Economics Study Set 17

Business

Quiz 28 :

Managing Aggregate Demand: Fiscal Policy

Quiz 28 :

Managing Aggregate Demand: Fiscal Policy

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(More difficult) Advocates of lower taxes on capital gains argue that this type of tax cut will raise aggregate supply by spurring business investment. Compare the effects on investment, aggregate supply, and tax revenues of three different ways to cut the capital gains tax: a. Reduce capital gains taxes on all investments, including those that were made before tax rates were cut. B) Reduce capital gains taxes only on investments made after tax rates are cut. C) Reduce capital gains taxes only on certain types of investments, such as corporate stocks and bonds. Which of the three options seems most desirable to you Why
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A. Reduction in capital gain tax on all investments
When there is a reduction in the capital gain tax on both old and new investments, it increases the profit. This encourages investors to invest more, which in turn increases new investments. Here, when the new investment increases, it increases the production; consequently, it increases the aggregate supply.
Since increase in output will generate more income, tax revenue will increase.
b. Reduction in capital gain tax on new investment
When there is a reduction in capital gain tax on new investments, this encourages investors to invest more, which in turn increases the new investments.
Here, when the new investment increases, it increases the production; consequently, it increases the aggregate supply.
Since increase in output will generate more income, tax revenue will increase.
c. Reduction in capital gain tax on certain investments
When there is a reduction in capital gain tax on certain investments such as corporate stocks and bonds, it increases the new investment only in particular sectors.
Here, only some particular sectors are concentrated with new investments; perhaps, the investment diverts from other sectors to this particular sector to enjoy the privilege of tax cut.
As a result, the aggregate supply will reduce since the investment flows only to particular sectors and others are neglected. The reduction in output will generate less tax revenue to the government.
Desirable option is (b)
Option (c) will divert the investment and in turn supply will fall. Option (a) will make government more expensive by offering tax cut to both old and new investments. On the other hand, offering tax cut on new investment will increase the aggregate supply with less government expenditure. Hence, option (b) seems good.

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The federal budget for national defense increased substantially to pay for the Iraq and Afghanistan wars. How would GDP in the United States have been affected if this higher defense spending led to a. larger budget deficits b. less spending elsewhere in the budget, so that total government purchases remained the same
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Budget deficit
Budget deficit refers to the higher government expenditure than the government revenue.
Gross domestic product (GDP)
GDP refers to the total value of goods and services produced in the country during a period of time.
a. Impact of larger budget deficit on the GDP
The higher defense spending causes higher budget deficit. When the United States spends higher amount for the defense, it leads to an increase of investment on army goods and services in the United States. This increase in investment leads to an increase in output and employment, which in turn increases the GDP.
b. Impact of unchanged government expenditure on the GDP
When the total government purchases remain unchanged, the government investment remains unchanged. Since the government investment remains the same, there is no change in employment and output. Hence, there would be no change in GDP.

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Consider an economy in which tax collections are always $400 and in which the four components of aggregate demand are as follows: img Find the equilibrium of this economy graphically. What is the marginal propensity to consume What is the multiplier What would happen to equilibrium GDP if government purchases were reduced by $60 and the price level remained unchanged
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In Table (2), the GDP of an economy equals to consumption expenditure when both are at $1,720; hence, the equilibrium level of GDP is $1,720.
Graphical presentation of equilibrium level of GDP
In Figure (1), GDP is measured on horizontal axis and consumption expenditure is measured on vertical axis.
img Figure - 1
The above figure explains that the consumption expenditure and GDP obtain equilibrium at
img when both values are at $1,720 and intersects the 45-degree line.
The marginal propensity to consume (MPC) explains the increase in personal consumption per increase in additional amount of disposable income.
The marginal propensity to consume can be calculated using the following formula:
img ……(1)
The following table presents marginal propensity to consume using the formula in Equation (1).
Table - 3
img Fifth column of Table (1) shows the marginal propensity to consume is $0.75.
The consumption multiplier can be calculated using the following formula:
img ……(2)
Using Equation (2), calculate the multiplier:
img The result reveals that if 75 percent of the income is consumed, then its multiplier effect on income will be 4 percent.
Since the multiplier effect of consumption is 4, the reduction in government purchases by $60 will reduce the consumption expenditure by $240
img .

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Consider an economy described by the following set of equations: img Find the equilibrium level of GDP. Next, find the multipliers for government purchases and for fixed taxes. If full employment comes at Y = 1,800, what are some policies that would move GDP to that level
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Which of the proposed supply-side tax cuts appeals to you most Draw up a list of arguments for and against enacting such a cut right now.
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( More difficult ) Suppose real GDP is $10,000 billion and the basic expenditure multiplier is two. If two tax changes are made at the same time: a. fixed taxes are raised by $100 billion, b. the income-tax rate is reduced from 20 percent to 18 percent, will equilibrium GDP on the demand side rise or fall
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(More difficult) In the economy considered in Test Yourself Question 3, suppose the government, seeing that it has not wiped out the deficit, keeps cutting G until it succeeds in balancing the budget. What level of GDP will then prevail Reference Test Yourself Question 3, You are given the following information about an economy: img a. Find equilibrium GDP and the budget deficit. b. Suppose the government, unhappy with the budget deficit, decides to cut government spending by precisely the amount of the deficit you just found. What actually happens to GDP and the budget deficit, and why
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This question is a variant of the previous problem that approaches things in the way that a fiscal policy planner might. In an economy whose consumption function and tax function are as given in Test Yourself Question 1, with investment fixed at 320 and net exports fixed at -80, find the value of G that would make GDP equal to 1,800 Reference Test Yourself Question 1, Consider an economy described by the following set of equations: img Find the equilibrium level of GDP. Next, find the multipliers for government purchases and for fixed taxes. If full employment comes at Y = 1,800, what are some policies that would move GDP to that level
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Return to the hypothetical economy in Test Yourself Question 1, and now suppose that both taxes and government purchases are increased by $120. Find the new equilibrium under the assumption that consumer spending continues to be exactly three-quarters of disposable income (as it is in Test Yourself Question 1). Reference Test Yourself Question 1 Consider an economy in which tax collections are always $400 and in which the four components of aggregate demand are as follows: img Find the equilibrium of this economy graphically. What is the marginal propensity to consume What is the multiplier What would happen to equilibrium GDP if government purchases were reduced by $60 and the price level remained unchanged
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Consider an economy similar to that in the preceding question in which investment is also $200, government purchases are also $500, net exports are also $30, and the price level is also fixed. But taxes now vary with income, and as a result, the consumption schedule looks like the following: img Find the equilibrium graphically. What is the marginal propensity to consume What is the tax rate Use your diagram to show the effect of a decrease of $60 in government purchases. What is the multiplier Compare this answer to your answer to Test Yourself Question 1. What do you conclude
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You are given the following information about an economy: img a. Find equilibrium GDP and the budget deficit. b. Suppose the government, unhappy with the budget deficit, decides to cut government spending by precisely the amount of the deficit you just found. What actually happens to GDP and the budget deficit, and why
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When the income-tax rate declines, as it did in the United States in the early 2000s, does the multiplier go up or down Explain why.
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Now put yourself in charge of the economy in Test Yourself Question 2, and suppose that full employment comes at a GDP of $1,840. How can you push income up to that level
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Which of the following is considered a fixed tax and which a variable tax a. The gasoline tax b. The corporate income tax c. The estate tax d. The payroll tax
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Suppose you are put in charge of fiscal policy for the economy described in Test Yourself Question 1. There is an inflationary gap, and you want to reduce income by $120. What specific actions can you take to achieve this goal
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Explain why G has the same multiplier as I , but taxes have a different multiplier.
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Discuss the pros and cons of having a higher or lower multiplier.
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In a certain economy, the multiplier for government purchases is 2 and the multiplier for changes in fixed taxes is 1.5. The government then proposes to raise both spending and taxes by $100 billion. What should happen to equilibrium GDP on the demand side
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If the government decides that aggregate demand is excessive and is causing inflation, what options are open to it What if the government decides that aggregate demand is too weak instead
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