Chapter 16 Homework

Assuming a fixed amount of taxes and a closed economy and that the marginal propensity to consume equals 0.80​, calculate the value of the following multipliers. Be sure to use a negative sign​ (-) to show if a multiplier has a negative value. The government purchases multiplier equals _____ The tax multiplier equals _____ The balanced budget multiplier equals _____

5 1/(1-MPC) ; -4 -MPC/(1-MPC) ; 1 the value of the balanced budget multiplier is always 1, meaning that if government purchases and taxes both change by the same amount (and in the same direction) then equilibrium GDP will change in exactly the same way

crowding out

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

aggregate demand and aggregate supply model

An extension of the basic​ AD-AS model that introduces the following​ conditions: 1. The economy experiences continuing​ inflation, with the price level rising every year. 2. The economy experiences​ long-run economic​ growth, with the LRAS curve shifting to the right every year.

​Similarly, explain why a decrease in the marginal propensity to import would increase the size of the government purchases multiplier. The value of the government purchases multiplier would decrease because in the formula for the multiplier the denominator is A. 1​ + ​[MPC×​(1 −​t) − ​MPI] B. 1 − ​[MPC×​(1 −​t) − ​MPI] C. 1 − ​[MPC×​(1 −​t) ​+ MPI] D. 1​ + ​[MPC×​(1 −​t) ​+ MPI]

B. 1 − ​[MPC×​(1 −​t) − ​MPI]

corporate income tax

Cutting the corporate income tax can increase the return to investment and innovation and can increase the pace of technological change.

individual income tax

Cutting the individual income tax reduces the tax wedge and increases the quantity of labor supplied. In​ addition, it increases the returns to saving and the return to entrepreneurship.

capital gains and dividends taxes

Lowering taxes on capital gains and dividends paid to stockholders increases the supply of loanable funds and increases saving and investment. It also lowers the equilibrium real interest rate.

current income

Reflects​ consumers' current disposable income.

permanent income

Reflects​ consumers' expected future income.

tax wedge

The difference between the pretax and the posttax return to an economic activity.

budget deficit

The situation in which the​ government's expenditures are greater than its tax revenue.

budget surplus

The situation in which the​ government's expenditures are less than its tax revenue.

liquidity constrained

The spending of this type of consumer is more likely to depend on their current income.

If actual real GDP in 2006 occurs at point B and potential GDP occurs at LRAS06​, we would expect the federal government to pursue​ a(n) ______ fiscal policy part 2: If the​ government's policy is​ successful, what is the effect of the policy on the following macroeconomic​ indicators? actual real GDP: ____ potential real GDP:______ Price level:_____ unemployment: ______

contractionary In reaction to an economy that is producing beyond its​ capacity, the federal government conducts contractionary fiscal policy. Contractionary fiscal​ policy: 1. Increasing taxes on individuals and businesses 2. Decreasing government spending on goods and services As a​ result, spending by firms and households falls and the aggregate demand curve decreases​ (shifts left). The government pursues this type of policy to achieve price stability. In this​ example, the economy is initially at equilibrium at point A in the 2005. ​ However, by​ 2006, spending is increasing faster than the economy​ (AD shifts by more than LRAS in​ 2006), and inflation results. Actual real GDP​ (given by point​ B) is greater than potential GDP​ (given by LRAS06​). After the appropriate policy is​ enacted, AD06 shifts to AD06 (policy)​, price level falls and actual real GDP​ falls, ceteris paribus. In​ reality, price increases by less than it would have without the policy. part two: decreases; does not change; decreases; increases Contractionary fiscal​ policy: 1. Increasing taxes on businesses and individuals 2. Decreasing government spending on goods and services Price​ level: After the government​ acts, AD06 shifts to AD06 (policy)​, price level falls from point​ "C" to point​ "B". Actual real​ GDP: As a result of the federal​ government's actions, actual real GDP falls from point​ "C" to point​ "B", ceteris paribus. Potential​ GDP: is given by LRAS06. LRAS does not change as a result of the policy. ​Rather, it shifted due to economic growth which is due​ to: 1. Changes in labor 2. Changes in capital 3. Changes in technology. ​Unemployment: As actual real GDP​ falls, unemployment rises.

contractionary fiscal policy

involves decreasing government purchases or increasing taxes. Decreasing government purchases decreases aggregate demand directly because government purchases are a component of aggregate demand. Increasing taxes decreases disposable income​ which, in​ turn, decreases consumption by households and firms.

What is the difference between federal government purchases​ (spending) and federal government​ expenditures? A. Government purchases are included in government expenditures. B. Government expenditures are included in government purchases. C. Government purchases refer to spending for which no good or service is received. D. They are the same.

A. Government purchases are included in government expenditures. Government expenditures and government spending are not the same thing. In​ fact, government purchases of goods and services are included under the larger category of government expenditures. Government spending on a highway or an aircraft carrier is a transaction for which a good or service is ultimately received. In this​ case, the government receives the highway or the aircraft carrier. ​However, the government also spends money for which a good or service is not received. For​ example, the government pays interest on loans and issues grants to state and local governments. The largest category of government expenditure is transfer payments. Included in this category are payments such as unemployment benefits and disability insurance. It is an​ important, and​ large, category of government​ expenditure, but not one for which a good or service is received.

From an understanding of the multiplier​ process, explain why an increase in the tax rate would decrease the size of the government purchases multiplier. The value of the government purchases multiplier would decrease because in the formula for the multiplier A. the MPC is multiplied by​ (1 − ​t). B. the MPC is multiplied by t. C. the MPC is multiplied by −t. D. the MPC is multiplied by​ (t −​1).

A. the MPC is multiplied by​ (1 − ​t).

After September​ 11, 2001, the federal government increased military spending on wars in Iraq and Afghanistan. Is this increase in spending considered fiscal​ policy? A. Yes. Fiscal policy refers to changes in government spending and taxes. B. Yes. Increases in defense spending are designed to achieve macroeconomic policy objectives. C. No. The increase in defense spending after that date was designed to achieve homeland security objectives. D. No. Fiscal policy refers to changes in interest rates and the money supply.

C. No. The increase in defense spending after that date was designed to achieve homeland security objectives. Fiscal Policy Changes in federal taxes and purchases that are intended to achieve macroeconomic policy​ objectives, such as high​ employment, price​ stability, and high rates of economic growth. Subsidies paid to people who buy hybrid cars are considered environmental​ policy, and the increase in military spending after September​ 11, 2001 is considered part of defense and homeland security​ policy, which have different objectives than fiscal policy.

fiscal policy

Changes in federal taxes and purchases that are intended to achieve macroeconomic policy​ objectives, such as high​ employment, price​ stability, and high rates of economic growth.

Does government spending ever reduce private​ spending? A. ​No, due to crowding out. B. ​No, they are unrelated. C. ​Yes, due to reduced interest rates. D. ​Yes, due to crowding out.

D. ​Yes, due to crowding out. Crowding out A decline in private expenditures as a result of an increase in government purchases. If the federal government increases​ spending, the demand for money increases from MD1 to MD2 as real GDP and income rise. With the supply of money constant at​ $950 billion, the result is an increase in interest rates from​ 3% to​ 5%. This​ reduces, or​ "crowds out," some of the additional​ consumption, investment, and net exports that the increase in government spending was designed to increase.

expansionary fiscal policy

involves increasing government purchases or decreasing taxes. Increasing government purchases increases aggregate demand directly because government purchases are a component of aggregate demand. Decreasing taxes increases disposable income​ which, in​ turn, increases consumption by households and firms.

Using the line drawing​ tool, show on the graph to the right the change in the aggregate demand curve that would result from a​ $5 billion increase in government purchases if the government purchases multiplier equals 2. Label this line ​'ADmult ​= 2​ '. Now on the same​ graph, show the change in the aggregate demand​ curve, using the line drawing​ tool, that would result from the same increase in government purchases if the government purchases multiplier equals 4. Label this line ​'ADmult ​= 4​ '.

AD will increase by 10 million (5x2) AD will increase by 20 million (4x5)

What are the gains to be had from simplifying the tax​ code? A. Increased efficiency of households and firms. B. Resources from the tax preparation industry freed up for other endeavors. C. Greater clarity of the decisions made by households and firms. D. All of the above.

D. All of the above. In addition to the potential gains from cutting individual​ taxes, there are also gains from tax simplification. If the tax code were​ simplified, the economic resources currently used by the tax preparation industry would be available to produce other goods and services. A simplified tax code would increase economic efficiency by reducing the number of decisions households and firms make solely to reduce their tax payments.

If the marginal propensity to consume equals 0.90​, the tax rate equals 0.25​, and the marginal propensity to import equals 0.10​, what is the value of the government purchases​ multiplier? The government purchases multiplier is equal to

2.35

Suppose the economy is in equilibrium in the first period at point​ (A). In the second​ period, the economy reaches point​ (B). What policy would the federal government likely pursue in order to move AD2 to AD2, policy and reach equilibrium​ (point C) in the second​ period? A. Increase government spending B. Open market purchase of government securities C. Increase taxes D. All of the above

A. Increase government spending In the dynamic​ AD-AS model we​ assume: 1. The economy experiences inflation​ and, 2. the economy experiences long run growth. That​ is, the LRAS curve shifts to the right each year. In​ addition, the AD and the SRAS curves also shift to the right each year. ​However, sometimes the AD curve does not shift by enough to keep the economy in​ long-run macroeconomic equilibrium. In this example the AD1 shifted to AD2 in the second period. This was not enough to maintain​ long-run equilibrium and the economy is in recession.​ Specifically, in the second​ period, the actual real GDP​ (point B) is less than the potential GDP​ (given by LRAS2​). This economic condition is often met with an expansionary fiscal policy which​ includes: 1. Decreases in taxes on businesses and individuals 2. Increases in government spending . When the federal government enacts the appropriate fiscal​ policy, the AD curve shifts to the right and moves the economy in to​ long-run macroeconomic equilibrium in the second period​ (point C).

​One-time tax​ rebates, such as those in 2001 and​ 2008, increase consumption spending by less than a permanent tax cut because​ one-time tax rebates increase A. current income. B. taxable income. C. permanent income. D. the multiplier effect.

A. current income. Permanent​ income: Reflects​ consumers' expected future income. Current​ income: Reflects​ consumers' current disposable income. Liquidity​ constrained: The spending of this type of consumer is more likely to depend on their current income. Many economists believe that consumers base their spending on their permanent income​, rather than their current income. ​One-time tax​ rebates, such as those in 2001 and​ 2008, increase​ consumers' current​ income, but not their permanent income. Only a permanent decrease in taxes increase a​ consumer's permanent income.​ Therefore, a tax rebate is likely to increase consumption spending by less than would a permanent tax cut and is likely to have its greatest effect on consumers who are liquidity constrained.

As a result of crowding out in the short​ run, the effect on real GDP of an increase in government spending is often A. less than the increase in government spending. B. equal to the increase in government spending. C. unrelated to the increase in government spending. D. more than the increase in government spending.

A. less than the increase in government spending. The economy begins in a recession with real GDP of 12.2 trillion​ (point A). In the absence of crowding​ out, expansionary fiscal policy shifts aggregate demand from AD1 to AD2 and brings the economy to equilibrium at a level of potential GDP of​ $12.4 trillion​ (point B). ​But, the higher interest rate that results from the increased government purchases reduces​ consumption, investment, and net​ exports, causing aggregate demand to shift to AD2, crowding out. The result is a new​ short-run equilibrium at point​ C, with real GDP of​ $12.3 trillion, which is​ $100 billion short of potential GDP.

Consider the figures below. Determine which combination of fiscal policies shifted AD1 to AD2 in each figure and returned the economy to​ long-run macroeconomic equilibrium. A. Example​ (A): Expansionary fiscal policy. Example​ (B): Expansionary fiscal policy. B. Example​ (A): Expansionary fiscal policy. Example​ (B): Contractionary fiscal policy. C. Example​ (A): Contractionary fiscal policy. Example​ (B): Expansionary fiscal policy. D. Example​ (A): Contractionary fiscal policy. Example​ (B): Contractionary fiscal policy.

B. Example​ (A): Expansionary fiscal policy. Example​ (B): Contractionary fiscal policy. Expansionary fiscal policy involves increasing government purchases or decreasing taxes. Increasing government purchases increases aggregate demand directly because government purchases are a component of aggregate demand. Decreasing taxes increases disposable income​ which, in​ turn, increases consumption by households and firms. Contractionary fiscal policy involves decreasing government purchases or increasing taxes. Decreasing government purchases decreases aggregate demand directly because government purchases are a component of aggregate demand. Increasing taxes decreases disposable income​ which, in​ turn, decreases consumption by households and firms. In example​ (A), the economy begins in a recession at point A. Expansionary fiscal policy increases aggregate demand and shifts AD1 to AD2. As a​ result, the price level and real GDP increase from P1 and y1 to P2 and​ y2, respectively. In example​ (B), the economy begins in an expansion at point A. Contractionary fiscal policy decreases aggregate demand and shifts AD1 to AD2. As a​ result, the price level and real GDP decrease from P1 and y1 to P2 and​ y2, respectively.

When is it considered​ "good policy" for the government to run a budget​ deficit? A. When borrowing is used for current expenses. B. When borrowing is used to pay for social insurance programs. C. When borrowing is used for​ long-lived capital goods. D. All of the above.

C. When borrowing is used for​ long-lived capital goods. Budget deficit The situation in which the​ government's expenditures are greater than its tax revenue. Budget surplus The situation in which the​ government's expenditures are less than its tax revenue. Some economists argue that the government should always run a deficit. When the government runs a deficit it must sell U.S. Treasury bonds in order to pay its bills. Borrowing to pay bills is bad policy unless it is for​ long-lived capital goods. For​ example, it is considered good policy to borrow money to buy a​ house, but it is not good policy to borrow money to pay the electric bill each month.​ Similarly, when the government borrows to buy a new​ highway, it is borrowing to buy a​ long-lived capital good.

Policy that is specifically designed to affect aggregate supply and increase incentives to​ work, save, and start a​ business, by reducing the tax wedge is called A. ​tax-and-spend economics. B. ​demand-side economics. C. ​supply-side economics. D. labor economics.

C. ​supply-side economics. Tax wedge The difference between the pretax and posttax return to an economic activity. For​ example, if you earn​ $20 per hour and your marginal tax rate is​ 25%, then the​ after-tax wage is​ $15 per hour and the tax wedge equals​ $5. Economists argue that the smaller the tax wedge for any​ activity, the more of that activity that will occur. Policy that is aimed largely at increasing aggregate supply by increasing incentives to​ work, save, and start a business is referred to as ​supply-side economics. Individual income tax. Cutting the individual income tax reduces the tax wedge and increases the quantity of labor supplied. In​ addition, it increases the returns to saving and the return to entrepreneurship. Corporate income tax. Cutting the corporate income tax can increase the return to investment and innovation and can increase the pace of technological change. Capital gains and dividends taxes. Lowering taxes on capital gains and dividends paid to stockholders increases the supply of loanable funds and increases saving and investment. It also lowers the equilibrium real interest rate.

How does a budget deficit act as an automatic stabilizer and reduce the severity of a​ recession? A. During​ recessions, tax obligations fall due to falling wages and profits. B. Consumers spend more than they would in the absence of social insurance​ programs, like unemployment. C. Transfer payments to households increase. D. All of the above.

D. All of the above. Budget deficit The situation in which the​ government's expenditures are greater than its tax revenue. Budget surplus The situation in which the​ government's expenditures are less than its tax revenue. Budget deficits occur automatically during recessions for two reasons.​ First, tax revenues fall due to falling wages and profits.​ Second, spending on transfer​ payments, such as unemployment​ insurance, increases. Automatic budget surpluses and deficits can help stabilize the economy. When the economy is in a​ recession, falling wages decrease tax obligations. Increased transfer payments to households also increase during recessions.​ Together, the two events work as an automatic stabilizer and allow households to consume at a higher level than they otherwise would have.

Increased government debt can lead to higher interest rates​ and, as a​ result, crowding out of private investment spending. In terms of borrowing​ (debt-spending), what will offset the effect of crowding out in the long run so that government debt poses less of a problem to the​ economy? A. ​Debt-spending on highways and ports. B. ​Debt-spending on research and development. C. ​Debt-spending on education. D. All of the above.

D. All of the above. In the long​ run, government debt can pose a problem if it increases relative to GDP. This is due to the possibility of crowding out when increasing debt drives up interest rates. This effect is offset if the debt was incurred for improvements in​ infrastructure, education, and research and development. Better​ infrastructure, an educated​ workforce, and high levels of research and development can increase the productive capacity of the economy and keep debt low relative to GDP.

Consider the figure. An increase in government spending shifted the aggregate demand curve from AD1 to AD2. As a​ result, both price level and real GDP increased. What can be​ said, however, about the increase in real​ GDP? A. It increased by the same amount as indicated by a multiplier with a constant price level. B. It increased by less than indicated by a multiplier with a constant price level. C. It increased by more than indicated by a multiplier with a constant price level. D. None of the above.

The economy is initially at point A. An increase in government purchases causes the aggregate demand curve to shift to the right from AD1 to the dotted AD curve. The multiplier effect shifts the curve further to AD2. Due to the​ upward-sloping short-run aggregate supply​ curve, the shift in aggregate demand results in a higher price level. In the new​ equilibrium, point​ C, both real GDP and the price level have increased. The increase in real​ GDP, however, is less than indicated by the multiplier effect with a constant price level​ (point B).

Suppose the economy is in equilibrium in the first period at point​ (A). In the second​ period, the economy reaches point​ (B). We would expect the federal government to pursue what type of policy in order to move AD2 to AD2, policy and reach equilibrium​ (point C) in the second​ period? part 2: If the​ federal government's policy is​ successful, what is the effect of the policy on the following macroeconomic​ indicators? actual real GDP: ____ potential real GDP:______ Price level:_____ unemployment: ______

expansionary fiscal policy In the dynamic​ AD-AS model we​ assume: 1. The economy experiences inflation​ and, 2. the economy experiences long run growth. That​ is, the LRAS curve shifts to the right each year. In​ addition, the AD and the SRAS curves also shift to the right each year. ​However, sometimes the AD curve does not shift by enough to keep the economy in​ long-run macroeconomic equilibrium. In this example the AD1 shifted to AD2 in the second period. This was not enough to maintain​ long-run equilibrium and the economy is in recession.​ Specifically, in the second​ period, the actual real GDP​ (point B) is less than the potential GDP​ (given by LRAS2​). This economic condition is often met with an expansionary fiscal policy which​ includes: 1. Decreases in taxes on businesses and individuals 2. Increases in government spending . When the federal government enacts the appropriate fiscal​ policy, the AD curve shifts to the right and moves the economy in to​ long-run macroeconomic equilibrium in the second period​ (point C). part 2: increase; does not change; increase ; decrease Expansionary fiscal​ policy: 1. Decreases in taxes on businesses and individuals 2. Increases in government spending Price​ level: After the federal government​ acts, AD2 shifts to AD2, policy​, price level rises from 102 to 103. Actual real​ GDP: After the​ government's actions, actual real GDP rises from point​ "B" to point​ "C", ceteris paribus. Potential​ GDP: is given by LRAS2. LRAS does not change as a result of the policy. ​Rather, it shifted due to economic growth which is due​ to: 1. Changes in labor 2. Changes in capital 3. Changes in technology. ​Unemployment: As actual real GDP​ rises, unemployment falls.