Quiz 28: Managing Aggregate Demand: Fiscal Policy

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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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Essay

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.

Q 2

Consider an economy in which tax collections are always $400 and in which the four components of aggregate demand are as follows: 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. Figure - 1 The above figure explains that the consumption expenditure and GDP obtain equilibrium at 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: ……(1) The following table presents marginal propensity to consume using the formula in Equation (1). Table - 3 Fifth column of Table (1) shows the marginal propensity to consume is $0.75. The consumption multiplier can be calculated using the following formula: ……(2) Using Equation (2), calculate the multiplier: 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 .

Q 3

Explain why G has the same multiplier as I , but taxes have a different multiplier.

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Investment multiplier Investment multiplier refers to the change in the income level due to the change in the level of investment. Government expenditure multiplier Government expenditure multiplier refers to the change in the income level due to change in the level of government expenditure. Tax multiplier Tax multiplier refers to the change in the income level due to change in the level of tax. Reasons for government expenditure multiplier being same as investment multiplier The government expenditure is equal to the investment. When government purchases goods and services from the private, then the investment of the private firms would increase. Since the government expenditure directly affects the investment, the government expenditure has the same multiplier as caused by the investment. Reasons for tax expenditure multiplier being different from expenditure multiplier The expenditure multiplier directly increases the income through increasing the level of investment, whereas the tax multiplier affects the income level through consumption, which alters the investment. The level of consumption depends on the marginal propensity to consume. This change in the tax does not affect the marginal propensity to consume. Hence, the tax multiplier is not same as government multiplier.

Q 4

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: 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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Q 5

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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Q 6

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: 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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Q 7

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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Q 8

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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Q 9

(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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Q 10

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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Q 11

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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Q 12

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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Q 13

Discuss the pros and cons of having a higher or lower multiplier.

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Q 14

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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Q 15

( 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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Q 16

Consider an economy described by the following set of equations: 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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Q 17

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: 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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Q 18

You are given the following information about an economy: 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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Q 19

(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: 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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Quiz 28: Managing Aggregate Demand: Fiscal Policy

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