# Macroeconomics Study Set 63

## Quiz 13 :Fiscal Policy, Deficits, and Debt

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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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The Cyclically Adjusted Budget is to adjust actual Federal budget deficit and surplus to account for the changes in tax revenues that happen automatically whenever GDP changes.
The Cyclical Adjusted Budget measures what the budget deficit and surplus would have been under existing tax rates and government spending levels if the economy has achieved its full-employment level of GDP.
The Cyclical Adjusted Budget is different from the actual budget because it removes budget deficits or surpluses that arise simply because of cyclical changes in GDP.
Here, G refers to the Government Expenditure and T refers to Taxes.
The Cyclical Adjusted Budget deficit is zero. The economy's full employment is GDP3 , where the government spending equals to tax revenue. When the economy operates at GDP2 , which is smaller than GDP3 , tax revenue falls short of government spending automatically and actual budget deficit is positive, however, this deficit happens because of the cyclical change of GDP , rather than fiscal policy. Thus, the cyclical adjusted budget is zero, the same with that when the economy is operating at full-employment level.
Since the economy is suffering a recession, government should cut tax. This is reflected by a downward shift of the tax line from T to T'. The cyclical adjusted budget has a positive deficit, because there is a tax cut. It showed as below:
Diagram of Government Tax Cut:

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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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The Fiscal Policy refers to the economy is influenced by the policies of government tax collection and expenditure.
Time lag is the time between the recessions or inflation happens and the time of awareness of such a thing is actually happening. It takes months of economic slowdown for a confidence conclusion to arrive that a recession is at place. Thus, by the time the government announcement of the recession/inflation the economy has already been in it for a while.
A Political Business Cycle is the swing of the economy caused by politically motivated fiscal policy, not caused by the intrinsic problems of the economy itself. Politicians tend to overheat the economy in order to be reelected.
If there is an expectation of a near-term reversal of a tax cut, people will save more to meet the expected future tax raise, reducing the strength of the current tax cut.
Similarly, if there an expectation of a near-term reversal of tax raise, people will spend more than the policy intended, because they expect the current tax raise will be reversed and there will soon be a tax cut.
The Crowding-Out Effect is the reduction of private investment caused by an increase of government spending, which increases money demand and drives up interest rate.
The crowding-out effect is related to fiscal policy because when government spending increases, it is possible to reduce private investment, leaving total expenditure unchanged or even decreased, a result not intended by the expansionary fiscal policy.
Fiscal policy is useful to combat recession and inflation, but it has some criticisms such as time lag, political business cycle, policy reversal, and crowding-out effect. The initial intend may be dampened and the strength of fiscal policy may be reduced because of these problems. Thus, it is hard for fiscal policy to fine tune the economy.

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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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Refinancing the public debt would increase the money demand from government. With money supply constant the increased demand would drive up annual interest payment.
Investment is a negative function of interest rate; the increased interest rate would crowd out private investment.
Capital Stock is the accumulation of investment. The decreased private investment would decrease capital stock. If the increase in public spending leads to an increase in public investment, total capital stock may stay constant or increased.
Economic Growth is a function of capital stock. Other things equal, a decrease in capital stock leaves less resource for future economic growth. Economic growth would slow down. In summary, refinancing the public debt would slow down economic growth.
Investment in public capital may offset the crowding-out effect of private investment, and keep capital stock increased or unchanged.
Complimentary Public Investment may encourage more private investment and offset the crowding-out effects.

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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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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? Essay Answer: Tags Choose question tag Why might economists be quite concerned if the annual interest payments on the U.S. public debt sharply increased as a percentage of GDP? Essay Answer: Tags Choose question tag 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. Essay Answer: Tags Choose question tag 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? Essay Answer: Tags Choose question tag (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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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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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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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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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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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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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. Essay Answer: Tags Choose question tag 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?