Econ 144 - Test #5 - From Book

Is government debt a problem? (issue of defaulting ; size of debt relative to size of the economy ; Long run implications)

-The government isn't at risk of defaulting on its debt because it can raise the funds it needs through taxes to make the interest payments. -If the debt becomes too large compared to the size of the economy, however, the government might have to sharply increase taxes or cut back on other types of spending. -In the long run, a debt that increases size relative to GDP (like what happened in '08) can be a problem.(crowding out of investment spending might occur if an increasing debt drives up interest rates)

If tax reduction and simplification are effective, what will the economy experience?

1)Increases in: labor supply, saving, & investment 2)the formation of new firms 3)greater economic efficiency ~Together these factors will result in an increase in the quantity of real GDP supplied at every price level

What is the Phillips curve?

A curve showing the short-run relationship between the unemployment rate and the inflation rate.

What is "crowding out"?

A decline in private expenditures as a result of an increase in government purchases

How does a temporary increase in government purchases effect the money market? How does this relate to crowding out?

As the government spends the certain specified amount during, lets say the course of a year, income and real GDP will increase. As real GDP and income rise, the demand for money increases, causing the downward sloping "money demand" line to shift to the right, intersecting at a higher point now on the vertical money supply line, which causes the equilibrium interest rate to rise. Higher interest rates will result in a decline in each component of private expenditures.

Why do economists refer to the initial increase in government purchases as autonomous?

Because it is a result of a decision by the government and is not directly caused by changes in the level of real GDP.

Why do some economists argue that the federal government should normally run a deficit, even at potential GDP?

Because when the federal budget is in deficit, the U.S. Treasury sells bonds to investors to raise the funds necessary to pay the government's bills. (borrowing to pay the bills is not good if the bills are for current expenses, but it is not a bad policy if the bills are for long-lived capital goods)

How does cutting individual income taxes and cutting taxes on business income affect AD respectively?

Cutting the individual income tax will increase household disposable income and consumption spending, thereby increasing AD. Cutting taxes on business income can increase AD by increasing business investment.

_____ government purchases or ______ taxes can slow the growth of aggregate demand and reduce the inflation rate.

Decreasing ; raising

When does a budget deficit result?

If the government's expenditures are greater than its tax revenue.

If the long-run Phillips curve is a vertical line, what does this mean in terms of the trade-off?

If the long-run Phillips curve is a vertical line, no trade-off exists between unemployment and inflation in the long-run

What is the long-run effect of a permanent increase in government spending?

In this case, most economists agree that the result is complete crowding out.

In addition to purchases, what are the three other categories of federal government expenditure?

Interest on the national debt (this represents payments to the holders of the bonds the federal government has issued to borrow money), grants to state and local governments, and transfer payments

Does government spending reduce private spending?

It can. Sometimes, the size of the multiplier effect may be limited if the increase in government purchases causes one of the nongovernment, or private components of aggregate expenditures (C, I, or NX) to fall. A decline in private expenditures as a result of an increase in government purchases is called "crowding out"

How did the recession of 2007-2009 and it's slow recovery affect federal government expenditures?

It caused them to rise to their highest levels since WWII

Over time, what happens to potential real GDP? How do we show this on a graph?

It increases ; We show the long-run aggregate supply curve shifting to the right

Is the tax multiplier positive or negative? Why?

It is negative because changes in taxes and changes in real GDP move in opposite directions

What are the supply-side effects of a tax change?

LRAS shifts to the right and so output and employment are increased, and at the same time, the price level is reduced.

Should the federal budget always be balanced?

Many economists believe that it is a good idea for the federal government to have a balanced budget when the economy is at potential GDP, however few economists believe that the federal government should attempt to balance its budget every year. (to balance the budget every year, the government might have to take actions that would destabilize the economy)

Does increasing or decreasing the money supply have a direct effect on government spending or taxes? Does increasing or decreasing government spending or taxes have a direct effect on the money supply?

No & No.

Are all of the decisions the federal government makes in regards to changing taxes and spending considered fiscal policy actions?

No because not all of these actions are intended to achieve macroeconomic policy goals or to affect the national economy.

During a typical recession, does most of the increase in the federal budget deficit take place by Congress and the president taking action?

No, most of the increase in the federal budget deficit occurs due to the effects of automatic stabilizers.

Was the short run trade off between unemployment and inflation always recognized by the Fed?

No. Although today the short run trade off between unemployment and inflation plays a role in the Fed's monetary policy decisions, this trade-off was not widely recognized until the late 1950's when New Zealand economist A. W. Phillips came out with the Phillips Curve.

Does an expansionary fiscal policy have to cause complete crowding out in the short run?

No. If the economy is below potential real GDP, it is possible for both government purchases and private expenditures to increase. But, in the long run, any permanent increase in government purchases must come at the expense of private expenditures.

Will the fraction of the tax cut that households save or spend on imports increase aggregate demand? How does this effect the first period of the multiplier process.

No. Therefore, the first period of the multiplier process will see a smaller increase in government purchases, and the total increase in equilibrium real GDP will be smaller.

Why are structural relationships useful in formulating economic policy?

Policy makers can anticipate that these relationships are constant

What is the "cyclically adjusted budget deficit or surplus"?

The deficit or surplus in the federal government's budget if the economy were at potential GDP.

What does the "cyclically adjusted budget deficit or surplus" provide a more accurate measure of?

The effects on the economy of the government's spending and tax policies than can the actual budget deficit or surplus.

What is the purpose of expansionary fiscal policy?

The purpose of e.f.p. is to increase aggregate demand either by having the government directly increase its own purchases or by cutting taxes to increase household disposable income and, therefore, consumption spending.

What is the purpose of expansionary monetary policy?

The purpose of e.m.p. is to lower interest rates, which in turn increases aggregate demand. When interest rates fall, households and firms are more willing to borrow more money to buy cars, houses, and factories.

What is the multiplier effect?

The series of induced increases in consumption that results from an initial increase in autonomous expenditures.

What is the "natural rate of unemployment"?

The unemployment rate that exists when the economy is at potential GDP. (actual unemployment will fluctuate in the short run, but will always come back to the natural rate in the long run, and so will the actual level of real GDP)

Did Obama's stimulus package impact real GDP and employment like the economists working for the administration had predicted?

They predicted that the increase in AD resulting from the package would increase real GDP by 3.5 percent and increase employment by 3.5 million. Actually, real GDP ended up increasing by 4.4 percent and employment declined by 3.3 million.

What is contractionary fiscal policy?

This involves decreasing government purchases or increasing taxes.

How are federal government purchases different from federal government expenditures?

When the federal government makes a purchase, it receives a good or service in return. Federal government expenditures include government purchases plus all other federal government spending.

When does a budget surplus occur?

When the government's expenditures are less than its tax revenues.

Do deficits occur automatically during recessions? If so, why?

Yes, for two reasons: 1) During a recession, wages and profits fall, causing government tax revenues to fall. 2) The government automatically increases its spending on transfer payments when the economy moves into a recession.

Do fiscal and monetary policy have the same goals? Do they have the same effects on the economy?

Yes. No.

During most years, the AD curve also shifts to the right, indicating that ...

aggregate expenditure is higher at every price level

Government spending and taxes which automatically increase and decrease along with the business cycle are referred to as _______ _______.

automatic stabilizers ("automatic" meaning that changes in these types of spending and taxes happen without actions by the government)

Every time the federal government runs a budget deficit, the Treasury must _____ _____ _____ ____ by _____ ______ ______.

borrow funds from investors ; selling "bonds" i.e. Treasury securities (for simplicity, we will refer to all Treasury securities as "bonds")

If the federal government were to run a contractionary fiscal policy, the result would be a cyclically adjusted _______ _______.

budget surplus

Most fiscal policy actions that attempt to increase aggregate supply do so by ...

changing taxes to increase the incentives to work, save, invest, and start a business.

Supply-side economics --> -Cutting taxes on any activity will increase the level of that activity. a) Cutting taxes on ______ will increase _____ (tax free weekends) b) Cutting taxes on _______ will increase ______ c) Cutting taxes on ______ will increase the amount of ______ ______... which increases output (GDP)

consumption ; consumption ; investment ; investment ; income ; labor supplied

Congress and the president can use ______ fiscal policy in a time of ______ _______ and decrease ______ _____ or increase ______ in order to cause _____ _____ and the _____ _____ to _____.

contractionary ; rising inflation ; government spending ; taxes ; real GDP ; price level ; fall (or more correctly, causes these to RISE LESS than they would without the policy)

If an increasing debt drives up interest rates, _____ ______ might occur, which will lower _______ spending which means a lower _____ _____ in the long run and a reduced capacity of the economy to produce goods and services.

crowding out ; investment ; capital stock

Since budget deficits automatically increase during recessions and decrease during expansions, economists often look at the ______ _____ _____ _____ ___ ______, which can provide a more accurate measure of the effects on the economy of the government's spending and tax policies than can the actual budget deficit or surplus.

cyclically adjusted budget deficit or surplus

Economists who are skeptical of the magnitude of supply-side effects believe tax cuts have their greatest effect on aggregate ______ rather than aggregate ______.

demand ; supply

With _____ _____ _____, the government takes actions to change spending or taxes.

discretionary fiscal policy

A cut in tax RATES affects equilibrium real GDP through two channels: 1) A cut in tax rates increases the _____ _____ of households, which leads them to increase their ______ ______ 2) a cut in tax rates increases the size of the ______ ______

disposable income ; consumption spending ; multiplier effect

With the corporate income tax remaining in place, one way to reduce the "_____ _____" problem is to reduce the taxes on _______ and _______ _______.

double taxation ; dividends and capital gains.

Congress and the president can use ______ fiscal policy in a time of ______ and increase ______ _____ or decrease ______ in order to cause _____ _____ and the _____ _____ to _____.

expansionary ; recession ; government spending ; taxes ; real GDP ; price level ; rise (or more correctly, causes these to FALL LESS than they would without the policy)

Crowding out may reduce the effectiveness of an ______ _______ policy.

expansionary fiscal

The federal government's budget shows the relationship between its _______ and its _______ ______.

expenditures ; tax revenues

The total value of U.S. Treasury bonds outstanding is referred to as the _____ _____ _____ or the _____ _____.

federal government debt ; national debt

The factors that cause LRAS to the shift to the right also cause ... How do we show this on the graph?

firms to supply more goods and services at any given level in the short run. We show this by the short-run aggregate supply (SRAS) curve shifting to the right.

Getting the timing right with _____ policy can be more difficult than with ______ policy. What are the 2 main reasons for this?

fiscal ; monetary ; Getting timing right is more difficult with fiscal policy because of the fact that control over monetary policy is in the hands of the FOMC which can change the monetary policy at any of its 8 meetings, whereas if the President and congress want to change fiscal policy, there are often large legislative delays. Secondly, even after a change in fiscal policy has been approved, it takes time to implement.

Congress and the president can attempt to stabilize the economy by using _____ policy to affect the _____ level and the level of _____ _____.

fiscal ; price ; real GDP

Changes in federal taxes and spending that are intended to achieve macroeconomic policy objectives are called ______ ______.

fiscal policy

About two-thirds of the stimulus package took the form of increases in ____ ____ and one-third took the form of ____ ____

government expenditures ; tax cuts

Fiscal policy is changes in _____ _____ and _____. These lead to changes in _____ ______ which can affect the level of real GDP, employment, and the price level.

government purchases ; taxes ; aggregate demand

The ratio of change in equilibrium real GDP to the initial change in gov purchases is known as the ______ ______ _______.

government purchases multiplier

The inflation rate may _____ when real GDP is beyond potential GDP.

increase

When the economy is in a recession, ______ in government purchases, or _______ in taxes will increase aggregate demand.

increases ; decreases

Policy makers use contractionary fiscal policy to reduce ...

increases in aggregate demand that seem likely to lead to inflation.

What does expansionary fiscal policy involve?

increasing government purchases or decreasing taxes

How can discretionary fiscal policy can increase the federal budget deficit during recessions by ...

increasing spending or cutting taxes to increase aggregate demand (AD)

If crowding out occurs, and investment spending drops, causing lower capital stock in the long run and a reduced capacity of the economy to produce goods and services, this effect is somewhat offset if some of the government debt was incurred to finance improvements in _________ ; _________ ; or ___ & ____.

infrastructure (bridges, highways, and ports) ; education ; research and development (financing these things can add to the productive capacity of the economy)

The greater the sensitivity of consumption, investment, and net exports to changes in _____ _____, the more crowding out will occur.

interest rates

Phillips documented that there is usually an _____ ______ between unemployment and inflation.

inverse relationship

What will an increase in government purchases do to aggregate demand and why?

it will increase aggregate demand directly because government purchases are a part of aggregate demand

The actual change in real GDP resulting from an increase in government purchases or a cut in taxes will be ____ than indicated by the ______ _____ _____with a constant _____ ______.

less ; simple multiplier effect ; price level

Lowering the tax rates on dividends and capital gains increases the supply of ______ ______ from households to firms, increasing _____ and ______ and lowering the ______ ______ interest rate.

loanable funds ; saving and investment ; equilibrium real

The tax wedge applies to the ______ tax rate, which is the ..

marginal ; fraction of each additional dollar of income that must be paid in taxes.

Cutting the ______ ______ ______ ______ rate would encourage _______ spending by increasing the return corporations receive from new investments in equipment, factories, and office buildings.

marginal corporate income tax ; investment (could increase the pace of technological change)

The FOMC meets eight times a year to decide whether to change ______ policy.

monetary

An important consideration for the Federal Reserve as it carries out _____ policy is that in the short run, there can be a trade off between ______ and _______.

monetary ; unemployment ; inflation

The Federal Reserve carries out monetary policy through changes in the _____ _____ and ______ _____.

money supply ; interest rates

Decreasing government purchases or increasing taxes can keep real GDP from ...

moving beyond its potential level.

The uncertainty about the size of the ______ indicates the difficulty that economists have in arriving at a firm estimate of the effects of fiscal policy.

multiplier

A successful policy of tax reductions and simplifications will benefit the economy by increasing _____ & ______ and, at the same time, may result in smaller increases in the _____ _____.

output ; employment ; price level

Most economists agree that in the short run, an increase in government spending results in ...

partial, but not complete, crowding out.

When the federal government runs a budget surplus, the Treasury _____ _____ some existing _____.

pays off ; bonds

Because many economists and policymakers in the 1960s viewed the Phillips curve as a structural relationship, they believed it represented a ...

permanent trade-off between unemployment and inflation.

Friedman concluded that the long-run aggregate supply curve is a vertical line at the ____ _____ ____, and the long-run Phillips curve is a vertical line at the ____ _____ ___ ______.

potential real GDP ; natural rate of unemployment

In the long run, a higher or lower price level has no effect on real GDP because ...

real GDP is always at its potential in the long run.

A tax ______ is likely to increase consumption spending less than would a permanent tax _____.

rebate ; cut

There is a _____ _____ ______-_____ between unemployment and inflation

short run trade-off

In addition to the potential gains from cutting individual taxes, there are also gains from tax _______.

simplification

In general, economists believe that the ______ the tax wedge for any economic activity, the more of that economic activity will occur.

smaller

Before the Great Depression of the 1930s, where did the majority of government spending take place? During the Great Depression, what happened to the size of the federal government? Since WWII, the federal gov's share of total gov expenditures has been between __-__ and __-__

state and local levels ; it grew ; two-thirds ; three-quarters

During the 1960's some economists argued that the Phillips curve represented a _____ _____ in the economy which is a relationship that depends on the basic behavior of consumers and firms and that remains unchanged for long periods.

structural relationship

Some fiscal policy actions are intended to have long-run effects by expanding the productive capacity of the economy and increasing the rate of economic growth. These policy actions primarily affect AS rather than AD, and are sometimes referred to as _____-_____ ______.

supply-side economics

The difference between the pretax and the posttax return to an economic activity is known as the ____ _____.

tax wedge

Reducing marginal tax rates on individual income will reduce the _____ _____ faced by workers, thereby increasing the amount of _______ _______.

tax wedge ; labor supplied

Congress and the president make changes in ______ and ______ _______ to achieve things like high employment, price stability, and high rates of economic growth.

taxes ; government purchases

In the long run, a higher or lower inflation rate will have no effect on the unemployment rate because ...

the unemployment rate is always equal to the natural rate in the long run.

The largest and fastest growing category of federal expenditures is _____ _____.

transfer payments (such as Social Security, unemployment insurance, and medicare)

Slow growth in aggregate demand leads to both higher ______ and lower ______. What does this relationship explain?

unemployment ; inflation ; This relationship explains why there is a short-run trade-off between unemployment and inflation.

Over time, economists came to agree that the long-run aggregate supply curve was ______. If this observation was true, then the Phillips curve could not be...

vertical ; downward sloping in the long run