilizers
become more effective.
9. When viewing a provincial economy as a separate entity, items from outside
the province are treated as imports (and therefore as withdrawals) in the same
way as products from outside Canada. This means that the MPW within a
provincial economy is greater than the MPW within the entire Canadian economy.
The result is a lower spending multiplier for provincial fiscal policy.
10.
Price Level (GDP deflator, 1997
= 100)
Price Level (GDP deflator, 1997 =
100)
FIGURE 12A–3 Effects of Annually Balanced Budgets
Real GDP (1997 $ billions)
Real GDP (1997 $ billions)
When the economy faces a recessionary gap (graph a), net tax revenues are
reduced because of low incomes and high unemployment. The requirement of an
annually balanced budget means that either government purchases must be
reduced or tax revenues raised. In either case, aggregate demand decreases
from AD0 to AD1. The result is a higher recessionary gap and a more severe
downturn in the economy. In contrast, an inflationary gap (as shown in graph
b), leads to an expansion of tax revenues due to high incomes and low
unemployment. Given the requirement of an annually balanced budget, either
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government purchases must be raised or taxes reduced. Either action causes an
increase in aggregate demand from AD2 to AD3, increasing the size of the
inflationary gap and heightening inflationary pressures in the economy.
11. A series of federal budget surpluses causes the reverse of the deficitdebt spiral. As budget surpluses reduce the size of the outstanding public
debt, debt charges decrease, raising budget surpluses even further. This cycle
accelerates the decline in public debt.
Price Level (GDP deflator,
1997 = 100)
Price Level (GDP deflator,
1997 = 100)
12.
Real GDP (1997 $ billions)
Real GDP (1997 $ billions)
FIGURE 12A–4 Effects of Differing Estimates of Potential Output
When the economy faces a recessionary gap (graph a) the apparent gap is
enlarged if the estimate of potential output rises from PO1 to PO2. In
contrast, when the economy faces an inflationary gap (graph b) the apparent
gap is reduced if the estimated potential output rises from PO1 to PO2.
Therefore, changes in the estimated potential output have a direct effect on
the apparent size of any recessionary gap and an inverse effect on the
apparent size of any inflationary gap.
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Internet Application Questions
1a. Answers are found in the link to 'Budget Info'.
b. Answers are found in the same link as in part a.
2a. Answer found in links to 'Data', 'Gross Domestic Product', and '9014'
(Canada Gross Domestic Product, Expenditure-Based). Click on 'Ann 1981-00-00
D24193 Gross Domestic Product at Market Prices' and then press down the
control key and click on 'Ann 1981-00-00 D24166 Govt Current Expenditure on
Goods and Services'. Then click on 'Go' and 'Go'. Under 'Output Format' click
on '2D Line Graph', and under 'Display Option' click on '% of D24166 - Gross
Domestic Product at Market Prices'. Then press 'Go'. You can print out the
resulting graph.
b. Fiscal policy was particularly expansionary between 1981 and 1983 and then
again between 1990 and 1994. It was particularly contractionary between 1987
and 1989 and then again after 1995.
ANSWERS TO QUESTIONS AT END OF 'THE AGGREGATE EXPENDITURES MODEL'
1a. Using the spending-output approach, a further $200 billion increase in G
and T has two effects: the aggregate expenditures (AE) line shifts up by $200
billion due to the increase in G, and it also shifts down by $150 billion due
to the tax-induced decrease in C. Overall the AE line shifts up by $50
billion, and equilibrium output rises from $1200 billion to $1400 billion.
Using the injections-withdrawals approach, there are three effects: the total
injections (I+G+X) line shifts up by $200 billion due to the increase in G,
the total withdrawals (S+T+M) line shifts up by $200 billion due to the
increase in T, and S+T+M also shifts down by $50 billion due to the taxinduced decrease in S. Overall, total injections rise by $200 billion at every
output level while total withdrawals rise by $150 billion, so that equilibrium
output again expands from $1200 billion to $1400 billion.
b. Total change in output = 1 x (change in G or T) = $200 billion
c. As shown in Figure B on page 303, the multiplier is accurate only if the AS
curve is horizontal. Once changes in the price level are taken into account
then the overall change in real output is less than the balanced budget
multiplier would suggest.
2a. When saving increases, total withdrawals (the S+M line) shift upwards,
causing the intersection with total injections (the I+X line) to occur at a
lower real output than before.
b. No. Though an increase in saving can have a short-run contractionary effect
on real output, in the long run high savings promote economic growth, since
saving is essential for investment in new capital goods to take place.
ANSWERS TO QUESTIONS AT END OF 'ECONOMIST EXTRAORDINAIRE'
1a. According to neoclassical economists, a fall in wages does not lead to
permanent underspending in the economy since, based on Say’s Law, supply
creates its demand -- regardless of whether the demand originates with workers
or other resource-providers in the economy. As workers’ incomes are reduced,
other incomes will rise, so that all of the economy’s production can be
purchased. In contrast, in the Keynesian view, a fall in spending by workers
may not be counteracted by spending increases by other economic participants,
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which means that underspending and an economic downturn are possible.
b. According to neoclassical economists, an increase in injections will cause
interest rates to change until expenditures and withdrawals are made equal at
a single equilibrium level of output. On the other hand, in the Keynesian
view, a rise in injections causes an increase in equilibrium output, which is
needed to eradicate the discrepancy between injections and withdrawals.
2a. According to neoclassical economists, periods of low output and high
unemployment are self-correcting without government intervention. Given
flexible labour markets, high unemployment is eliminated by changes in real
wages. Also, a temporary lack of spending causes an adjustment in interest
rates. This adjustment balances injections and withdrawals and therefore
eradicates the initial underspending. Keynes disagreed for two reasons. First,
in his view labour markets do not necessarily reach equilibrium through
changes in real wages. Second, interest rates do not necessarily adjust to
counteract a temporary lack of spending. It is only through government
intervention, said Keynes, that the elimination of low output and high
unemployment can be assured.
ANSWERS TO QUESTIONS AT THE END OF 'MOUNTAIN OR MIRAGE'
1a. With a $500 billion public debt, the budget deficit is $10 billion [= $180
billion + (.06 x $500 billion) - $200 billion]. In contrast, a $600 billion
public debt means the budget deficit is $16 billion [= $180 billion + (.06 x
$600 billion) - $200 billion]. Therefore, budget deficits and the size of the
public debt are directly related, since a higher public debt means greater
public debt charges, which cause a higher budget deficit.
b. With a $500 billion public debt, the budget deficit is $5 billion [= $180
billion + (.05 x $500 billion) - $200 billion], and with a $600 billion public
debt, the budget deficit is $10 billion [= $180 billion + (.05 x $600 billion)
- $200 billion]. Therefore budget deficits and interest rates are directly
related, since higher interest rates mean greater public debt charges, which
cause a higher budget deficit.
2. This statement refers to the reversal of the crowding out effect. A decline
in public debt means that government borrowing is reduced, which decreases the
demand for borrowed funds. As a result, interest rates fall, raising the
amount of investment spending carried out by businesses.
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