FISCAL POLICY [“G” and “T”]

FISCAL POLICY [“G” and “T”]
Even if I have to dig a hole and cover it back up, I do have a job. FISCAL POLICY [“G” and “T”] John Maynard Keynes “Father of Fiscal Policy”

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

Taxes (“T”) and “G”Spending
Up until 1915, the federal government collected few taxes and spent little. In 1902, it employed fewer than 350,000 people and spent $650 million. Today, it employs nearly 4.3 million people and spends more than $3.4 trillion.

Government Revenue Government expansion started with the 16th Amendment to the U.S. Constitution (1913) which extended the taxing power to incomes. Today, the federal government collects over $2.7 trillion a year in tax revenues.

Let’s say the German government decides to connect East Germany to West Germany by constructing a water bridge over the Elbe River. They did this, spending 500 million euros. The next picture is a kilometer-long “concrete bathtub” water bridge near the town of Magdeburg.

D2 S D1 Loanable Funds Market G T IR=10% IR=8% F1 F2
[*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] D2 D1 S Use the “real interest rate” with LFM, because it is long-term. Use “nominal interest rate” with money market, as it is short-term. Borrowers Lenders Starting from a balanced budget, if the G incr spending or decr T to get out of a recession, they would now be running a deficit and have to borrow, pushing up demand in the LFM and increasing the interest rate. Real Interest Rate, (percent) IR=10% E2 IR=8% E1 $2 T $2 T G T F1 F2 Quantity of Loanable Funds Balanced Budget [G&T=$2 Tr.]

Demand for Loanable Funds Market
Demand for Loanable Funds at 3% [no G borrowing] Business firms demand for Loanable Funds at 3% [a lot of investment] Real DI Interest S Rate D1[no G] A 3% A 3% LFM 1.5 QID Low interest rates, so - a lot of investment Trillions of Dollars Trillions of Dollars

Demand for Loanable Funds Market Higher interest rates, so
With “G” borrowing, the demand for LF at 5% Business firms demand for Loanable Funds at 5% [not as much investment] Government Demand for Funds Business Demand for Funds D2(G) DI Real S Interest Rate D1[no G] 5% B 5% B A 3% 3% A Higher interest rates, so not as much investment LFM 1.0 1.5 QID2 QID1 Trillions of Dollars Trillions of Dollars

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

Expansionary Fiscal Policy
[Incr G; Decr T] PL SRAS AD2 Start from a Balanced Budget G & T = $2 Trillion LRAS AD1 “Now, this is better.” “I can’t get a job.” PL2 $2 T $2 T PL1 E2 G T E1 YR YF Real GDP G G I.R. AD Y/Empl./PL; LFM T Y/Emp/PL; DI C AD T LFM IR

[Decr G; Incr T to close a contractionary gap]
Contractionary Fiscal Policy [Decr G; Incr T to close a contractionary gap] PL SRAS Start from a Balanced Budget G & T = $2 Trillion AD2 LRAS PL1 E1 $2T $2T PL2 G T E2 AD1 YF YI Real GDP [like we have “money trees”] G G I.R. AD Y/Empl./PL; LFM T Y/Emp/PL; DI C AD T LFM IR

Everyone Wants To Go To Heaven But No One Wants To Die.
Everyone Wants Government Spending But No One Wants To Pay Taxes.

Keynes and Lydia Lopokova
Fiscal Policy During Recession Recessionary Gap SRAS AD2 LRAS AD1 YR Y* Expansionary Fiscal Policy G T Keynes and Lydia Lopokova

Expansionary Fiscal Policy
Fiscal Policy During Inflation Inflationary Gap SRAS LRAS AD2 AD1 Y* YI Expansionary Fiscal Policy Contractionary Fiscal Policy G G T T

Automatic Stabilizers
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 flight. But when the going gets rough, the economy must use manual controls. [discretionary G&T] Automatic Stabilizers Nondiscretionary Fiscal Policy (Automatic stabilizers) 1. Transfer Payments A. Welfare checks B. Unemployment checks C. Food Stamps D. Social Security E. Corporate dividends F. Veteran’s benefits 2. Progressive Income Taxes AS AD2 AD2 AD3 Automatic stabilizers take 33-50% out. Stabilizers are like a thermostat maintaining temperature. They are shock absorbers. YR Y* YI 33%-50% YR ; T ; AD2 YI ; T ; AD3 A pilot may take a stroll thru & let the co-pilot cruise. If there is turbulence, the pilot will rush back to the cockpit [President & Congress] and use manual controls to correct economic turbulence. Discretionary fiscal policy is our manual control system.

Government Expenditures,
BUILT-IN STABILITY More vertical [more progressive], the more stability for the economy. Taxes Taxes Transfers More tax money More Transfers Government Expenditures, G, and Tax Revenues, T Surplus Deficit Gov. purchases by Fed, state and local governments Fewer Transfers Fewer Transfers Less Tax Money GDP1 GDP2 GDP3 YR Y* YI Real Domestic Output, GDP

Keynesian Model Recess. Gap Inflat. Gap

Discretionary Fiscal Policy Nondiscretionary 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 5. Progressive Tax System Unempl. check Discretion of Congress

Suppose the economy is in recession:
Fiscal Policy Automatic stabilizers. Suppose the economy is in recession: Tax collections Real GDP Transfer payments AS AD1 AD2 G > T PL The deficit grows YR Y* “Recession”

If the economy has an inflationary gap:
Fiscal Policy Automatic stabilizers. If the economy has an inflationary gap: Tax collections Real GDP Transfer payments AS AD2 PL AD1 G < T Y* YI The surplus grows “Inflationary Gap”

Discretionary Fiscal Policy
Contractionary Fiscal Policy Decrease “G” Increase “T” Discretionary Expansionary Fis. Policy Increase “G” Decrease “T”

The “Golden Age of Fiscal Policy”
The Kennedy/Johnson $10 Billion Tax Cuts of 1964 The “Golden Age of Fiscal Policy”

Fiscal Policy and Tax Cuts.
When Kennedy came into office: 1. The top marginal tax rate was 91% & drops to 52% [35% today] 2. The unemployment rate was 6.7% & drops below 5%. 3. A recession becomes a very good low unemployment - low inflation (2%) economy. 4. The expansion continued to 1969. Kennedy had been hesitant about a $10 billion tax cut but finally saw the Keynesian Light. 12/31-65

Keynesian Policy: “Balance the Economy, not the Budget.”
“Even if the jobs are digging holes and filling them up.” Deficits Surpluses

[Is borrowing or printing the money more expansionary?]
FINANCING OF DEFICITS [Is borrowing or printing the money more expansionary?] 1. Government borrows from the public [results in higher interest rates which crowds out investment] Higher I.R. MS1 MS2 2. Just print the money [Money creation – lower interest rates so this would be more expansionary] 7% 4% Lower I.R. But the LR increase in MS results in an increase in inflation AS AD2 AD1 PL2 PL1 Y* Y

1. Debt Retirement 2. Impound The Surplus How To Dispose of Surpluses
[Should we hold the surplus or give it back] 1. Debt Retirement [Give the surplus back during recessions to get lower interest rates and expand the economy] 2. Impound The Surplus [Keep the surplus during inflations and give it back during recessions] AS AD2 AD1 PL Y* YI

“CROWDING OUT” EFFECT [Incr G incr I.R. Decr Ig]
AS G can finance a deficit by: 1. Borrowing - this raises interest rates in the LFM and “crowds out” investment. 2. Money Creation - no “crowding out” so is more expansionary than borrowing. 16 14 12 10 8 6 4 2 AD2 AD1 4% 2% G IG YR Y* Real interest rate (%) Crowding Out Effect DI Friedman Just follow the “monetary rule.” Investment (billions of dollars)

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

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

Liberal (“G”) or Conservative (“G”)
Liberals Recession: Increase “G”; Inflation: Increase “T” G Conservatives Recession: Decrease “T”; Inflation: Decrease “G” G

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

The G is like a “Fool in the Shower.”
LRAS SRAS1 AD1 SRAS2 AD2 E1 E2 E4 E3 YR YF YI E2

Traditional Fiscal Policy [“G” & “T”] will not work with Stagflation
SRAS2 AD1 LRAS 15% 10% 4% AD3 15% 10% YR 5% Stagflation YR YF

Laffer Curve and Supply-Side Economics
Was Reagan a “closet Keynesian” with all the “G” & “T”? Perhaps he was a “Keynesian in drag.”

THE LAFFER CURVE 100 Tax rate (percent) l Tax revenue (dollars)

THE LAFFER CURVE 100 Tax rate (%) m l Tax revenue (dollars)

THE LAFFER CURVE 100 n Tax rate (percent) m l Tax revenue (dollars)

THE LAFFER CURVE Maximum Tax Revenue Tax rate (%)
100 n m m Maximum Tax Revenue Tax rate (%) l Tax revenue (dollars)

Ben Stein [from “Ferris Bueler’s Day Off”] graduated from
Ben Stein’s part in this movie as a boring econ prof was voted one of the 50 most famous scenes in American film. Ben Stein [from “Ferris Bueler’s Day Off”] graduated from Columbia University in 1966 with a degree in economics and from Yale Law School in 1970 as valedictorian. He was a speech writer for Nixon. He has written 16 books, including his latest humor book, “How To Ruin Your Life”.

For rich people, there would be a disincentive to quit working when
THE LAFFER CURVE President Reagan said he was on the Laffer curve. He said that after WWII, when he started making big money, that he could do 4 movies before hitting the top marginal tax rate of 90%. After 4, because he could only keep 10%, he would quit making movies until the next year. “Yes, I was on the Laffer cuve. I couldn’t shoot my way out” Maximum Tax Revenue m l n Tax revenue (dollars) Reagan The “Gipper” Bonzo m 100 Tax rate (percent) For rich people, there would be a disincentive to quit working when they hit the top marginal tax rate. For most workers, this was not the case.

SUPPLY-SIDE FISCAL POLICY
Emphasis on Expansionary Tax Cuts [which shifts AD to the right, increasing Y & PL] Impact upon... Saving and Investment [Lower taxes increase DI & S; less business taxes will increase investment. Our “national factory” will increase.] Work Incentives [Keeping more of our money makes us work harder and longer] Risk Taking [Lower tax rates promise a larger potential after-tax reward] So, the AS Curve will shift right bringing prices down. We will have Economic Heaven.

SUPPLY-SIDE FISCAL POLICY
Can sustain a much greater increase in AD if the AS curve is also shifting to the right. AD1 AD2 AS1 AS2 Price level PL2 PL1 10% PL3 Q1 Q2 Q3 Real GDP 10%

MULTIPLIER WITH PRICE-LEVEL CHANGES
Inflation and the Multiplier [4] AS Full Multiplier Effect Reduced Multiplier Effect Due to Inflation AD3 AD2 AD1 +20 +20 Price Level P2 P1 + 40 bil. + 80 bil. GDP1 GDP2 GDP3 M(4)=chg.Y/chg.E [80] [20] M(2)=chg.Y/chg. E [40] [20]

EXPANSIONARY FISCAL POLICY
[MPS=.25] the multiplier at work... $5 billion initial direct increase in spending AS AD1 AD2 Full $20 billion increase in AD +5 Price level P1 $485 $505 Real GDP (billions)

CONTRACTIONARY FISCAL POLICY direct decrease in spending
[MPS=.25] the multiplier at work... AS AD2 AD1 P1 $5 billion initial direct decrease in spending Price level P2 Full $20 billion decrease in AD $515 Real GDP (billions)

Council of Economic Advisors(CEA) Joint Economic Committee (JEC)
LEGISLATIVE MANDATES Employment Act of 1946 Council of Economic Advisors(CEA) Joint Economic Committee (JEC)

Legislative Mandates for Remedial Fiscal Measures
1. Employment Act of 1946 – a law promoting economic stability (by promoting “maximum employment, production, and purchasing power”) through monetary and fiscal policies. This act was a government commitment to ensure prosperity after WWII. [not only “could” but “would” – no more laissez faire] This act gave the Keynesians economists the theoretical and legal justification to use fiscal policy to stabilize the economy. 2. Council of Economic Advisers (CEA) [for the President] – 3 distinguished economists (on leave from universities) who assist and advise the President on economic matters. Their staff is made up of 11 senior and 6 junior economists. They forecast and project the deficit, inflation, GDP growth, foreign exchange rates, immigration, & antitrust legislation. The President must submit an annual economic report describing the current economic state with recommendations. “The President’s intelligence arm in the war against the business cycle.”

Head of the CEA Greg Mankiw of Harvard has ridiculed Ben Bernanke,
supply-side tax cuts as “fad economics” conceived by “charlatans and cranks,” in his textbook. Head of the CEA Edward Lazear PHD in Econ, Harvard Matt Slaughter of Dartmouth Ben Bernanke, Former Board Governor, succeeded Maniew. [scored 1590 on SAT] [Now Chairman of Fed] Katherine Baicker U.C.L.A.

Joint Economic Committee of Congress and Humphrey-Hawkins Act of 1978
If you look at my “C” average college grades, the CEA can help me.

AE & Fiscal Policy Questions on 2000 AP Exam
1. (81%) The value of the spending multiplier (ME) decreases when a. tax rates are reduced d. government spending increases b. exports decline e. the marginal propensity to save increases c. imports decline 2. (75%) Which of the following policies would a Keynesian recommend during a period of high unemployment and low inflation? a. decreasing the MS to reduce AD b. decreasing taxes to stimulate AD c. decreasing government spending to stimulate AS d. balancing the budget to stimulate AS 3. (47%) Which of the following best explains why equilibrium income will increase by more than $100 in response to a $100 increase in G? a. Incomes will rise, resulting in a tax decrease. b. Incomes will rise, resulting in higher consumption. c. The increased spending raises the aggregate price level. d. The increased spending increases the money supply, lowering interest rates. e. The higher budget deficit reduces investment. 4. (56%) Unexpected increases in inventories usually precede a. increases in inflation b. increases in imports c. stagflation d. decreases in production e. decreases in unemployment If MPS incr from .10 to .20, the ME would decrease from 10 to 5. The Multiplier ensures more C with each round.

S AE C+Ig C 5. (63%) The economy on the right is
currently experiencing a. inflation b. recession c. expansion d. stagflation e. rapid growth 6. (77%) Correct monetary policy to reach FE GDP is to increase a. the MS b. the RR c. discount rate d. taxes e. exports 7. (36%) The minimum increase in government spending to reach full employment is a. $2,000 b. $1,000 c. $500 d. $ e. $100 8. (58%) In the simple Keynesian AE model [not AD/AS] of an economy, changes in Ig or G will lead to a change in which of the following? a. the price level b. the level of output and employment c. interest rates d. the AS curve 9. (83%) In a closed-private in which the APC is .75, which of following is true? a. If income is $100, then saving is $75. d. If income is $200, then “C” is $75 b. If income is $100, then “C” is $50 e. If income is $500, then saving is $100 c. If income is $200, then saving is $50 AE S C+Ig E $500 C A $400 Full.Employ. $800 $1,000 $2,000 Determine what the “M” is going from A to E; then M X ? = $1,000

Fiscal Policy Questions from 2000 Exam
10. (63%) Suppose that DI is $1,000, consumption is $700, and the MPC is .6. If DI then increases by $100, consumption and savings will equal which of the following? Consumption Savings a. $ $280 b. $ $400 c. $ $320 d. $ $440 e. $ $340 Fiscal Policy Questions from 2000 Exam 11. (73%) An inflationary gap can be eliminated by all of the following EXCEPT a. an increase in personal income taxes d. a decrease in G b. an increase in the MS e. a decrease in Xn c. an increase in the interest rate 12. (56%) A major advantage of automatic stabilizers in fiscal policy is that they a. reduce the public debt b. increase the possibility of a balanced budget c. stabilize the unemployment rate d. go into effect without passage of new legislation e. automatically reduce the inflation rate If $700 of $1,000 DI is consumed, then saving is $300. MPC of .6 means if DI increases by $100, then $60 more will be consumed & $40(.4) more will be saved(40%). The $60 added to the $700 already consumed = $760 consumed and the additional $40 saved = $340 saved. Which answer does not slow the economy?

13. (70%) In the short run, a contractionary fiscal policy will cause AD,
output, and the price level to change in which of the following ways? AD Output Price level a. decrease decrease decrease b. decrease increase increase c. increase decrease decrease d. increase increase increase 14. (52%) Crowding out due to government borrowing occurs when a. lower interest rates increase private sector investment b. lower interest rates decrease private sector investment c. higher interest rates decrease private sector investment d. a smaller money supply increases private sector investment 15. (41%) If, at FE, the G wants to increase its spending by $100 billion without increasing inflation in the short run, it must do which of the following? a. raise taxes by more than $100 billion c. raise taxes by less than $100 b. raise taxes by $100 billion d. lower taxes by $100 billion 16. (42%) Compared to expansionary monetary policies adopted to counteract a recession, expansionary fiscal policies tend to result in a. less public spending c. a high rate of economic growth b. higher interest rates d. lower prices

17. (71%) An increase in which will increase the value of the ME?
1995 AP Exam 17. (71%) An increase in which will increase the value of the ME? a. The supply of money d. The marginal propensity to consume b. Equilibrium output e. The required reserve ratio c. Personal income tax rates 18. (61%) An AS curve may be horizontal over some range because within that range a. a higher PL leads to higher interest rates, which reduces the MS & “C” b. changes in the aggregate PL do not induce substitution c. output cannot be increased unless prices and interest rates increase d. rigid prices prevent employment from fluctuating e. resources are underemployed & an increase in AD will be satisfied without any pressure on the PL 19. (45%) What could cause simultaneous increases in inflation & unemployment a. a decrease in government spending d. An increase in inflationary expectations b. A decrease in the money supply e. An increase in productivity c. A decrease in the velocity of money 20. (85%) Which of the following will result in the greatest increase in AD? a. A $100 increase in taxes b. A $100 decrease in taxes c. A $100 increase in government expenditures d. A $100 increase in government expenditures, coupled with a $100 increase in taxes e. A $100 increase in government expenditures, couples with a $100 decrease in taxes 21. (65%) Which of the following will result from a decrease in government spending? a. An increase in output d. A decrease in AS b. An increase in the price level e. A decrease in AD c. An increase in employment

Questions 22-23 refer to the diagram(rt),
which depicts an economy’s “C” function. 22. (56%) If the MPC increases, the equilibrium levels of income and consumption will change in which of the following ways? Equil. Level Equil. Level of Income of Consumption a. No change No change b. No change Increase c. Increase No change d. Increase Increase e. Decrease Decrease S C+Ig C Expenditures C2 + $100 Ig C1 $700 $1,500 $2,000 Real Income A larger MPC means a smaller MPS, and a larger M. this will increase income and result in more “C” at the new level of equilibrium income (GDP). 23. (48%) If private investment of $100 is added to the economy, the equilibrium levels of income and consumption will change in which of the following ways? Equil. Level Equil. Level of Income of Consumption a. Increase Decrease b. Increase Increase c. Increase No change d. No change Increase e. No change No change

22. (61%) The graph indicates equilibrium at E
for a closed economy without G. If the addition of G results in equilibrium at F, which of the following is true? a. G is $300 and the multiplier is 5. b. G is $100 and the multiplier is 5. c. G is $100 and consumption increased by $500. d. G and Ig increase by $500. e. Consumption and GDP increase by $500 each. AE C+Ig+G F C+Ig E $300 $200 $1,000 $1, GDP 23. (84%) According to Keynesian theory, decreasing taxes and increasing G will most likely change consumption and unemployment in which of the following ways? Consumption Unemployment a. Decrease No change b. Decrease No change c. Increase Decrease d. Increase Increase e. No change Decrease 24. (79%) In an economy at full employment, a presidential candidate proposes cutting the government debt in half in 4 years by increase T and reducing G. According to Keynesian theory, implementation of these policies is most likely to increase a. unemployment d. aggregate supply b. consumer prices e. the rate of economic growth c. aggregate demand

fiscal policy most effective in stimulating production and employment?
25. (79%) If the economy is in a severe recession, which of the following is the fiscal policy most effective in stimulating production and employment? a. Government spending increases. b. Government spending decreases. c. Personal income taxes are increased. d. The Fed sells bonds on the open market. e. The Fed buys bonds on the open market. 26. (27%) Faced with a large federal budget deficit, the government decides to decrease expenditures and tax revenues by the same amount. This action will affect output and interest rates in which of the following ways? Output Interest Rates a. Increase Increase b. Increase Decrease c. No change Decrease d. Decrease Increase e. Decrease Decrease 27. (28%) If crowding out only partially offsets the effects of a tax cut, which of the following changes in interest rates and GDP are most likely to occur. Interest Rates GDP a. Increase Increase b. Increase Remain unchanged c. Increase Decrease d. Remain unchanged Increase e. Decrease Decrease An equal decrease in G & T [Let’s say by $10 billion] would decrease GDP by $10 billion. The decrease in GDP would decrease PL which would cause a decrease in interest rates. Partially means GDP increases. Starting from a balanced budget, the tax cut would put the G in deficit and the G borrowing would increase demand for money in the LFM and push up interest rates.

28. (62%) According to the Keynesian saving schedule, when aggregate income increases by a given amount, savings will a. remain the same b. decrease by the amount of the change in income c. increase by the amount of the change in income d. increase by less than the amount of the change in income e. increase by more than the amount of the change in income

President Bush’s College Transcript
And – What did President Bush have to say about “power pants”?

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

C A YR YI AE2 9. In a severe recession, Keynesians PL
would favor a(n) (increase/decrease) in taxes. AE2 PL AE1 YR Y* ? 10. If the government tries to eliminate a budget deficit during a depression, these efforts will (help/hurt) the depression. 11. A conservative economist who advocates an active fiscal policy would recommend tax (increases/decreases) during a recession and (increases/decreases) in government spending during inflation. S AE PL O C A YR YI 12. If the F.E. GDP is OC, then it would be appropriate fiscal policy for government to (increase/decrease) “G” and (increase/decrease) “T”. 13. If the F.E. GDP is OA, then it would be appropriate fiscal policy for

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

Recognition, Action, & Effect Lags of Fiscal Policy
Recognition Lag Action Lag Effect Lag

FISCAL POLICY – Pure and Simple
There are 3 things that could “diminish AD.” AD1 AD2 AS Fiscal Policy: No Complications P1 Price level $490 YR $510 Y* Real GDP (billions)

Three things that could “diminish AD.”
Crowding-out Effect Net Export Effect AD1 AD’2 AD2 AS Net Export Effect Expansionary fiscal policy leads to more government borrowing, increasing the interest rate, & decreasing Ig PL1 Crowding-out Effect Higher interest rates decrease investment] and the . . . $ $510 $503 Real GDP (billions)

3. Inflation would be a third factor
That could reduce aggregate demand AS AD2 AD1 Price level P1 $495 $505 $515 Real GDP (billions)

NS 18-21 T2 1 Answer the next 3 questions(18-21) based on the diagram.
18. Deficits will be realized at GDP levels (below/above) C, and surpluses (below/above) C. 19. If the F.E. GDP for the economy is at D, the F.E. budget will entail a (deficit/surplus). 20. If the tax line had a greater slope [more progressive tax system], stability would be (less/greater). 21. If government adhered strictly to an annually balanced budget then the government’s budget would tend to (destabilize/stabilize) the economy.

NS 22-30 For Questions 22-24 [graph]
22. (T1/T4) tax system is characterized by the least built-in stability. 23. (T1/T4) tax system is characterized by the most built-in stability. 24. (T1/T4) tax system will generate the largest cyclical deficits. 25. Nondiscretionary Fiscal Policy (does/does not) require congressional action. NS 22-30 26. If the MPC is .5, a $10 B increase in “G” will increase “C” [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] 27. If government tries to give back a surplus during an inflationary FE year, this will be (pro-cyclical/counter-cyclical). 28. When politicians use fiscal policy to cause an improvement in the economy just prior to an election, this is called a (presidential/Congressional/political) business cycle. 29. When G incurs a deficit which is financed by borrowing, causing interest rates to increase which decreases Ig, this is called the (crowding-in/crowding out) effect. 30. Supply-siders argue that the primary effect of tax cuts is to shift the AS curve (leftward/rightward).

NS 31-34 AE billion, and the level of investment is $10
31. If the MPC is .8, a $2 billion increase in “G” will increase “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] 32. If the MPC is .9, a $1 billion increase in “G” will increase “consumption” by ($10/$9/$8) billion. S C+Ig AE 33. In a private-closed economy, the MPS is .2, consumption equals income at $200 billion, and the level of investment is $10 billion. The equilibrium level of income at the new level is ($200/$250) billion. “C” +$10 Ig 200 ? S 34. If the MPS is .2 and the economy has a recessionary spending gap of $5 billion, we may conclude that the equilibrium level of GDP is ($5/$20/$25) below the FE GDP. AE2 AE AE1 +$5 YR ?

NS S 35. If the MPS is .5 and the economy has an inflationary spending gap of $6 billion, we may conclude that the equilibrium level of GDP is ($6/$12/$18) billion above the FE GDP. AE AE1 AE2 -$6 Y* YI 36. If the government decreases G&T by $10 billion, then a MPS of .10, the equilibrium GDP would (increase/decrease) by ($5/$10/$100) billion. 37. With a MPC of .75, Government increases G&T by $8 billion. The equilibrium GDP (increases/decreases) by ($75/$32/$8) billion. 38. If the government runs a budget surplus and desires to curb inflation, it should (give the surplus back/keep it in storage).

Fiscal Policy Test Review 1-4
1. Expansionary fiscal policy will be most effective [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. 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. An expansionary fiscal policy [incr G, decr T] would cause a[an] 4. In the AE model, if AE[AD]doesn’t buy up FE output(GDP), then the equilibrium output is (less than/more then) full employment output. [On #3, start from a balanced budget] [G ; LFM ; In. Rates ] G $2 Tr T $2 Tr. [G ; LFM ; In. Rates ] “Recessionary Gap” “Inflationary Gap”

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

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

Test Review 19-22 19. To increase equilibrium GDP by $400,000,
with a MPC of .5, a Keynesian economist would (decrease “T”/increase “G”) by $200,000. 20. Assume equilibrium GDP is $500 billion & MPS is .4. Now “G” collects taxes of of $22 billion and spends the entire amount. As a result, equilibrium GDP will change to: ($445/$478/$522/$555). 21. With a MPC of .5, a $12 billion increase in “G” will increase “C” by ($12/$24/$36) bil. 22. With a MPC of .5 and the economy in a recessionary spending gap of $12 billion, we may conclude that the equilibrium is ($12/$24/$36) billion short of FE GDP.

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

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

E-con The End

Review for AE & Fiscal Policy
“Econ, econ” Review for AE & Fiscal Policy

FISCAL POLICY [“G” and “T”]

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FISCAL POLICY [“G” and “T”]

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