Ag Econ Exam 3 - Ch.12

(12.7) Identify the benefits and costs of government debt.

A deficit allows the government to spend more than its revenue. Allowing the government to run a deficit permits the government to respond to unexpected events and to undertake expansionary fiscal policy. However, there are also costs of running deficits. Interest needs to be paid on the debt, the government may not spend the money efficiently, and high government deficits may affect interest rates and reduce investment in the economy.

(12.6) Explain the difference between the government deficit and debt.

Deficits occur when annual spending is more than annual revenue. A surplus occurs when annual spending is less than annual revenue. The public debt is the total amount of money that the government has borrowed over time. The debt and the deficit are closely related: The budget deficit tells us how much the government borrows each year, and the debt tells us the total that the government has borrowed and not paid back over time. In other words, the debt is the cumulative sum of all deficits and surpluses.

(12.5) Describe how revenue and spending determine a government budget.

The government budget includes all of the revenue it collects in taxes and all of the money it spends on government programs. When the government spends more than it collects in revenue, it runs a deficit. When it collects more revenue than it spends, it has a surplus. In most years, the government spends more than it collects in revenue. In the effort to fight the latest recession, the gap between spending and revenue has increased to about 10 percent of GDP, making for a large budget deficit.

(12.2) Explain how fiscal policy can counteract short-run economic fluctuations.

The government can use fiscal policy to counteract business-cycle fluctuations. When the economy is sluggish, the government can conduct expansionary fiscal policy to stimulate demand. This will lead to a faster recovery than without the fiscal policy. On the other hand, if the economy is overheating, the government can undertake contractionary fiscal policy to reduce aggregate demand. This action also returns the economy closer to the long-run equilibrium level.

(12.3) Discuss the main fiscal policy challenges faced by the government and how stabilizers can automatically adjust fiscal policy as the economy changes.

The government faces two primary potential challenges when implementing fiscal policy: time lags and Ricardian equivalence. Time lags come in many forms. There are information lags (how long it takes to get the right information about the overall health of the economy), formulation lags (getting everyone to agree on the right policy), and implementation lags (how long it takes fiscal policy to have an effect on the economy). To get around these lags, some aspects of fiscal policy automatically stimulate or slow the economy. For example, income tax revenues will decrease when the economy is weaker, and increase as the economy is booming. The second potential challenge is known as Ricardian equivalence. This theory predicts that if governments cut taxes but not public spending, people will continue to save rather than spend, consumption will not increase, and the tax cut will be unsuccessful in changing aggregate demand. The government will have to borrow money to cover the financial shortfall that's been created, and at some point in the future, taxes will have to go back up to repay the extra government debt incurred through tax cuts.

(12.4) Calculate the fiscal multiplier for spending and taxation, and explain why it differs for these two policies.

The government-spending multiplier measures how much output increases when government spending increases by $1. The government-taxation multiplier measures how much output increases when taxation falls by $1. The multiplier effect from both spending and taxation occurs because there is a feedback effect between income and consumption: Higher income (whether from increased government spending or lower taxes) increases consumption, which increases income, again increasing consumption, resulting in a feedback loop. The government-spending multiplier is larger than the taxation multiplier because government spending directly affects income, whereas taxation does so indirectly, through consumption.

(12.1) Explain the difference between contractionary fiscal policy and expansionary fiscal policy.

Together, the level of taxation and government spending is called fiscal policy. We say that fiscal policy is either expansionary or contractionary. Expansionary fiscal policy involves changes to fiscal policy that cause the aggregate demand curve to increase (shift out to the right). It is expansionary because it expands demand. Expansionary fiscal policy occurs either because government spending increases or the level of taxation decreases and is a response to recessionary conditions. On the other hand, contractionary fiscal policy involves changes to fiscal policy that contract aggregate demand, causing the aggregate demand curve to decrease (shift in to the left). Contractionary fiscal policy occurs when government spending decreases or when taxation increases, and is a response to an overheating economy with the accompanying threat of excessive inflation.

contractionary fiscal policy

fiscal policy that decreases aggregate demand

expansionary fiscal policy

fiscal policy that increases aggregate demand

fiscal policy

government decisions about the level of taxation and government spending

transfer payments

payments from government accounts to individuals for programs, like Social Security, that do not involve a purchase of goods or services

automatic stabilizers

taxes and government spending that affect fiscal policy without specific action form policy-makers

taxation multiplier

the amount GDP decreases when government taxes increase by $1

government-spending multiplier

the amount by which GDP increases when government spending increases by $1

budget deficit

the amount of money a government spends beyond the revenue it brings in

budget surplus

the amount of revenue a government brings in beyond what it spends

marginal propensity to consume (MPC)

the amount that consumption increases when after-tax income increases by $1

multiplier effect

the increase in consumer spending that occurs when spending by one person causes others to spend more too, increasing the impact of the initial spending on the economy

public debt

the total amount of money that a government owes at a point in time