Chapter 21: Fiscal Policy

Chapter 21 Fiscal Policy Key Concepts Summary Practice Quiz Internet Exercises©2000 South-Western College Publishing1In this chapter, you will learn to solve these economic puzzles:Is an increase in government spending or a tax cut of equal amount the greater stimulus to economic growth?Can Congress fight a recession without taking any action?Why did Ronald Reagan think the federal government could increase tax revenues by cutting taxes?2What is a Discretionary Fiscal Policy?The deliberate use of changes in government spending or taxes to alter aggregate demand and stabilize the economy3What are examples of Expansionary Fiscal Policy?Increase government spendingDecrease taxesincrease government spending and taxes equally4What are examples of Contractionary Fiscal Policy?Decrease government spendingIncrease taxesDecrease government spending and taxes equally5$6$6.1$6.2AS0150155Full EmploymentAD1AD2Real GDPPrice LevelE2XE1155Government Spending to Combat a Recession6Increase in government spendingIncrease in the aggregate demand curveIncrease in the price level and the real GDP7With an MPC of 0.75, what is the Spending Multiplier?1/1-MPC = 1/1-0.75 = 1/25/100 = 1 /  = 48How much will real GDP increase by with an increase in government spending of $50 bil?4 x $50 bil = $200 bil9What is theTax Multiplier?The change in aggregate demand (total spending) resulting from an initial change in taxes10What happens when government cuts taxes by $50 bil?The multiplier process is less because initial spending increases only by $38 bil instead of $50 bil11What is the formula for the Tax Multiplier?1 – spending multiplier12How much does real GDP increase by with a cut in taxes of $50 bil?3 x $50 bil = $150 bil13Can we assume that the MPC will remain fixed?No, it can change from one time period to another14Can 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 curve15What will happen to AD with a cut in G spending of 25 bil?-$25 bil x 4 = -$100 bil16$6$6.1AS0155160Full EmploymentAD1AD2Real GDPE2E1Using Fiscal Policy to Combat InflationE´Price Level17Decrease in government spendingDecrease in the aggregate demand curveDecrease in the price level18What will happen to AD with a cut in Taxes of 33.3 bil?$33.3 x -3 = -$100 bil19What 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 spending20What is anAutomatic Stabilizer?Federal expenditures and tax revenues that automatically change levels in order to stabilize an economic expansion or contraction21What are examples of Automatic Stabilizers?Transfer paymentsUnemployment compensationWelfare22What is aBudget Surplus?A budget in which government revenues exceed government expenditures in a given time period23What is a Budget Deficit?A budget in which government expenditures exceed government revenues in a given time period24$1,000$750$500$250$4$6$8G Spending and TaxesG$2,500TReal GDPBudget deficitBudget surplusAutomatic Stabilizers25Increase in real GDPTax collections fall and government transfer payments riseBudget offsets inflation26Decrease in real GDPTax collections fall and government transfer payments riseBudget offsets recession27What is Supply-Side Fiscal Policy?A fiscal policy that emphasizes government policies that increase aggregate supply28What is the purpose of Supply-Side Fiscal Policies?To achieve long-run growth in real output, full employment, and a lower price level2924681012AS0100200250Demand-Side Fiscal PolicyFull EmploymentReal GDPAD1AD2E1E2Price Level15030Increase in government spending; decrease in net taxesIncrease in the aggregate demand curve31246810120100200250Supply-Side Fiscal PolicyFull EmploymentReal GDPADE1E2Price Level150AS1AS232Decrease in resource prices; technological advances; subsidies; decrease in regulationsIncrease in the aggregate supply curve33L1L20W2W1Labor DemandQ of LaborWage rateE2E1Supply-Side Policies Affect Labor MarketsAfter tax-cut labor supplyBefore tax-cut labor supply34Will an increase in Taxes lead to higher Government Revenues?That depends on where the economy is on the Laffer Curve35What is theLaffer Curve?Puts forth the idea that increasing taxes from zero will increase tax revenues up to a certain point36What happens beyond a certain point?Tax revenues begin to decline as the economic pie begins to shrink37Why does the Economic Pie begin to shrink?Workers have less incentive to work and investors have less of an incentive to invest38TmaxT0RRmaxFederal Tax RateFederal Tax RevenueAThe Laffer Curve100%BCD39Key Concepts40Key ConceptsWhat 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?41Key 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?42Key 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?43Summary44 Fiscal policy is the use of government spending, taxes, and transfer payments for the purpose of stabilizing the economy.45 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. 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. 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.48 Increase government spending Decrease taxes Increase government spending and taxes equally Expansionary ContractionaryDiscretionary Fiscal Policies Decrease government spending Increase taxes Decrease government spending and taxes equally49 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. Expressed as a formula, the tax multiplier = 1 - spending multiplier.50 A balanced budget multiplier in 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. 51 Combating recession and inflation can be accomplished by changing government spending or taxes. 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. 52Increase in government spendingIncrease in the aggregate demand curveIncrease in the price level and the real GDP53Decrease in government spendingDecrease in the aggregate demand curveDecrease in the price level54 A budget surplus occurs when government revenues exceed government expenditures. A budget deficit occurs when government expenditures exceed government revenues. 55 Automatic stabilizers are changes in taxes and government spending that occur automatically in response to changes in the level of real GDP. The business cycle therefore creates braking power: A budget surplus slows down an expanding economy. A budget deficit reverses a downturn in the economy. 56$1,000$750$500$250$4$6$8G Spending and TaxesG$2,500TReal GDPBudget deficitBudget surplusAutomatic Stabilizers57 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. 58 The Laffer curve represents the relationship between the income tax rate and the amount of income tax revenue collected by the government.59 Chapter 21 Quiz©2000 South-Western College Publishing601. 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. regulating net exports.d. decreasing government spending or increasing taxes.D. The money supply is under control of the Federal Reserve and not Congress.612. 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.623. If the marginal propensity to consume (MPC) 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 = 2.5 634. Assume the economy is in recession and real GDP is below full employment. The marginal propensity to consume (MPC) 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Y = $2,500 billion645. 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.656. 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.C. 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 spend. 667. 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 (MPC) is 0.80, federal policymakers could follow Keynesian economics and restrain inflation bya. decreasing government spending by $200 billion.b. decreasing taxes by $100.c. decreasing taxes by $1,000 billion.d. decreasing government spending by $1000 billion.A. Change in government spending (G) x spending multiplier = change in aggregate demand, rewritten: G = change in aggregate demand / spending multiplierSpending multiplier = 1 / (1-MPC) = 1 / (1-0.80) = 1 / 20/100 = 5 G = -$1,000/5, G = -$200 billion.678. 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 multiplierSpending multiplier = 1 / (1-MPC) = 1 / (1-0.80) = 1 / 20/100 = 5Tax multiplier = 1 - 5 = -4, T x -4 = -$500 billionT = $125 billion689. 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 (MPC) is 0.75, federal policy-makers could follow Keynesian economics and restrain inflation bya. 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.6910. If no fiscal policy changes are implemented, suppose the future aggregate demand curve will shift and 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. Change in taxes (T) x tax multiplier = change in aggregate demand, rewritten: Tax multiplier = 1 - spending multiplier Spending multiplier = 1 / (1-MPC) = 1/(1-0.90) = 1/10/100 = 10 7011. 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.7112. 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. 7213. 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 automatic stabilizers tends to destabilize the economy. d. To combat inflation, Keynesians recommend lower taxes and greater government spending. A. 73TmaxT0RRmaxFederal Tax RateFederal Tax RevenueAThe Laffer Curve100%BCD74Internet ExercisesClick on the picture of the book, choose updates by chapter for the latest internet exercises75END76