chapter 9 fiscal policy review

What is the maximum change in equilibrium real GDP that could occur as result of a one time $50 billion tax cut if the MPC is .75

$150 billion increase -50 (tax cut) x tax multiplier (-mpc/1-mpc) = 150

in the simple keynesian model with government spending and lump-sum taxes, the tax multiplier is equal to

-MPC/MPS

Federal budget deficits/surpluses

-if G>T, government has a budget deficit equal to the difference between government spending and tax revenues -if G<T, government has a budget surplus equal to the difference between tax revenues and government spending

balanced budget

-if government spending is equal to tax revenues (G=T), government has a balanced budget This implies that if the federal government were

supply-side economics emphasizes:

-low marginal tax rates -increasing incentives to work, save, and invest -long-run effects on aggregate supply rather than short-run effects on aggregate demand

Supply-side fiscal policy: changes in marginal tax rates

-supply-side policies are designed to stimulate output or aggregate supply. -One such policy is a decrease in marginal tax rates: the rate applied to additional personal and business income -marginal tax = the change in income tax payments divided by the change in income • During 1970s, stagflation (relatively high rates of unemployment together with significant inflation), and the failure of demand-side policies, led to the development of supply-side economics • Supply-side policies aim to increase incentives for households and businesses to work, save, and invest in order to increase aggregate supply. Example: decrease in marginal tax rate (Income tax) • However, tax revenues might also fall due to lowering tax rate

assume the government cuts taxes by $125 billion. if the mpc = 0.8, what is the maximum potential impact on real gdp according to the simple keynesian model?

5 x -125 government spending multiplier x tax cut real gdp decreases by 625 billion

When the marginal propensity to consume is .80, the spending multiplier is _________, the tax multiplier is _________, and the balances budget multiplier is _________

5, -4, 1

In the simple Keynesian model, when the MPC is 0.8, the autonomous spending multiplier is _________ and the tax multiplier is _________. 5; 4

5; -4

autonomous expenditures (spending) multiplier

=1/(1-MPC)=1/MPS

If equilibrium real GDP is equal to $5,000 billion and the natural real GDP is equal to $5,450 billion and the MPC is .90, which of the following could move the economy to equilibrium at natural real GDP?

A $45 billion increase in govt spending A $50 billion decrease in taxes A $450 billion increase in govt spending financed by a $450 billion increase in taxes

one which average tax rate decreases as income increases.

A regressive tax rate

An example of automatic fiscal policy is

An increase in the number of people receiving unemployment benefits during an economic downturn

a balanced budget amendment to the US constitution would require that

Federal spending be financed by tax revenue

Which of the following is an example of automatic, expansionary fiscal policy?

Higher unemployment compensation payments that occur when the economy is in a recession

If equilibrium real GDP falls short of full-employment (natural) real GDP by $60 million when the MPC = 0.75, which of the following would eliminate the recessionary gap that exists according to the Keynesian model?

Increase G by $15 million Decrease T by $20 million Increase both G and T by $60 million

The relationship between tax rates and tax revenues is shown by the

Laffer curve

if equilibrium real gdp falls short of full-employment (natural) real gdp by 60 million when the mpc =0.75. which of the following would eliminate the recessionary gap that exists according to the keynesian model?

MPS = 0.25 X 60 = increase G by 15 MILLION

changes in AD via government spending &/or tax changes

The demand-side fiscal policies tend to increase or decrease the level of aggregate demand (AD) in the economy and will shift the AD curve. For example, the fiscal policy of changing the government expenditure will increase the AD and, therefore, is demand-side fiscal policy. (e) An increase in unemployment compensation The recipients will spend unemployment compensation, and thus, the aggregate demand will rise. So, it is demand-side policy.

Fiscal Policy: discretionary automatic fiscal policy (stabilizers)

Who decides the Fiscal Policy? The President and Congress make basic fiscal policy decisions during the budgetary process. The fiscal policy can changes either, or both: 1. The Government Expenditure (G) 2. The net taxes, T (total tax revenue minus transfer payments made by the Government) • Built-in, or automatic stabilizers (non-discretionary fiscal policy): they change automatically, as economic conditions change, and they counteract the business cycle. - Example: During recession, unemployment benefit rises, or during boom, tax revenues rises due to higher income (which lowers the inflationary gap) • Discretionary fiscal policy: changes in government spending and taxation designed to achieve specific macroeconomic goals. - Example: Building new roads and infrastructure The discretionary part needs to be changed annually, the built-in part automatically adjusts

when government spending exceeds tax revenue in a given year

a budget deficit exists and the national debt increases

When tax receipts are greater than government expenditures during a single year, the result is

a budget surplus.

Demand-side fiscal policy

a keynesian, demand-side approach dominated policy decision into the 1970s. However, a period of stagflation - relatively high rates of unemployment accompanied by significant inflation - and the failure of demand-side policies to stabilize the economy led to the development of supply-side economics.

changes in government spending and taxing that counteract the business cycle and occur as a result of changing economic conditions are

automatic (built-in) stabilizers

the increase in personal income tax payments that occurs when an economic expansion causes incomes to rise is an example of

automatic, contractionary fiscal policy

in the simple keynesian model, when the mpc is 0.8 the autonomous spending multiplier is and tax multiplier is -4

autonomous spending =1/(1-MPC) 5 -4

when tax receipts are less than government expenditures during a single year, the result is

budget deficit. It means that expenditure is more than revenue .

when tax receipts are greater than government expenditures during a single year, the result is

budget surplus. It means that revenue are more than expenditure of country.As taxes are collected more as compare to government expenditure.

fiscal policy is best defined as

changes in government spending and taxing for the purpose of achieving certain macroeconomic goals.

AD might shift to the right to AD1 to close the recessionary gap if

congress uses expansionary discretionary fiscal policy

suppose the economy is initially at full-employment equilibrium. Which of the following events could cause a recessionary gap?

consumers spend less due to declining consumer confidence in the economy

decreases in government spending and higher taxes represent

contractionary fiscal policy

Interest on the National Debt

creates income for bondholders, but liabilities for taxpayers

reductions in private consumption spending and/or investment spending that occur as a result of increased government taxing, spending, and borrowing is referred to as

crowding out

cyclical versus structural deficit

cyclical deficit :congress passes a balanced budget, downturns in economic activity can trigger automatic increases in government spending and decreases in tax revenue if congress approves a budget for which spending is greater than projected tax revenue, then there is already a structural deficit

Which of the following is an example of supply side fiscal policy

decrease in marginal tax rates designed to increase incentives to work and produce

when government expenditures exceeds net taxes, a budget

deficit

if government spending increases from $500 billion to $550 billion then equilibrium income

difference in government spending x spending multiplier (1/1-MPS) = 500 + equilibrium income = 15,500 increase by $500 billion to $15,500 billion

the use of government spending and taxing by congress in order to influence conditions in the macroeconomy is called

discretionary fiscal policy

suppose congress believes that the economy is entering a recession and approves a budget that includes increased overall government spending with no corresponding increase in taxes in order to stimulate aggregate demand. This is an example of

discretionary, expansionary fiscal policy

Suppose Congress believes that the economy is entering a recession and approves a budget that includes increased overall government spending (with no corresponding increase in taxes) in order to stimulate aggregate demand. This is an example of

discretionary, expansionary fiscal policy.

increases in government spending and lower taxes represent

expansionary fiscal policy

changes in government spending or taxing policy for the purpose of influencing macroeconomic outcome is

fiscal policy and is conducted by Congress

changes in government spending or taxing policy for the purpose of influencing macroeconomic outcomes refers to

fiscal policy which is conducted congress

as of november 2018, the accumulated national debt in the US

had passed the 21.5 trillion mark

which of the following is an example of automatic, expansionary fiscal policy?

higher unemployment compensation payments that occur when the economy is in a recession

If a constitutional amendment was passed requiring a balanced budget for the federal government, then:

if the government starts with a balanced budget, any increase in government spending would have to be financed by an equal increase in taxes

if a constitutional amendment was passed requiring a balanced budget for the federal government, then

if the government starts with a balanced budget, any increase in government spending would have to be financed by an equal increase in taxes

Keynesian economics suggests that the most effective way to eliminate a recessionary gap is for government to

increase its spending in order to increase aggregate demand

expansionary fiscal policy may not be an effective tool for increasing aggregate demand if

increases in government spending crowd out private sector (investment) activity

the laffer curve suggest that

increasing marginal tax rates may actually reduce tax revenues

The Laffer curve suggests that:

increasing marginal tax rates may actually reduce tax revenues.

according to keynes recessions are a result of

insufficient aggregate demand

The total stock of outstanding government securities (bonds) is the:

national debt. It means that central government comprising more external debt as compare to internal.

the largest source of revenue for the federal government in the US is the

personal income tax is the main source of revenue for the us government.

The largest source of revenue for the federal government in the U.S. is the

personal income tax.

the data reflect a

progressive tax rate. As income increases tax rate also increases.

from a keynesian perspective, the appropriate fiscal policy to deal with this

recessionary gap is to increase government spending and or reduce taxes

From a Keynesian perspective, the appropriate fiscal policy to deal with this:

recessionary gap is to increase government spending and/or reduce taxes.

As income increases, tax liability as a percentage of income

rises

marginal propensity to consume = 0.75

spending multiplier= 1/MPS tax = -MPC/MPS balanced budget =1

If government spending financed by borrowing causes crowding out, then

the economy will likely grow at a slower rate due to less capital accumulation

if government spending financed by borrowing causes crowding out then

the economy will likely grow at a slower rate due to less capital accumulation

in an economy that has automatic (built-in) stabilizers:

the severity of recessions tend to be reduced

equilibrium is at income real gdp equal to

y= 600 + 0.9 (y-t) + g + i Yd= y-t solve for y = equilibrium at income

Laffer Curve

• According to Arthur Laffer: At the beginning tax revenue increases with increase in tax rate, but after a certain point, it sharply declines

balanced budget multiplier

• If the budget is balanced, then G and T both increases by the same amount • The Balanced budget multiplier = (1/mps) + (-mpc/mps) = 1-MPC/MPS = MPS/MPS = 1

Closing Gaps: The Keynesian Approach

• The Government Spending Multiplier: 1/MPS (same formula as the autonomous spending multiplier, or the Keynesian multiplier) Example: if MPC = 0.75, and G increases by $100, then income(Y) will change by = (1/0.25)X 100 = $400 If I increases by $100, then for the same MPC, Y will increase by (1/0.25)X 100 = $400

Tax Multiplier

• The Tax multiplier: (-MPC/MPS) Note: There is a negative sign here. Example: if T reduces by $100, then for the above example, Y increases by (-0.75/0.25)X(-100) = $300 calculate changes in real GDP that result from tax changes Important Observation: the effect of an increase in G is larger than that of a decrease in an equivalent amount of T

expansionary v. contractionary

• When the economy is experiencing a Recessionary Gap: Use Expansionary fiscal policy through increasing G, or reducing T, or a combination of both. • When the economy is experiencing an Inflationary Gap: Use Contractionary fiscal policy, through decreasing G, or increasing T, or a combination of both. Fiscal Policy can be directed towards private expenditures (C+I), or public expenditure (G).