Chapter 13: Fiscal Policy, Deficits, and Debts

Recognition Lag

the time between the beginning of the recession or inflation and the certain awareness that it is actually happening.

Administrative Lag

the time between the need for fiscal action is recognized and the time action is taken.

Contractionary Fiscal Policy

When demand-pull inflation occurs, a contractionary fiscal policy will decrease aggregate demand and lower inflation by reducing government spending and/or increase taxes.

As a percentage of GDP, the total U.S. public debt is the highest such debt among the world's advanced industrial nations:

False

The total public debt is more relevant to an economy than the public debt as a percentage of GDP:

False

The portion of the U.S. debt held by the public (and not by government entities) was larger as a percentage of GDP in 2015 than it was in 2000:

True

Spending Multiplier

1/(1-MPC)

What type of tax system would have the most built-in stability?

A progressive tax because it increases at an increasing rate as incomes rise, thus having more of a dampening effect on rising (or falling) incomes.

A sudden recession is recognized by politicians, but it takes many months of political deal making before a stimulus bill is finally approved.

Administrative lag

Crowding-Out Effect

An expansionary fiscal policy (deficit spending) may increase the interest rate and reduce investment spending, thereby weakening or cancelling the stimulus of the expansionary policy.

Fiscal Policy

Consists of deliberate changes in government spending and tax collections designed to achieve full employment, control inflation, and encourage economic growth.

Budget Deficit

If the federal budget is balanced at the outset, expansionary fiscal policy will create a government budget deficit in which government spending is in excess of tax revenues.

What are the two ways to measure the public debt?

Its absolute dollar size and its relative size as a percentage of GDP.

Assume that a hypothetical economy with an MPC of 0.8 is experiencing severe recession. By how much would government spending have to rise to shift the aggregate demand curve rightward by $25 billion?

MPC = 0.8 means the spending multiplier is 1/(1-mpc) = 1/ (1- 0.8) = 1/ 0.2 = 5 and the tax cut multiplier is mpc/ (1-mpc) = 0.8/ (1-0.8)= .8/.2= 4. So to get an increase in aggregate demand of $25 billion, increase in govt spending required is $ (25/5) = $5 billion. If the tax cut route is followed, to increase aggregate demand by $25 billion, a tax cut of $ (25/ 4)= $6.25 billion will be required. The difference is because in the first round itself a govt spending increase of $5 billion leads to an increase in aggregate demand by the Govt. by $5billion, where as when the tax cut of $ 5 billions given, the taxpayers do not increase their aggregate demand by $6.25 billion, but only by $5 billion as they save (1-0.8)*6.25 = $1.25 billion of the tax relief of $6.25 billion.

Tax Cut Multiplier

MPC/(1-MPC)

Expansionary Fiscal Policy

May be in order during a recession because it increases government spending and/or decreases taxes in order to increase aggregate demand and therefore raise real GDP.

To fight a recession, Congress has passed a bill to increase infrastructure spending—but the legally required environmental-impact statement for each new project will take at least two years to complete before any building can begin.

Operational lag

To fight a recession, the president orders federal agencies to get rid of petty regulations that burden private businesses—but the federal agencies begin by spending a year developing a set of regulations on how to remove petty regulations.

Operational lag

Distracted by a war that is going badly, inflation reaches 8 percent before politicians take notice.

Recognition lag

Progressive Tax System

The average tax rate (=TR/GDP) rises with GDP

In January, the interest rate is 5 percent and firms borrow $50 billion per month for investment projects. In February, the federal government doubles its monthly borrowing from $25 billion to $50 billion. That drives the interest rate up to 7 percent. As a result, firms cut back their borrowing to only $30 billion per month. Which of the following is true?

There is a crowding-out effect of $20 billion.

An internally held public debt is like a debt of the left hand owed to the right hand:

True

For a person who thinks the public sector is too large, the fiscal options for ending severe demand-pull inflation would include

a cut in government spending.

The economy is in a recession. A congresswoman suggests increasing spending to stimulate aggregate demand but also at the same time raising taxes to pay for the increased spending. Her suggestion to combine higher government expenditures with higher taxes is:

a mediocre and contradictory combination of tax and expenditure changes.

The Council of Economic Advisers (CEA) advises the president on

economic matters and provides recommendations for discretionary fiscal policy action.

For a person who wants to preserve the size of government, the fiscal options for ending severe demand-pull inflation would include

an increase in taxes.

Built-In Stabilizers

anything that increases the government's budget deficit (or reduces its budget surplus) during a recession and it increases its budget surplus (or reduces its budget deficit) during an expansion without requiring explicit action by policy makers.

An internally held debt is one in which the

bondholders live in the nation having the debt.

Expectations of a near-term policy reversal weaken fiscal policy because

consumers may hesitate to increase their spending because they believe that tax rates will rise again.

The problem of time lags in enacting and applying fiscal policy is that

in the time it takes to identify the situation, enact a policy, and allow it to work, economic circumstances may have changed.

Paying off an externally held debt

may lower the dollar exchange rate.

The "ratchet effect" makes anti-inflationary policy

more difficult.

Paying off an internally held debt would

not burden the economy as a whole.

A political business cycle is the concept that

politicians are more interested in re-election than in stabilizing the economy.

Operational Lag

the time between fiscal action is taken and the time that action affects output, employment, or the price level.

The government's fiscal policy options for ending severe demand-pull inflation include

reducing government spending, increasing taxes, or both.

Refinancing the public debt means

selling new bonds to retire maturing bonds.

Political Business Cycles

swings in overall economic activity and real GDP resulting from election motivated fiscal policy.

Built-in (or automatic) stabilizers work by changing

taxes and government payouts so that changes in GDP are reduced.

The distinction between the absolute and relative sizes of the public debt is important because

the absolute size doesn't tell you about an economy's capacity to repay the debt.

Regressive Tax System

the average tax rate falls as GDP rises.

Proportional Tax System

the average tax rate remains constant as GDP rises

If the annual interest payments on the debt sharply increased as a percentage of GDP,

the government would have to use tax revenues or go deeper into debt.

Consider 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."

the impact of fiscal policy will affect the economy differently depending on the timing of the policy and the severity of the situation

The crowding-out effect is

the reduction in investment spending caused by the increase in interest rates arising from an increase in government spending.