Quiz 13: Fiscal Policy, Deficits, and Debt

Business

Assume that a hypothetical economy with an MPC of.8 is experiencing severe recession. By how much would government spending have to rise to shift the aggregate demand curve rightward by $25 billion? How large a tax cut would be needed to achieve the same increase in aggregate demand? Determine one possible combination of government spending increases and tax increases that would accomplish the same goal without changing the amount of outstanding debt.

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Essay

The government spending would be magnified by the multiplier effects. We first calculate multiplier by using MPC. Then we calculate government spending. By tax cut, consumption increases by From the steps above, to bring the same change in demand, the change in consumption equals to change in government spending. For the combination of spending raise and tax cut, let us suppose government spending raise by G, and tax was cut by T. The total effect should increase initial spending by $5 billion, and the multiplier effect would push the total demand by $25 billion. Any Government expenditure and Tax that meet the above equation can be a combination. For example, if tax cut is $5 billion, then government spending increase should be $1 billion. It showed as below:

Q 2

What is the role of the Council of Economic Advisers (CEA) as it relates to fiscal policy? Use an Internet search to find the names and university affiliations of the present members of the CEA.

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The Council of Economic Advisers (CEA) initiated advice of fiscal policy to the president to provide expertise and assistance on economic matters. The fiscal policy is discretionary (active). The present members of CEA are : 1. Alan B. Krueger, Princeton University, 2. Katharine Abraham, University of Maryland, 3. Carl Shapiro, University of California, Berkeley.

Q 3

Refer back to the table in FigurE₁2.7 in the previous chapter. Suppose that aggregate demand increases such that the amount of real output demanded rises by $7 billion at each price level. By what percent will the price level increase? Will this inflation be demand-pull inflation or will it be cost-push inflation? If potential real GDP (that is, full-employment GDP) is $510 billion, what will be the size of the positive GDP gap after the change in aggregate demand? If government wants to use fiscal policy to counter the resulting inflation without changing tax rates, would it increase government spending or decrease it?

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Real Gross Domestic Production ( GDP ) refers to the total value of all final goods and services produced given a period of time or in a year. Aggregate Demand refers to the total amount of goods and services demanded in the economy at a given general price level and given a period of time. Table of increases in Aggregate Demand: The new equilibrium price level iS₁08, where the new demand equals the supply. Before the change the equilibrium price level waS₁00. The price level increases by 8%. It showed as below: The inflation is caused by an increase in demand; thus, it is a Demand-pull Inflation. If the potential GDP IS $510 billion and the equilibrium GDP is $513 billion, there is an inflationary GDP gap of $3 billion. The government should implement contractionary fiscal policy to eliminate the inflation. It can reduce government spending.

Q 4

What are government's fiscal policy options for ending severe demand-pull inflation? Which of these fiscal options do you think might be favored by a person who wants to preserve the size of government? A person who thinks the public sector is too large? How does the "ratchet effect" affect anti-inflationary fiscal policy?

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Q 5

(For students who were assigned Chapter 28) Assume that, without taxes, the consumption schedule for an economy is as shown below: a. Graph this consumption schedule. What is the size of the MPC? b. Assume that a lump-sum (regressive) tax of $10 billion is imposed at all levels of GDP. Calculate the tax rate at each level of GDP. Graph the resulting consumption schedule and compare the MPC and the multiplier with those of the pretax consumption schedule. c. Now suppose a proportional tax with a 10 percent tax rate is imposed instead of the regressive tax. Calculate and graph the new consumption schedule and note the MPC (tax inclusive) and the multiplier. d. Finally, impose a progressive tax such that the tax rate is 0 percent when GDP is $100, 5 percent at $200, 10 percent at $300, 15 percent at $400, and so forth. Determine and graph the new consumption schedule, noting the effect of this tax system on the MPC (tax inclusive) and the multiplier. e. Use a graph similar to FigurE₃0.3 to show why proportional and progressive taxes contribute to greater economic stability, while a regressive tax does not.

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Q 6

(For students who were assigned Chapter 11) Use the aggregate expenditures model to show how government fiscal policy could eliminate either a recessionary expenditure gap or an inflationary expenditure gap (FigurE₁1.7). Explain how equal-size increases in G and T could eliminate a recessionary gap and how equal-size decreases in G and T could eliminate an inflationary gap.

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Q 7

Refer to the accompanying table for Waxwania: L02, a. What is the marginal tax rate in Waxwania? The average tax rate? Which of the following describes the tax system: proportional, progressive, regressive? b. Suppose Waxwania is producing $600 of real GDP, whereas the potential real GDP (or full-employment real GDP) is $700. How large is its budget deficit? Its cyclically-adjusted budget deficit? Its cyclically-adjusted budget deficit as a percentage of potential real GDP? Is Waxwania's fiscal policy expansionary or is contractionary?

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Q 8

Some politicians have suggested that the United States enact a constitutional amendment requiring that the Federal government balance its budget annually. Explain why such an amendment, if strictly enforced, would force the government to enact a contractionary fiscal policy whenever the economy experienced a severe recession.

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Q 9

Suppose that a country has no public debt in year 1 but experiences a budget deficit of $40 billion in year 1, a budget deficit of $20 billion in year 2, a budget surplus of $10 billion in year 3, and a budget deficit of $2 billion in year 4. What is the absolute size of its public debt in year 4? If its real GDP in year 4 is $104 billion, what is this country's public debt as a percentage of real GDP in year 4?

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Q 10

Briefly state and evaluate the problem of time lags in enacting and applying fiscal policy. Explain the idea of a political business cycle. How might expectations of a near-term policy reversal weaken fiscal policy based on changes in tax rates? What is the crowding-out effect, and why might it be relevant to fiscal policy? In view of your answers, explain the following statement: "Although fiscal policy clearly is useful in combating the extremes of severe recession and demand-pull inflation, it is impossible to use fiscal policy to fine-tune the economy to the full-employment, noninflationary level of real GDP and keep the economy there indefinitely."

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Q 11

Suppose that the investment demand curve in a certain economy is such that investment declines by $100 billion for every 1 percentage point increase in the real interest rate. Also, suppose that the investment demand curve shifts rightward by $150 billion at each real interest rate for every 1 percentage point increase in the expected rate of return from investment. If stimulus spending (an expansionary fiscal policy) by government increases the real interest rate by 2 percentage points, but also raises the expected rate of return on investment by 1 percentage point, how much investment, if any, will be crowded out?

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Q 12

Explain how built-in (or automatic) stabilizers work. What are the differences between proportional, progressive, and regressive tax systems as they relate to an economy's built-in stability?

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Q 13

Define the cyclically-adjusted budget, explain its significance, and state why it may differ from the actual budget. Suppose the full-employment, noninflationary level of real output is GDP3 (not GDP2) in the economy depicted in FigurE₃0.3. If the economy is operating at GDP2, instead of GDP3, what is the status of its cyclically-adjusted budget? The status of its current fiscal policy? What change in fiscal policy would you recommend? How would you accomplish that in terms of the G and T lines in the figure?

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Q 14

How do economists distinguish between the absolute and relative sizes of the public debt? Why is the distinction important? Distinguish between refinancing the debt and retiring the debt. How does an internally held public debt differ from an externally held public debt? Contrast the effects of retiring an internally held debt and retiring an externally held debt.

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Q 15

Why might economists be quite concerned if the annual interest payments on the U.S. public debt sharply increased as a percentage of GDP?

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Q 16

Trace the cause-and-effect chain through which financing and refinancing of the public debt might affect real interest rates, private investment, the stock of capital, and economic growth. How might investment in public capital and complementarities between public capital and private capital alter the outcome of the cause-effect chain?

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Q 17

LAST WORD What do economists mean when they say Social Security and Medicare are "pay-as-you-go" plans? What are the Social Security and Medicare trust funds, and how long will they have money left in them? What is the key long-run problem of both Social Security and Medicare? Do you favor increasing taxes or do you prefer reducing benefits to fix the problem?

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Quiz 13: Fiscal Policy, Deficits, and Debt

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