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discretionary 1. What is the difference between discretionary and nondiscretionary nondiscretionary fiscal policy? expansionary 2. What is the cause-effect.

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Presentation on theme: "discretionary 1. What is the difference between discretionary and nondiscretionary nondiscretionary fiscal policy? expansionary 2. What is the cause-effect."— Presentation transcript:

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3 discretionary 1. What is the difference between discretionary and nondiscretionary nondiscretionary fiscal policy? expansionary 2. What is the cause-effect chain for expansionary and contractionary contractionary fiscal policy? automatic stabilizers 3. What are the automatic stabilizers? Golden Age of Fiscal Policy 4. What period is considered the Golden Age of Fiscal Policy? crowding-out 5. What is the crowding-out effect? negative net export effect 6. What is the negative net export effect? lags 7. What are the lags involved in fiscal policy? Supply-side 8. What is Supply-side economists? Council of Economic Advisers 9. What is the Council of Economic Advisers and the Joint Economic Committee Joint Economic Committee?

4 Discretionary Fiscal Policy [G & T] can be used if further smoothing is required. Even if I have to dig a hole and cover it back up, I do have a job. John Maynard Keynes Father of Fiscal Policy Peak Peak Trough Trough Peak Peak Contraction Contraction Contraction Contraction Nondiscretionary Fiscal Policy can take Nondiscretionary Fiscal Policy can take 33 % to 50 % of the curves out of the business cycle. [ Automatic stabilizers, like welfare and unemploy. insur.] Expansion Expansion

5 This chapter confronts the following questions: government spending and tax policies 1. Can government spending and tax policies help ensure full employment? 2. What policy actions will fight inflation help fight inflation? roles of government intervention 3. What are the roles of government intervention?

6 1915Up until 1915, the federal government collected few taxes and spent little ,000 peoplespent $650 million.In 1902, it employed fewer than 350,000 people and spent $650 million. 5 millionpeople $3 trillionToday, it employs nearly 5 million people and spends more than $3 trillion.

7 Government Revenue 16th Amendment1913Government expansion started with the 16th Amendment to the U.S. Constitution (1913) which extended the taxing power to incomes. $2.6 trillionToday, the federal g overnment collects over $2.6 trillion a year in tax revenues.

8 Real GDP Price Level AD 2 AD 1 SRAS $490 Y R $510 Y F PL 1 Recessions Decrease in AD LRAS

9 Real GDP Price Level AD 2 AD 1 Full $20 Billion Increase in AD SRAS $490 Y R $510 Y F PL 1 Expansionary Fiscal Policy Expansionary Fiscal Policy [Increase G or decrease T w. M E of 4] LRAS $5 Billion in additional G spending

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11 Real Interest Rate, (percent) Quantity of Loanable Funds [*Use this graph if there is a chg in savings by consumers or chg in fiscal policy] [* Use the Money Market graph when there is a change in MS ] r=6%r=6%r=6%r=6% D1D1D1D1 F1F1F1F1 S balanced budget Starting from a balanced budget, if the G incr spendingdecr T G incr spending or decr T to get out of recession a recession, they would now be running deficitpushing a deficit and have to borrow, pushing up demand in the LFMincreasing up demand in the LFM and increasing the interest rate the interest rate. D2D2D2D2 r=8%r=8%r=8%r=8% F2F2F2F2 E1E1E1E1 E2E2E2E2 Borrowers Lenders $ 2 T G T Balanced Budget [G&T=$2 Tr.] $2.2 T $2 T $2 T real interest rate Use the real interest rate with LFMlong-term LFM, because it is long-term. nominal interest rate Use nominal interest rate with money marketshort-term money market, as it is short-term.

12 Real Interest Rate, (percent) Quantity of Loanable Funds r=6%r=6%r=6%r=6% D1D1D1D1 F1F1F1F1 S1S1S1S1 r=4%r=4%r=4%r=4% F2F2F2F2 E1E1E1E1 E2E2E2E2 Borrowers Lenders S2S2S2S2 The following would cause an increase in supply in the LFM and lower real interest rates: 1.Fed increases MS 2.HH save more 3.Business save more 4.Government saves more 5.Foreigners save more here [*Use this graph if there is a chg in savings by consumers or chg in fiscal policy] [* Use the Money Market graph when there is a change in MS ]

13 Demand for Loanable Funds Market (a) (b) Demand for L oanable Funds at 3 % [no G borrowing] Business firms demand for L oanable Funds at 3 % [a lot of investment] Rate Interest 3% 3% S D 1[ no G] LFM A A Trillions of Dollars 3% 1.5 QID QID DIDIDIDI Low interest rates, so - a lot of investment Real

14 Demand for Loanable Funds Market (a) (b) Rate Interest 3% 3% S D 1[ no G] LFM A Trillions of Dollars 3% 1.5 DIDIDIDI With G borrowing, the demand for LF goes to 5 % Business firms d emand for Loanable Funds at 5 % [not as much investment] D 2 (G) 5% QID1 QID1 Higher interest rates, so not as much investment 1.0 Government Demand for Funds Business Demand for Funds A B Real B 5%5%5%5% QID2 QID2

15 B alanced B udget [$2 T ril. G = $2 T ril. T] $2 Trillion G T Recession Incr G to $2.2 or or Decr T to $1.8 Deficit so higher I.R. Inflation Decr G to $1.8 or Incr T to $2.2 Surplus so Lower I.R. Budget So expansionary fiscal policy leads to higher interest rates. Deficit Wow! A surplus So, contractionary fiscal policy leads to lower interest rates. Gonna have to borrow

16 Real GDP PL SRAS AD 2 YRYRYRYR YFYFYFYF [Incr G; Decr T] [ But we get negative Xn] P L1 AD 1 PL 2 G ADY/Empl./PL; G LFM I.R. T DIDIDIDICAD Y/Emp/PL; TLFM IRIRIRIR Start from a Balanced Budget G & T = $2 Trillion $2 tr. I cant get a job. N ow, this is better. G T G T E1E1E1E1 E2E2E2E2 LRAS D1D1D1D1 D2D2D2D2S Loanable Funds Market r =6 % r =8 % Real In. Rate F1F1F1F1 F2F2F2F2 $2 tr. $2.2 tr. $2.2 $2.2 $1.8 $1.8

17 $2 T tril. Real GDP PL SRAS AD 2 YIYIYIYI YFYFYFYF [Decr G; Incr T ] [Again, we get negative Xn] P L1 AD 1 PL 2 G ADY/Empl./PL; G LFM I.R. T DIDIDIDICAD Y/Emp/PL; TLFM IRIRIRIR Start from a Balanced Budget G & T = $2 Trillion $2 tril. G T G T [like we have money trees] E1E1E1E1 E2E2E2E2 LRAS Loanable Funds Market r =3 % r =6 % D1D1D1D1 D2D2D2D2 F1F1F1F1 F2F2F2F2 S $2.2 T tril. $1.8 tril.. $ 1.8 $2.2 $2.2 Real In. Rate

18 Discretionary Fiscal Policy Deliberate use of government spending and/or taxing. G and T Nondiscretionary Fiscal Policy Automatic Stabilizers 1.Welfare & food stamps 2. Unemploy. insurance 3. Social security 4. Corporate Dividends Progressive Tax System 5. Progressive Tax System Unempl. check Discretion of Congress

19 recession : Suppose the economy is in recession : Real GDP Taxcollections Transfer payments GTG > TGTG > T The deficit grows [Automatic stabilizers ] AS AD 2 AD 1 Recession Y R Y R Y* PL

20 inflationary gap If the economy has an inflationary gap : Taxcollections Transfer payments G

21 [Takes about 1/3 to ½ out of the curves] Discretionary [Active] Fiscal Policy [G & T] YRYRYRYR YFYF YIYIYIYI AD 3 AD 1 AD 2 AS PL 3 PL 1 PL 2 Contractionary Fiscal Policy 1.Decrease G 2.Increase T Peak Trough Contraction Expansion E xpansionary F iscal Policy 1.Increase G 2.Decrease T nutshell [in a nutshell] Peak Peak Trough

22 YRYRYRYR YFYFYFYF YIYIYIYI AD 3 AD 1 AD 2 Balance the economy over the course of the Business Cycle AS PL 3 PL 1 PL 2 Peak Peak RaiseT Deficit Spending Trough RaiseT Even if the jobs are digging Even if the jobs are digging holes and filling them up. Recess – Lower T Deficits Inflat – Raise T Surpluses Deficit S pending RaiseTaxes Bus. Cycle

23 2. Just print the money [Money creation – lower interest rates [Money creation – lower interest rates so this would be more expansionary] so this would be more expansionary] FINANCING OF DEFICITS [ I s borrowing or printing the money more expansionary?] 1. Government borrows from the public [results in higher interest rates which crowds out investment] which crowds out investment] 7% MS1 AS AD 2 Y * Y Y * Y But the LR increase in MS results in an increase in inflation PL 1 PL 2 AD 1 Lower I.R. HigherI.R. MS2 4%

24 [Should we hold the surplus or give it back] 1. Debt Retirement recessions [Give the surplus back during recessions to get lower interest rates and expand the economy] AS AD 2 Y I Y* Y I 2. Impound The Surplus inflations [Keep the surplus during inflations and give it back recessions during recessions] PL 2 AD 1 PL 1

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26 10% 8% 6% 4% 2% IGIGIGIG Real interest rate DIDIDIDI Investment (billions of dollars) [Incr G incr I.R. Decr Ig] Crowding Out Effect AS AD 1 AD2 4%4%2%2%4%4%2%2% YRYRYRYR G Friedman Just follow the monetary rule. Y*Y*Y*Y* D1D1D1D1 D2D2D2D2 s 6%6%6%6% 10 % Quantity of LF F1F1F1F1 F2F2F2F2 PL Real I.R. Loanable Funds Market Market 15 In this case, it would be 100% crowding out. [The higher RIR could also cause crowding-out of Xn.] G can finance a deficit by: 1. Borrowing - this raises interest rates in the LFM and crowds out investment. rates in the LFM and crowds out investment. 2. M oney C reation - no crowding out so is more expansionary than borrowing. so is more expansionary than borrowing. 0

27 Negative Net Export Effect of Fiscal Policy Y R Y* Expansionary Fiscal Policy Negative Xn Negative Xn Due to higher interest rates, dollar appreciates SRAS +Ig +C -Xn LRAS AD +G AD AD

28 Negative Net Export Effect of Fiscal Policy Y R Y* Due to lower interest rates, dollar depreciates Expansionary Fiscal Policy Negative Xn of Negative Xn of Contractionary Fiscal Policy Due to higher interest rates, dollar appreciates SRAS SRAS +G +Ig +C -Xn -Ig -C +Xn Y* Y I Y* Y I LRAS LRAS AD -G AD AD

29 Liberal ( G ) Conservative (G) Liberal ( G ) or Conservative (G)Liberals R ecession : Increase G ; Inflation: Increase T G G Conservatives Recession: Decrease T; Inflation: Decrease G

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31 starts out too cold The shower starts out too cold, because the pipes have turns up the hot water not yet warmed up. So the fool turns up the hot water. turns up the hot water further Nothing happens, so he turns up the hot water further. scalds himturns up the The hot water comes on and scalds him. He turns up the cold waterturns up cold water. Nothing happens right away, so he turns up the cold further the cold further. When the cold finally starts to come up, too cold he finds the shower too cold, and so it goes. Fiscal Policy lags 1.Data (recognition) lag 2.Wait-and-see lag – short run 3.Legislative lag (political) 4.Effect lag [takes months]

32 YFYFYFYF YRYRYRYR YIYIYIYI AD 2 AD 1 LRAS LRAS SRAS 1 SRAS 2 E4E4E4E4 E4E4E4E4 E2E2E2E2 E1E1E1E1 E2E2E2E2 E3E3E3E3 Discretionary fiscal policies recession intended to fight a recession feeding a boom often end up feeding a boom and vice versa. All too often, policy makers can inadvertently exacerbate rather than mitigate the magnitude of economic fluctuations.

33 Traditional Fiscal Policy [G & T] will not work with Stagflation AD 1 LRAS 4% 5%5%5%5% 10 % 10 % 10 % Y R SRAS 2 Stagflation AD 2 15% 15 % AD3 YFYFYFYF YRYRYRYR

34 0 100 l Tax revenue (dollars) Tax rate (percent)

35 0 100 m l Tax revenue (dollars) Tax rate (%)

36 0 100 m n l Tax revenue (dollars) Tax rate (percent)

37 0 100 m m n l Tax revenue (dollars) Tax rate (%) MaximumTaxRevenue

38 Shift the AS curve back to the right 1. Reduce corporate taxes from 50% to 35% [they have more money and increase investment, so more jobs] [they have more money and increase investment, so more jobs] 2. Accelerated depreciation of capital investment from 10 years to 3 years [businesses save taxes enabling them to invest more] [businesses save taxes enabling them to invest more] 3. Reduce personal income taxes by $250 billion [keeping more of our money makes us work harder & longer; also, we buy more, so more jobs and in makes us work harder & longer; also, we buy more, so more jobs and in addition, we save more, which lowers interest rates, which increases Ig] addition, we save more, which lowers interest rates, which increases Ig] 4. Tax Credits for R & D [businesses have more money, so more Ig and more jobs] Motto: Get the government off our [ regulations] backs & watch the AS curve shift. 10% Supply-Side Economics [Voodoo Economics?] 5% AS 1 AD 3% AS 2 10 % PL Was P resident Reagan closet Keynesian a closet Keynesian with all the G & T? Perhaps he was a Keynesian in drag.

39 Tax rate (percent) b b c a Maximum Tax Revenue President Reagan said he was on the Laffer curve. He said that after WW II, when he started making big money, that he could do 4 movies before making $200,000 and hitting the top marginal tax rate of 91%. After four, because he could only keep 9%, he would quit making movies until the next year. Yes, I was on the Laffer cuve. I couldnt shoot my way out The Gipper Bonzo rich peopledisincentive to keep working, so they would quit For rich people, this was a disincentive to keep working, so they would quit most workersnot the case when they hit the top marginal tax rate. For most workers, this was not the case. R eagan Tax revenue (dollars)

40 0 Price level Real GDP AD 1 AD 2 AS 1 AS 2 PL 1 PL 2 PL 3 Q1Q1Q1Q1 Q2Q2Q2Q2 Q3Q3Q3Q3 Can sustain a much greater increase in AD if the Can sustain a much greater increase in AD if the AS curve is also shifting to the right. AS curve is also shifting to the right. 10 %

41 Price Level AS AD 2 Inflation and the Multiplier [4] Inflation and the Multiplier [4] GDP 1 GDP 2 P1P1P1P1 AD 1 AD 3 GDP 3 P2P2P2P2 Full Multiplier Effect ReducedMultiplier Effect Due to Inflation bil bil. M(4) = Y/ E [80] [20] [80] [20] M(2) = Y/ E [40] [20] [40] [20]

42 Price level Real GDP (billions) EXPANSIONARY FISCAL POLICY Full $20 billion increase in AD AD 1 AD 2 $5 billion initial direct increase in spending MPS=.25 [MPS=.25] the multiplier at work... PL $ AS $505

43 Price level Real GDP (billions) CONTRACTIONARY FISCAL POLICY MPS=.25 [MPS=.25] the multiplier at work... PL 2 $515 Full $20 billion decrease in AD AD 1 AD 2 $5 billion initial direct decrease in spending PL 1 AS

44 GDP 1 GDP 2 GDP 3 Real Domestic Output, GDP Government Expenditures, G, and Tax Revenues, T Deficit More tax money Taxes G ov. purchases YRYRYRYR Y* YIYIYIYI More vertical [more progressive], the more stability for the economy. Transfers Surplus FewerTransfers MoreTransfers Less Tax Money FewerTransfers Taxes Even more Tax money But larger deficits 5%5%5%5% 50 % 10 % 35 %

45 pilot may take a stroll thruco-pilot A pilot may take a stroll thru and let the co-pilot cruiseturbulencepilot will rush cruise. If there is turbulence, the pilot will rush to the cockpituse manual to the cockpit [President & Congress] and use manual controls to correct turbulenceDiscretionary controls to correct turbulence. Discretionary fiscal policy is our manual control system fiscal policy is our manual control system. Nondiscretionary [Passive] Fiscal Policy (Automatic stabilizers) Transfer Payments 1. Transfer PaymentsD. Corporate dividends A. Welfare checks E. Social Security B. Food Stamps F. Veterans benefits C. Unemployment checks Progressive Income Taxes 2. Progressive Income Taxes automatic pilotof our economy 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 going getsroughmust use manual controls the flight. But when the going gets rough, the economy must use manual controls. discretionary G&T [discretionary G&T] Automatic stabilizers 33-50% out take 33-50% out. S tabilizers are like a thermostat maintaining temperature. They are shock absorbers. Y R ; T ; AD 2 Y I ; T ; AD 3 AD 2 AD 1 AD 3 Y R Y* Y I Y R Y* Y I AS 33 %- 50 % Taxes reduce the drop in D I during recessions and during recessions and reduces. the jump in D I during expansions.

46 AE (billions) o 45 oRGDP Consumption C + I g + X n C + I g + X n + G Government Spending of $20 Billion $20 Billion Government Spending & Impact on Equilibrium Y Mixed - Open Private-public - ROW $20 bil. on N ational D efense 550 Increases Y by $80 [$20 x 4 = $80] $390 $470 $550

47 -20 x 3 = -$60 Incr. T by $20 billion [MT = 3] Equilibrium GDP[-60] o 45 o Real domestic product, GDP (billions of dollars) $550 C + I g + X n + G C a + I g + X n + G $490 Mixed-Open $20 bil. incr in T $490 $550 RGDP

48 Balanced Budget Multiplier [$20 billion] [T affects AD indirectly thru C; G affects AD directly] GDP =$80 Net Change in GDP = The increase in T means we would have consumed $15 and kept $5 in our pockets. The increase in G flows directly into the economy. ME = 1/MPS ME = 1/.25 = 4 So, 4 x $20 = $80 G $20 MT = MPC/MPS=.75/.25= 3 So, 3 x -$20 = -$60 GDP= -$60 Ca= -$15 Sa= -$5 T $20 $470 billion AS AD1 $490 billion PL AD 2 +$20

49 Employment Act of With the Employment Act of 1946, the federal government committed itself to accept (total/some) degree of responsibility for employment/prices. Fiscal policy 2. Fiscal policy is carried out primarily by the (local/state/federal ) government. Discretionary fiscal policy 3. Discretionary fiscal policy [G & T] (does/does not) require congressional action. mixedclosed economy 4. In a mixed [private & public) closed economy, taxes & (savings/government spending) leakages injections are leakages, while Ig and (savings/government spending) are injections. mixedeconomy 5. In a mixed economy, the equilibrium GDP exists where (C+Ig/C+Ig+G+Xn)=GDP. balanced budget multiplier 6. The balanced budget multiplier indicates that equal increases in G&T tend to (decrease/increase/not change) the equilibrium GDP. [M BB is 1] equilibrium GDP is $400 billion 7. Assume in a private economy that equilibrium GDP is $400 billion & the MPC is G collects new taxes of $50 bil.spends the entire amount.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) billion. constitutional amendmentG always balance 8. Suppose a constitutional amendment requires that the G always balance its budgetincrease GDP by $40 billion its budget. If it desired to increase GDP by $40 billion, G should (increase/decrease) government spending & taxes by ($30/$40/$50) billion.

50 F.E. GDP is OC 12. If the F.E. GDP is OC, then it would be appropriate fiscal policy for GT government to (increase/decrease) G and (increase/decrease) T. F.E. GDP is OA 13. If the F.E. GDP is OA, then it would be appropriate fiscal policy for GT government to (increase/decrease) G and (increase/decrease) T. eliminate a budget deficit during a depression 10. If the government tries to eliminate a budget deficit during a depression, these efforts will (help/hurt) the depression. conservative economist 11. A conservative economist who advocates an active fiscal policy tax recession would recommend tax (increases/decreases) during a recession and government spendinginflation (increases/decreases) in government spending during inflation. severe recession 9. In a severe recession, Keynesians would favor a(n) (increase/decrease) in taxes. YIYIYIYI C A AE 1 AE 2 PL Y R Y* Y R Y* 800 ? AE PL O YRYRYRYR

51 during a recession 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) most expansionary would tend to be the most expansionary. fiscal actions 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 curbing inflation by the public) is likely to be most effective in curbing inflation. greatest anti-inflationary impact of a budget 16. The greatest anti-inflationary impact of a budget surplus surplus will occur when the G (impounds/uses) the surplus funds & lets them (stand idle/pay off the debt). built-in stabilizers 17. In describing the built-in stabilizers, we can say that personal & corporate income tax collections as GDP increasestransfers automatically (incr/decr) as GDP increases & transfers and subsidiesas GDP increases and subsidies (incr/decr) as GDP increases. Should I give it back?

52 Recognition Lag Action Lag Effect Lag

53 FISCAL POLICY – Pure and Simple Fiscal Policy: No Complications Price level Real GDP (billions) AD 1 AD 2 PL $490 YR YR AS diminish AD. There are 3 things that could diminish AD. $510Y*

54 Crowding-out Effect Increasing G results in higher interest rates, decreasing investment and the... Real GDP (billions) AD 1 AD 2 PL $490$510 $490 $510 AS AD 2 $503 Three things that could diminish AD. Three things that could diminish AD. 1. Crowding-out Effect 1. Crowding-out Effect 2. Net Export Effect 2. Net Export Effect 3. Inflation 3. Inflation Net Export Effect Expansionary fiscal policy leads to more government borrowing, increasing the interest rate, appreciating the dollar, & decreasing Xn.

55 3. Inflation would be a third factor that could reduce aggregate demand Price level Real GDP (billions) AS AD 2 $ 495 $ 515 P1P1P1P1 AD 1 $ 505

56 Answer the next 3 questions(18-21) based on the diagram. Deficits 18. Deficits will be realized at GDP levels (below/above) C, and surpluses surpluses (below/above) C. F.E. GDPDF.E. budget 19. If the F.E. GDP for the economy is at D, the F.E. budget will entail a (deficit/surplus). tax line had a greater slope 20. If the tax line had a greater slope [more progressive tax system], stability stability would be (less/greater). adhered strictly to an annually balanced budget 21. If government adhered strictly to an annually balanced budget then the governments budget would tend to (destabilize/stabilize) the economy. T2T2 1 10% 35 % 5% [50%]

57 For Questions [graph] T4 22. (T1/T4) tax system is characterized by the least built-in stability. T4 23. (T1/T4) tax system is characterized by the most built-in stability. T4 24. (T1/T4) tax system will generate the largest cyclical deficits. 25. Nondiscretionary Fiscal Policy (does/does not) require congressional action. 5% 20% 15% 25% 10% 35% 50% 20% (represents a more progressive system) YRYRYRYR Y* YIYIYIYI GDP Tax Revenue Flat 20% Tax [T1] [T2] [T3] [T4]

58 $10 B increase in Gincrease C 26. If the MPC is.5, a $10 B increase in G will increase C not income [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] government tries to give back a surplusduring an 27. If government tries to give back a surplus during an inflationary FE year inflationary FE year, this will be (pro-cyclical/counter-cyclical). improvement 28. When politicians use fiscal policy to cause an improvement in the economy just prior to an election in the economy just prior to an election, this is a (presidential/Congressional/political) business cycle. G incurs a deficit which is financed by borrowing 29. When G incurs a deficit which is financed by borrowing, interest rates to increase which decreases Ig causing interest rates to increase which decreases Ig, this is called the (crowding-in/crowding out) effect. Supply-sidersprimary effect of tax cuts 30. Supply-siders argue that the primary effect of tax cuts is to shift the AS curve (leftward/rightward).

59 MPS is If the MPS is.2 and the economy has a recessionary spending gap of $5 bil., equilibrium level we may conclude that the equilibrium level of GDP of GDP is ($5/$20/$25) below the FE GDP. MPS is I n a private-closed economy, the MPS is. 2, consumption equals income at $200 billioninvestment is $10 billion, & the level of investment is $10 billion billion. The level of income at the new equilibrium level is ($200/$250) billion. MPC is.8$2 billion increase in G 31. If the MPC is.8, a $2 billion increase in G will increase consumption 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] MPC is.9$1 billion increase in G 32. If the MPC is.9, a $1 billion increase in G will increase consumption consumption by ($10/$9/$8) billion. C+Ig ? C +$10 Ig AE AE1 AE2 Y R ? AE +$5 S S

60 government decreases G&T by $10 billion 36. If the government decreases G&T by $10 billion, then a MPS of.10 equilibrium GDP MPS of.10, the equilibrium GDP would (increase/decrease) by ($5/$10/$100) billion. MPC of.75government increases G&T by $8 billion 37. With a MPC of.75, government increases G&T by $8 billion. equilibrium GDP The equilibrium GDP (increases/decreases) by ($75/$32/$8) billion. government runs a budget surplus and desires to 38. If the government runs a budget surplus and desires to curb inflation curb inflation, it should (give the surplus back/keep it in storage). MPS is If the MPS is.5 and the economy has an inflationaryspending gap of $6 billion inflationary spending gap of $6 billion, equilibrium level we may conclude that the equilibrium level of GDP of GDP is ($6/$12/$18) billion beyond the FE GDP. -$6 AE1 AE2 Y* Y I AE S

61 1. Expansionary fiscal policy will be most effective is [increase GDP] when the AS curve is (vertical/horizontal) & (incr/decr) C and (incr/decr) unemployment. 2. The paradox of thrift indicates that an increase in saving (matched/unmatched) by an increase in investment will lower equilibrium GDP.

62 contractionary fiscal policydecr G, incr T 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. expansionary fiscal policyincr G, decr T 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. AE[AD]doesnt buy up FE output(GDP) 4. In the AE model, if AE[AD]doesnt buy up FE output(GDP), then the equilibrium output is (less than/more then) full employment output. [G ; LFM ; In. Rates ] [On #3, start from a balanced budget] Recessionary Gap Inflationary Gap G $2 Trillion T $2 Trillion [T ; LFM ; In. Rates ]

63 decrease AD the greatest amount 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) recessionary gap equilibrium point[actual GDP] 7. In a recessionary gap (AE model) at the equilibrium point[actual GDP] planned investmentsaving,FE planned investment is (greater than/equal to/less than) saving, but at the FE GDP levelsaving GDP level, planned investment [backup ] is (greater than/equal to/less than ) saving. inflationarygap AE model 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 saving the FE level, planned investment is (greater than/equal to/less than) saving. unplanned increase in inventories 9. If businesses are experiencing an unplanned increase in inventories, AE is FE output & spending (less than/greater than) FE output & spending will (increase/decrease). unplanned decrease in inventoriesdisinvestment 10. If businesses are experiencing an unplanned decrease in inventories [disinvestment] FE output & spending AE is (less than/greater than) FE output & spending will (increase/decrease).

64 C equals income at $500 billionMPC is 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. conservative economist 12. A conservative economist would want tax (incr/decr) during recessioninflationary times a recession & (incr/decr) in G during inflationary times. liberal economist 13. A liberal economist would want tax (incr/decr) during an inflationrecessionary periods inflation & (incr/decr) in G during recessionary periods. inflationary gap 14. An inflationary gap indicates AE[actual GDP] (exceeds/falls short of) FE GDP. recessionary gap 15. A recessionary gap indicates AE[actual GDP] (exceeds/falls short of) FE GDP. increase GDP [but reduce military spending] 16. To increase GDP [but reduce military spending], we would combine two (domestic/overseas) bases into one (domestic/overseas) base. tax cut to expand the economy 17. A tax cut to expand the economy would (incr/decr) Y & (incr/decr) in. rates. tax increase to contract the economy 18. A tax increase to contract the economy would (incr/decr) Y & (incr/decr) IR

65 increase equilibrium GDP by $400, To increase equilibrium GDP by $400,000, with a MPC of.5, a Keynesian economist would ( decrease T /increase G ) by $ 200,000. quilibrium GDP is $500 billion 20. E quilibrium GDP is $500 billion and MPS is.4. Now G collects taxes of $22 billion and spends the entire amount. As a result, equilibrium GDP will change to: ($445/$478/$522/$555). MPC of.5$12 billion 21. With a MPC of.5, a $12 billion increase increase C in G will increase C by ($12/$24/$36) bil. MPC of With a MPC of.5 and the economy in a recessionary spending gap of $12 billion recessionary spending gap of $12 billion, we may conclude that the equilibrium is short of FE GDP ($12/$24/$36) billion short of FE GDP.

66 increase in Ig of $25 billion 23. An increase in Ig of $25 billion results in an increase in equilibrium income (GDP) of $50B, so the MPS is? contractionary fiscal policy 24. A contractionary fiscal policy results in a(n) (incr/decr) in output, and a(n) (incr/decr) in interest rates. Increasing T or decreasing G 25. Increasing T or decreasing G will (increase/decrease) consumption, and (increase/decrease) unemployment..5inflationaryGDP Gap$50BGinflationaryGDP Gap reducing government spending 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? MPC of.5current output at $500 billion but FE output is $700 bilcorrect fiscal policy 27. With a MPC of.5 and current output at $500 billion but FE output is $700 billion, correct fiscal policy would be to (increase G/decrease T) by $100 billion. [Incr T or Decr G].5 $25 billion

67 increase in Ig 28. An increase in Ig in an economy (increase)/decrease) GDP & (increase/decrease) C. recessionary economy 29. In a recessionary economy, at FEGDPsavingIg FE GDP, saving is (less than/more than) Ig. recessionary economy 30. In a recessionary economy, (actual Y/potential Y) exceeds (actual Y/potential Y). mixed-closed economyno Xnleakages 31. In a mixed-closed economy (no Xn), the leakages are? injections and the injections are? inflationary Gap 32. If the economy has an inflationary Gap, at FE GDPsaving FE GDP, saving (exceeds/is less than) Ig. equal increase in G & T of $25 bil 33. If there is an equal increase in G & T of $25 billion, outputinterest rates then output will (increase/decrease) & interest rates [based on PL] [based on PL] will (increase/decrease). [S & T] [G & Ig]

68 The End E-conE-con


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