AP Macro Test (chapter 31 and 36)

Discuss the problems that governments may encounter in enacting and applying fiscal policy

*Problems of timing* -recognition lag -administrative lag -operational lag *Political considerations* -political business cycles *Future policy reversals* - *Offsetting state and local finance* - *Crowding-out effect* indicates that an expansionary fiscal policy may increase the interest rate and reduce investment spending which may weaken or cancel the stimulus of expansionary fiscal policy

Discuss the size, composition, and consequences of the U.S. public debt

*Public debt* is the accumulation of all federal deficits and surpluses. -the federal government is in no danger of going bankrupt because it needs only to refinance (not retire) the public debt and it can raise revenues, if needed, through higher taxes The borrowing and interest payments associated with the public debt may: -increase income inequality -require higher taxes, which may dampen incentives -impede the growth of the nation's stock of capital through crowding out of private investment

Explain the role of built-in stabilizers in moderating business cycles

*Built-in stabilizer* is anything that increases the government's budget deficit (or reduces the budget surplus) during a recession and increases its budget surplus (or reduces its budget deficit) during an expansion without explicit action by policymakers. -Congress establishes tax rates, and the tax revenues then vary directly with the level of GDP that the economy achieves. -taxes reduce spending and AD, reductions in spending are desirable when the economy is moving toward inflation, whereas increases in spending are desirable when the economy is slumping *Progressive tax system* : the average tax rate (tax rev/GDP) rises with GDP *Proportional tax system* the average tax rate remains constant as GDP rises *Regressive tax system* the average tax rate falls as GDP rises The more progressive the tax system, the greater the economy's built-in stability. Transfer payments behave in the opposite way from tax revenues. Unemployment compensation payments and welfare payments decreases economic expansion and increase during economic contraction.

Identify and explain the purposes, tools, and limitations of fiscal policy

*Discretionary fiscal policy* is the purposeful change of government expenditures and tax collections by government to promote full employment, price stability, and economic growth, and to stabilize the economy. *Expansionary fiscal policy* may be in order when recession occurs. -gov spending increases (AD shifts to right, multiplier effect 1/MPS), tax reductions, or both -to increase AD and therefore raise rGDP Can create a budget deficit : government spending more than tax revenues *Contractionary fiscal policy* helps control demand-pull inflation -gov spending reductions, tax increases, or both -to decrease AD and therefore lower or eliminate inflation -without a government response, the inflationary GDP gap will cause further inflation (as input prices rise in the long run to meet the increase in output prices) Budget surplus : tax revenues in excess of government spending -To be implemented properly, contractionary fiscal policy must properly account for the ratchet effect and the fact that the price level will not fall as the government shifts the AD curve leftward.

Explain the short-run trade-off between inflation and unemployment (the Phillips Curve)

-Under normal circumstances, there is a short-run trade-off between the rate of inflation and the rate of unemployment. -Aggregate supply shocks can cause both higher rates of inflation and unemployment -There is no significant trade-off between inflation and unemployment over long periods of time *The Phillips Curve* suggests an inverse relationship between the rate of inflation and the rate of unemployment. When the actual rate of inflation is higher than expected, profits temporarily rise and the unemployment rate temporarily falls.

Discuss why there is no long-run trade-off between inflation and unemployment

As implied by the up-sloping short-run AS curve, there may be a short-run trade-off between the rate of inflation and the rate of unemployment. This is reflected in the Phillips Curve (a downward sloping curve in the short run) showing that lower rates of inflation are associated with higher rates of unemployment. -In the short-run, changes in AD are movements along a Phillips curve; AS shocks that produce severe cost-push inflation can cause stagflation (simultaneous increases in the inflation rate and the unemployment rate.) -AS Shocks can cause higher rates of inflation and unemployment by pushing AS to the left, and creating a new Phillips Curve to the left There is no long-run trade-off between inflation and unemployment. -After all nominal wage adjustments play out, the economy ends up back at its full employment level of output and its natural rate of unemployment. -The long-run Phillips Curve is vertical at the natural rate of unemployment. *Disinflation* is reductions in the inflation rate from year to year. When the actual rate of inflation is lower than the expected rate, profits temporarily fall and the unemployment rate temporarily rises.

Explain the relationship between short run aggregate supply and long run aggregate supply

Difference has to do with flexibility of input prices -input prices are inflexible or totally fixed in short run -input prices fully flexible in long run -output prices fully flexible in both *SRAS* assumes initial price is p1 (Yf), firms and workers have established nominal wages , and price level is flexible up and down.

Describe how the cyclically adjusted budget reveals the status of U.S. fiscal policy

Economists use the *cyclically adjusted budget* to adjust actual federal budget deficits and surpluses to account for the changes in tax revenues that happen automatically whenever GDP changes. The cyclically adjusted budget eliminates cyclical effects on net tax revenues and compares actual levels of net taxes that would occur if the economy were achieving its full-employment output

Explain how to apply the "extended" (short-run/long-run) AD-AS model to inflation, recessions, and economic growth

In the *short run*, demand-pull inflation raises both the price level and real output In the *long run*, nominal wages rise, the short-run aggregate supply curve shifts to the left, and only the price level increases Cost-push inflation creates a policy dilemma for the government -if it engages in expansionary policy to increase output, additional inflation will occur -if it does nothing, the recession will linger until input prices have fallen by enough to return the economy to producing at potential output The economy has mild, ongoing inflation, because the Fed uses expansionary monetary policy to shift the AD curve to the right slightly faster than the supply factors of economic growth shift the long-run AS curve to the right.

Explain the relationship between tax rates, tax revenues, and aggregate supply

Supply-side economics focuses on marginal tax rates- the rates on extra dollars of income- because those rates affect the benefits from working, saving, or investing more. -lower marginal tax rates encourage saving and investing. workers therefore find themselves equipped with more and technologically superior machinery and equipment -labor productivity rises which expands LRAS and economic growth, which in turn keeps unemployment rates and inflation low *The Laffer Curve* depicts the relationship between tax rates and tax revenues and suggests that, under some circumstances, cuts in tax rates will expand the tax base (output and income) and increase tax revenues.