073 - Chapter 73 - Fiscal & Monetary Policies in Economics

Three Tools of Contractionary Fiscal Policy

Decrease government spending Increase taxes Decrease transfer payments

fiscal cliff

Decrease in government spending and increase in tax rates; a simultaneous increase in tax rates and cuts in government spending

Assume the economy is in a recession and the Federal Reserve takes the appropriate monetary policy actions. Which of the following shows the effect of the monetary policy?

Increase consumption spending, investment spending, and Real GDP {Explanation - Expansionary monetary policy helps the economy grow by lowering interest rates, which makes it easier for consumers and businesses to borrow money. This in turn leads to more investment. Consumer spending and the real GDP also increase.}

The economy has entered a recession with high unemployment. The government will use its fiscal policy toolkit to do what?

Increase government spending, lower taxes, or raise transfer payments. {Explanation - When the economy is experiencing a recession, fiscal authorities use expansionary fiscal policy by increasing government spending, lowering taxes or raising transfer payments.}

If the economy is suffering from extremely high rates of inflation, how should the government intervene from the standpoint of a classical economist?

It should do nothing. {Explanation - Unlike Keynesian economists, Classical economists do not believe in government intervention for an economy that is overheating with inflation. They believe that the self-correcting forces of the free market will fix inflation on its own.}

When the economy is growing too slowly (recession) or too quickly (high inflation), the two approaches the government can use, according to economists, include which of the following?

Keynesian (intervene) and Classical (do nothing) {Explanation - In economics, there are basically two major approaches to how the government should deal with recessions or high inflation - the Keynesian approach and the Classical approach.}

Examples of Supply-Side Policies

Reducing marginal tax rates Lower tax rates on interest earned from savings Higher tax credits on investment Less government regulation, including the minimum wage Privatizing public industries

Monetary Policy Tools Used to Contract the Economy

Selling U.S. Treasury securities in the open market (that would be what we would call open market operations) Raising the reserve requirements Increasing the discount rate

Three Main Goals of the Federal Reserve

Sustainable economic growth High employment Stable prices

What is a policy lag?

The amount of time it takes for a policy to be implemented. {Explanation - The lag between the time an economic problem arises and the effect of a policy intended to counteract it is called policy lag. They happen because government actions take time and are not instantaneous.}

What does the word 'fiscal' refer to when discussing fiscal policy?

The government's budget. {Explanation - The word 'fiscal' means 'budget' and refers to the government's budget.}

What is fiscal policy?

The use of government spending, taxes, and transfer payments to influence aggregate demand {Explanation - Fiscal policy is the use of government spending, taxation or transfer payments to influence economic output, which economists measure using real GDP, or gross domestic product.}

Which one of the following is not an advantage to a market economy?

Wealth distribution {Explanation - Market economies can create a vast disparity in the distribution of wealth in a society. While some disparity in the distribution of wealth can be advantageous as an incentive for innovation and hard work, too much disparity indicates that a market may not have a level playing field.}

According to Keynesian economists, if the federal government attempts to balance the budget when the economy is in a recessionary gap, what effect will this have?

Worsen and prolong the recession.

Formula for Aggregate Demand

Y = C + I + G + (X - M) Economic output = Consumption + Investment + Government spending + (Exports - Imports)

business cycle

a period of macroeconomic expansion followed by a period of contraction

An increase in transfer payments raises aggregate demand indirectly

by increasing disposable income, which leads to higher consumption - and that leads to higher aggregate demand (by increasing disposable income, which then leads to higher consumption)

Lower taxes raise aggregate demand indirectly

by increasing disposable income, which leads to higher consumption and therefore higher aggregate demand (by increasing disposable income, which then leads to higher consumption)

automatic stabilizers

changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action; a type of fiscal policy that happens automatically and tends to offset fluctuations in economic activity without direct intervention by policymakers

three things that are in the toolkit (to influence aggregate demand and, therefore, real GDP)

government spending, taxes and transfer payments

An increase in government spending raises aggregate demand directly

so then they make the limousines. Once these orders are done, the sales are counted in real GDP, which means that economic output has increased

expansionary gap

the amount by which output in the short run exceeds the economy's potential output

policy lag

the lag between the time an economic problem arises, such as recession or inflation, and the effect of a policy intended to counteract it

discount rate

the minimum interest rate set by the Federal Reserve for lending to other banks; the rate that it charges banks who wish to borrow directly from the central bank

reserve requirement

the percentage of deposits that banking institutions must hold in reserve

classical economics

the theory that free markets will restore full employment without government intervention; a school of thought based on the idea that free markets regulate themselves;

Supply-side policy

the use of tax incentives, (de)regulation, and other mechanisms to increase the ability and willingness to produce goods and services

recessionary gap

what occurs when the equilibrium quantity of output is below potential output;

According to Keynesian economists, if policymakers thought the economy was headed into a recession, what action would be most appropriate?

A planned increase in the budget deficit.

proportional tax (flat tax)

A tax in which the average tax rate is the same at all income levels.

The central idea of supply-side economics is that certain types of tax cuts will increase:

Aggregate supply {Explanation - Supply-side economics, also referred to as 'trickle-down' economics, is the viewpoint that the best way to improve economic growth and create jobs is by increasing the production of goods and services. According to this theory, lowering taxes and limiting government removes barriers to investment, and leads to a rightward shift in the short-run aggregate supply curve and lower inflation.}

Supply-side economics

An economic philosophy that holds the sharp cutting of taxes will increase the incentive people have to work, save, and invest. Greater investments will lead to more jobs, a more productive economy, and more tax revenues for the government.

Which of the following is the best explanation of a market economy in the real world?

An economy with minimal government intervention and private individuals own most of the resources {Explanation - A pure market economy does not exist, but a market economy can generally be viewed as any economy with minimal government regulation of economic activities and where most resources are owned and controlled by private individuals.}

Three Tools of Expansionary Monetary Policy

Buying U.S. Treasury securities in the open market (which we call 'open market operations') Reducing the reserve requirement Lowering the discount rate

Economists would say it this way (Contractionary monetary policy):

"Higher interest rates tend to decrease aggregate demand by reducing consumption and investment."

Economists would say it this way (Expansionary Monetary Policy):

"Lower interest rates tend to increase aggregate demand by stimulating consumption and investment."

regressive tax

A regressive tax is a tax applied uniformly, taking a larger percentage of income from low-income earners than from high-income earners. It is in opposition to a progressive tax, which takes a larger percentage from high-income earners.

expansionary fiscal policy

An increase in government purchases of goods and services, a decrease in net taxes, or some combination of the two for the purpose of increasing aggregate demand and expanding real output; the government uses fiscal policy to stimulate aggregate demand

How does a progressive tax code affect consumers?

As people earn higher incomes, they pay more taxes. {Explanation - In the United States, the tax code is progressive, which means that the tax rates consumers pay get progressively higher the more income they earn.}

contractionary fiscal policy

Fiscal policy used to decrease aggregate demand or supply. Deliberate measures to decrease government expenditures, increase taxes, or both. Appropriate during periods of inflation; the government uses fiscal policy to reduce aggregate demand

Income $20,000 $30,000 $50,000 Plan A $2,000 $3,000 $5,000 Plan B $1,000 $3,000 $6,000 Plan C $2,000 $2,500 $3,000 Which tax rate plan is the most progressive?

Plan B {Explanation - Plan B sets up the tax rate for the lowest income to be taxed at 5%, the middle income is set at 10%, while the highest being taxed at 12%.}

An automatic stabilizer is BEST defined as _____.

a type of fiscal policy that automatically kicks in without the discretion of policymakers {Explanation - Automatic stabilizers are a type of fiscal policy that happen automatically and tend to offset fluctuations in economic activity without direct intervention from policymakers.}

Supply-side economics as an idea

came from economist Arthur Laffer in the 1970s, although we can trace parts of it back to the 18th-century French economist named Jean-Baptiste Say and probably the famous economist Adam Smith as well

Progressive Tax Code

means that people who earn higher incomes pay more taxes. For example, if an individual earning $50,000 pays a 15% marginal tax rate, while someone earning $100,000 pays a 28% marginal tax rate, this is a progressive tax code

Contractionary monetary policy

monetary policy that reduces aggregate demand; a policy used by monetary authorities to contract the money supply and reduce economic activity by raising interest rates to slow the rate of borrowing by companies, individuals and banks

crowding out

occurs when a government deficit drives up the interest rate and leads to reduced investment spending; a decrease in investment that results from government borrowing; When the government increases its own spending on goods and services and borrows money to pay for it, this borrowing drives up the demand for money in the money market and leads to higher interest rates

effectiveness lag

the amount of time it takes for a fiscal or monetary policy's effects to produce the desired result. Even after a policy is implemented, it still takes time for it to work

implementation lag

the amount of time it takes for fiscal and monetary policy decisions to be implemented

decision lag

the amount of time it takes for fiscal or monetary authorities to make a decision regarding how best to handle an economic problem

Recognition lag

the amount of time it takes for fiscal or monetary authorities to recognize a problem in the economy

marginal tax rate

the extra taxes paid on an additional dollar of income

Aggregate demand

the total level of demand for goods and services by consumers, businesses, the government and foreigners. It's illustrated using the aggregate demand curve;

stabilization policy

the use of government policy to reduce the severity of recessions and rein in excessively strong expansions

fiscal policy

the use of government spending, taxation or transfer payments to influence economic output, which economists measure using real GDP, or gross domestic product

average tax rate

total taxes paid divided by total income

Which of the following will a Keynesian economist most likely favor if the economy is operating to the right of the LRAS?

Contractionary fiscal policy. {Explanation - Keynesian economists believe that the government should step in and help, when necessary, to cool down an economy that is overheating with inflation. An economy that is operating at this point is beyond its long-run potential. Therefore, a Keynesian economist will most likely favor using contractionary fiscal policy to shift the aggregate demand curve to the left.}

All of the following are examples of fiscal policy to lower unemployment, EXCEPT:

EXCEPT: Decreasing government spending. {Explanation - The government typically increases its spending during periods of recessions or slow economic growth to spur the economy back to normal output levels. Government spending usually leads to job creation, which in turn reduces unemployment and increases disposable income.}

Suppose the President plans to cut taxes for consumers and also plans to increase defense spending. How will real GDP and the price level be affected?

GDP increases and inflation rises. {Explanation - Expansionary fiscal policy is the use of government spending, taxation, and transfer payments to stimulate aggregate demand, or the total level of demand for goods and services by consumers, businesses, the government, and foreigners. An increase in government spending and lower taxes will raise aggregate demand, and ultimately increase both real GDP and inflation.}

Which of the following reduces the effects of expansionary fiscal policy?

Higher interest rates that decrease private investment. {Explanation - When the government increases its own spending on goods and services and borrows money to pay for it, this borrowing can drive up the demand for money and lead to higher interest rates in the money market. This increase in interest rates will lead to less investment and reduce economic output.}

Which of the following is true about fiscal policy?

It uses government spending methods. {Explanation - Fiscal policy is the use of government revenue collection (taxes) and government spending to influence the economic activity in a country. These two fiscal methods, which are rooted in the works of the famous economist John Maynard Keynes (1880s - 1940s), work to improve unemployment rates, control inflation and increase/decrease personal income which affects economic growth. Monetary Policy aims to change the money supply, not fiscal policy.}

If in fiscal year 2010, the federal government receives $1,800 billion in revenues and spends $1,550 billion on goods and services, what will happen to the national debt?

It will decrease by $250 billion.

Which of the following policies would be supported by a supply-side economist?

Lower tax rates on interest earned from savings. {Explanation - Supply-side economists support policies such as reducing marginal tax rates, lowering tax rates on interest earned from savings, raising tax credits on investments, reducing government regulation, and privatizing public industries. Anything that increases the size of government or government regulations, or increases taxes on savings or personal income would not be considered a supply-side policy.}

In general, because of policy lags, which of the following is true?

Monetary policy works faster than fiscal policy. {Explanation - Monetary policy decisions can be implemented much quicker than fiscal policies. This is because the central bank is not a government bureaucracy and the tools they use are more efficient than the tools of fiscal policy. Therefore, there is much less of a lag time for monetary policy than fiscal policy.}

What are the three main tools or methods the Federal Reserve uses in implementing monetary policy?

Open market operations, discount rate, and the reserve requirement. {Explanation - Open market operations, discount rate, and reserve requirements are the main tools and methods for implementing monetary policy. Tax rates and government spending are fiscal policy tools.}

What is the appropriate contractionary fiscal policy response when inflation goes from a 3% to 10% annual rate and real GDP rises from 2% to 10%?

Raise taxes and decrease government spending. {Explanation - These numbers indicate that the economy is growing rapidly, but prices are also going up. The appropriate contractionary fiscal policy in this situation would be to increases taxes and decrease government spending. This will shift the aggregate demand curve to the left, which results in lower economic output and lower inflation.}

Which of the following will most likely result, due to the replacement of some portion of the federal personal income tax with a national sales tax?

Smaller overall progressivity in the tax code {Explanation - Switching the progressive tax to a more proportional tax lifts the larger burden of taxes from the rich and applies it to those who are making less.}

Which of the following is an example of contractionary monetary policy?

The Fed raises the reserve ratio. {Explanation - Contractionary monetary policy is a policy used by monetary authorities to contract the money supply and reduce economic activity by raising interest rates to slow the rate of borrowing by companies, individuals, and banks. Selling U.S. Treasury securities in the open market, raising the reserve requirements, and increasing the discount rate are all examples of contractionary monetary policy.}

How could monetary policy lower inflationary expectations?

The Federal Reserve announces that it will steadily raise the federal funds rate. {Explanation - The sale of U.S. Treasury securities in the open market will immediately cause the federal funds rate to rise. Such contractionary monetary policy can help the economy regain a more sustainable level of growth by slowing it down enough to reduce or minimize inflation.}

If the supply of money increases, what happens in the money market?

The interest rate falls. {Explanation - In the money market, an increase in the money supply leads to lower interest rates. This makes it easier for consumers and businesses to borrow money, which leads to increased investments and higher economic output.}

Keynesian Revolution

The name given to the widespread acceptance during the 1930s and 1940s of John Maynard Keynes's macroeconomic model; began with John Maynard Keynes' book "The General Theory of Employment, Interest and Money". Much of what you're learning in macroeconomics, as a matter of fact, is based on his thinking and idea

How would a government most likely change its tax rates during a recession? Why?

They would decrease tax rates in order to increase disposable income, leading to more spending and, ultimately, more jobs. {Explanation - To help the economy get out of a recession, the government can reduce tax rates on businesses and individuals. This will create more disposable income. As consumers spend money and demand more goods and services, businesses will make more money and hire additional people to keep up with the increased demand, which in turn will result in more people paying taxes into the government and generating revenue.}