Fiscal policy: foundational concepts/Fiscal policy/Automatic stabilizers

What effect does an increase in government spending have on the AD-AS model in the short run?

Aggregate demand (AD) increases **When government spending increases, AD increases and shifts to the right unless there is complete crowding out.

An economy is currently producing real GDP that is $500 billion more than its full employment output. It is also experiencing an undesirable amount of inflation. Its marginal propensity to consume is 0.75.Assuming that this is a closed economy with no crowding out, which of the following best describes the impact that a $100 billion increase in government spending will have on this economy?

Aggregate demand and real output will eventually increase by $400 billion, and the price level will decrease **

How do automatic stabilizers affect an economy during inflationary periods?

As national income increases, tax revenues increase, which slows consumption spending. **An increase in tax revenues reduces the income available for consumption, which slows the economy down and helps prevent it from overheating. Automatic stabilizers help to curb inflation during expansions.

The nation of Xela was in long-run equilibrium but experienced the aggregate demand shock shown below. The marginal propensity to consume (MPC) in Xela is 0.9. Which of the following is a fiscal policy action that would be the best choice to return the economy to full employment output?

Decrease spending by $2 million **There is a $20 million output gap caused by the positive aggregate demand shock. The government would need to use contractionary fiscal policy to close this, either increasing taxes or decreasing government spending. To find the correct amount of taxes or spending to implement, divide the size of the gap by the appropriate multiplier. The government spending multiplier here is equal to 10, so the amount of government spending needed is: -$20 million/10 = -$2 million

Xela's economy was in long-run equilibrium but experienced a shock as shown in this graph: If the government of Xela wants to use a discretionary fiscal policy tool to return the economy to full employment output, which of the following would be the most appropriate choice?

Decrease taxes **Xela has a recessionary (negative) output gap as a result of the negative supply shock shown in the graph. To close that gap, its government will need to engage in expansionary fiscal policy. Expansionary fiscal policy would include decreasing taxes or increasing government spending. Either action will increase AD and return the economy to full employment output.

Which of the following best describes why an increase in government spending increases aggregate demand directly but decreases in taxes affect aggregate demand indirectly?

Government spending is included as a component of aggregate demand, but it also affects consumption. Taxes only affect consumption. **The direct effect of government spending is included in the government spending category of aggregate demand (AD). Government spending also affects AD indirectly through its effect on consumption. Taxes, however, are not directly included in AD, so the effect of a tax decrease shows up only through its effect on consumption.

Which of the following would be a government spending and tax multiplier for a country?

Government spending multiplier equal 9 and tax multiplier equals -8 **The government spending multiplier is always greater than the tax multiplier by one, and the tax multiplier is always negative. This is because changes in government spending affect aggregate demand directly, but changes in taxes affect aggregate demand indirectly.

The marginal propensity to consume in the nation of Erd is 0.75. What is the value of the government spending multiplier and what is the value of the tax multiplier?

Government spending multiplier= 4 tax multiplier​= −3​ **The tax multiplier will always be one less in magnitude than the spending multiplier, and will be negative.

The government of Burginville passed a bill giving tax cuts to all citizens. But, by the time the government of Burginville got around to issuing tax cuts, the recession in Burginville had ended. As a result, the economy of Burginville experienced unanticipated inflation. Which of the following best describes the problem that Burginville experienced in this scenario?

Implementation lag **Implementation lag is the time it takes to put a policy action in place. In this scenario, the government had the information it needed to know it was in a recession, so the delay in policy effectiveness is not a data lag. The government also decided on a policy action, so this was not a decision lag. During the time it took to implement the policy the government decided on, the reason for that policy disappeared, causing the unintended consequence of inflation.

Suppose that an economy is in the middle of a recession and government policy makers want to increase aggregate demand by $800 billion.If the economy's marginal propensity to consume is 0.9 and there is no crowding out, the government should do which of the following fiscal policy actions?

Increase government spending by $80 billion **If the economy is in a recession, policy makers would want to use expansionary fiscal policy. If they know that they have a $800 billion gap to close, they divide the change in aggregate demand that they want by the appropriate multiplier. The government spending multiplier here is equal to 10. Therefore, the size of the spending change needed is: $800 billion/10 = $80 billion

The economy of Maxistan was in long-run equilibrium, but it experienced a shock shown in this graph. Which of the following would be the most appropriate discretionary fiscal policy action to restore Maxistan to full employment output?

Increase taxes **Maxistan is currently experiencing a positive output gap. To bring the economy back to full employment output, the government in Maxistan should choose a contractionary fiscal policy. Two examples of contractionary fiscal policy would be increasing taxes and/or decreasing government spending. Either of these actions would lower aggregate demand and restore Maxistan to full employment output.

Which of the following is an example of an automatic stabilizer that can reduce the effect of a recession on output?

Institutions such as paying unemployment compensation **In addition to tax revenues, there are frequently other types of automatic stabilizers in an economy. For example, paying unemployment insurance to people who have lost their jobs in a recession provides income that can be used on consumption, reducing the impact on aggregate demand.

Which of the following is a reason a government might increase government spending?

It is concerned that the unemployment rate is too high. **When government spending increases, the level of output in the economy increases, causing the unemployment rate to decrease. Increasing government spending is an example of an expansionary fiscal policy action that increases output, decreases the unemployment rate, and increases the price level.

Tax revenues are an example of an automatic stabilizer. Which of the following best describes changes in unemployment and real GDP that cause tax revenue to increase?

Real GDP is higher than full employment output; unemployment is lower than the natural rate **During an expansion, output is higher than full employment output, and the unemployment rate is lower than the natural rate of unemployment. These factors increase income, which leads to higher taxes.

Which of the following best describes the function of automatic stabilizers in an economy?

They decrease tax revenues when gross domestic product decreases. **During recessions, incomes decrease and, correspondingly, tax revenues decrease. A decrease in taxes frees up income that can be spent on consumption, preventing output from falling further.