Chapter 33

Assume that, without taxes, the consumption schedule for an economy is as shown below: GDP, Billions Consumption,Billions $100 $120 200 200 300 280 400 360 500 440 600 520 700 600 a. What is the size of the MPC given the data above? b. Graph this consumption schedule.

a. 0.8 Explanation a. MPC = ($200 billion - $120 billion)/($200 billion - $100 billion) = $80 billion/$100 billion = 0.8.

If the annual interest payments on the debt sharply increased as a percentage of GDP, interest payments would represent a smaller portion of tax revenues. there would be a smaller debt load. the government would have to use tax revenues or go deeper into debt. GDP would fall.

the government would have to use tax revenues or go deeper into debt. Explanation The weight of the debt is not its absolute size. Indeed, if there were no interest to be paid on the debt and refinancing was automatic, there would be no debt load at all. But interest does have to be paid. Lenders expect that, and to pay the interest the government must either use tax revenues or go deeper into debt. Interest on the debt, then, is important. Its weight can best be assessed by noting the size of the interest payments in relation to GDP, since the size of GDP is a measure of total national income or how much the government can raise in taxes to pay the interest.

Which of the following would help a government reduce an inflationary output gap? Instructions: You may select more than one answer. Click the box with a check mark for correct answers and click to empty the box for the wrong answers. Increasing government spending.unanswered Raising taxes.unanswered Decreasing government spending.unanswered Lowering taxes.

Raising taxes. Decreasing government spending. Explanation Raising taxes and decreasing government spending are the correct answers because each of them helps to reduce aggregate demand. Consider raising taxes. When the government raises taxes, it takes money away from households and businesses. With less money to spend, households reduce consumption spending and businesses reduce investment spending. Thus, the C and I components of aggregate demand fall and the AD curve shifts left. Reductions in government spending also reduce aggregate demand by directly reducing G. By contrast, lowering taxes and increasing government spending would both increase aggregate demand and shift the AD curve to the right—something that would only increase the size of the inflationary output gap.

The economy is in a recession. A congresswoman suggests increasing spending to stimulate aggregate demand but also at the same time raising taxes to pay for the increased spending. Her suggestion to combine higher government expenditures with higher taxes is: a mediocre and contradictory combination of tax and expenditure changes. the best possible combination of tax and expenditure changes. None of these are correct. the worst possible combination of tax and expenditure changes.

a mediocre and contradictory combination of tax and expenditure changes. Explanation The Congresswoman is right that that increased government spending will increase aggregate demand, other things equal. But her plan to raise taxes would decrease aggregate demand, other things equal. Thus, her two policy suggestions are going to offset each other, perhaps completely. It is for that reason that the correct answer is that her plan is a mediocre and contradictory combination of tax and expenditure changes. The best scenario would be to increase government spending while lowering tax rates. Any deficit would have to be covered by borrowing, but in terms of increasing aggregate demand in the short run, this combination would work very well.

Suppose that a country has no public debt in year 1 but experiences a budget deficit of $40 billion in year 2, a budget surplus of $10 billion in year 3, and a budget deficit of $2 billion in year 4.Instructions: Enter your answers as whole numbers. For the absolute size of its public debt, enter your answer as a positive number.a. What is the absolute size of its public debt in year 4? b. If its real GDP in year 4 is $104 billion, what is this country's public debt as a percentage of real GDP in year 4?

a. 32 billion b. 31% Explanation a. Public debt is the sum of deficits and surpluses (negative deficits) over time. Since the country started year 1 with no public debt, the country's debt at the end of year 4 is $32 billion (= $40 (deficit year 2) - $10 (surplus year 3, negative deficit) + $2 (deficit year 4)). b. If real GDP in year 4 is $104 billion, this country's public debt as a percentage of real GDP is 31 percent in whole numbers (= $32 (debt)/$104 (GDP) = 0.308).

a. What are the two ways to measure the public debt? Its absolute dollar size and its relative size as a percentage of GDP. Its real dollar size and its relative size as a multiple of GDP. Its relative dollar size and its relative size as a percentage of GDP. Its average dollar size and its relative size as a fraction of GDP. b. The distinction between the absolute and relative sizes of the public debt is important because the relative size doesn't tell you about an economy's capacity to repay the debt. the absolute size doesn't tell you about an economy's capacity to repay the debt. if the absolute size is larger than the relative size, then it is less of a problem. the United States has the largest relative size public debt of any country. c. Refinancing the public debt means selling new bonds to retire maturing bonds. swapping bonds for other assets. paying off bonds at maturity. buying new bonds to retire maturing bonds. d. An internally held debt is one in which the funds are spent on domestic projects. bondholders are citizens of other nations. bondholders are the ones receiving the payments. bondholders live in the nation having the debt. e. Paying off an internally held debt would involve selling government bonds. lower the dollar exchange rate. improve the distribution of income. not burden the economy as a whole. f. Paying off an externally held debt may lower the dollar exchange rate. would allow U.S. citizens to buy products or other assets abroad. would keep the proceeds in the domestic economy. would improve the distribution of income.

a. Its absolute dollar size and its relative size as a percentage of GDP. b. the absolute size doesn't tell you about an economy's capacity to repay the debt. c. selling new bonds to retire maturing bonds. d. bondholders live in the nation having the debt. e. not burden the economy as a whole. f. may lower the dollar exchange rate. Explanation a. There are two ways of measuring the public debt: (1) measure its absolute dollar size and (2) measure its relative size as a percentage of GDP. b. The distinction between the absolute and relative sizes of the public debt is important because the absolute size doesn't tell you about an economy's capacity to repay the debt. the United States has the largest public debt of any country, but as a percentage of GDP has a smaller debt than some other nations. This means that the United States has a greater ability (more income) to service that debt than those countries whose debt is a higher percentage of GDP. c. Refinancing the public debt simply means rolling over outstanding debt—selling "new" bonds to retire maturing bonds. Retiring the debt means purchasing bonds back from those who hold them or paying the bonds off at maturity. d. An internally held debt is one in which the bondholders live in the nation having the debt; an externally held debt is one in which the bondholders are citizens of other nations. e. Paying off an internally held debt would involve buying back government bonds. This could present a problem of income distribution because holders of the government bonds generally have higher incomes than the average taxpayer. But paying off an internally held debt would not burden the economy as a whole—the money used to pay off the debt would stay within the domestic economy. f. In paying off an externally held debt, people abroad could use the proceeds of the bond sales to buy products or other assets from the United States. However, the dollars gained could be simply exchanged for foreign currency and brought back to their home country. This reduces U.S. foreign reserve holdings and may lower the dollar exchange rate.

se the aggregate expenditures model to show how government fiscal policy could eliminate either a recessionary expenditure gap or an inflationary expenditure gap. a. Given that full employment exists at $4,500, does a recessionary gap or an inflationary gap exist? (Click to select) Inflationary gap Recessionary gap b. Identify this gap in the diagram below. c. What is the dollar amount of the expenditure gap?

a. Recessionary gap b. c. 1,000 billion Explanation a. The graph shows that current equilibrium GDP (where the aggregate expenditures curve (AE0) intersects the 45-degree line) is $3,000. If full employment is $4,500, then the current GDP is below full employment. That means that a recessionary gap exists. b. The recessionary gap exists between the aggregate expenditures curve (AE0) and the 45-degree line at the full employment GDP of $4,500. c. Reading the graph, we can see that the value for aggregate expenditures on the aggregate expenditures curve (AE0) where Real GDP = $4,500 is $3,500. The expenditure gap is the difference between the full employment GDP and the aggregate expenditures at the level. In other words the expenditure gap = $4,500 - $3,500 = $1,000.

a. The cyclically adjusted budget measures what the federal deficit or surplus would be if the economy reached the (Click to select) equilibrium normal actual full-employment level of GDP. b. If the cyclically adjusted budget is balanced, the government is engaging in either expansionary or contractionary policy. the government is not engaging in either expansionary or contractionary policy. the actual budget is also balanced. the actual budget is in surplus. c. Suppose the full-employment, noninflationary level of real output is GDP3 (not GDP2) in the economy depicted in the figure below. If the economy is operating at GDP2, instead of GDP3, the current fiscal policy is contractionary, since a surplus would exist. expansionary, since a surplus would exist. balanced, since there is no deficit. contractionary, since a deficit would exist. d. To move the economy to full employment, the government should cut taxes or decrease spending. increase taxes or increase spending. cut taxes or keep spending constant. cut taxes or increase spending.

a. full-employment level b. the government is not engaging in either expansionary or contractionary policy. c. contractionary, since a surplus would exist. d. cut taxes or increase spending. Explanation a. The cyclically adjusted budget measures what the federal deficit or surplus would be if the economy reached the full-employment level of GDP with existing tax and spending policies. The "actual" budget is the deficit or surplus that results when revenues and expenditures occur over a year if the economy is not operating at full employment. b. If the cyclically adjusted budget is balanced, then the government is not engaging in either expansionary or contractionary policy, even if, for example, a deficit automatically results when GDP declines. c. Even though the "actual" budget has no deficit at GDP2, fiscal policy is contractionary. d. To move the economy to full employment, the government should cut taxes or increase spending. You would raise the G line, lower the T line, or a combination of each until they intersect at GDP3.

a. Social Security and Medicare are "pay-as-you-go" plans. This means that most of the current revenues from the Social Security tax are paid to current Social Security retirees. most of the past revenues from the Social Security tax are paid to current Social Security retirees. current Social Security retirees have to pay some of these costs themselves. future Social Security retirees have to pay some of these costs now. b. Social Security and Medicare trust funds are assets held by these programs to help pay for future projected tax revenue shortfalls. asset projections used to plan for program expenditures. a description of the cost of these programs. congressional funds held in trust to finance these programs once they are no longer solvent. c. Social Security and Medicare trust funds are projected to be depleted by 2057 and 2037, respectively. 2037 and 2057, respectively. 2033 and 2024, respectively. 2024 and 2033, respectively. d. The key long-run problem of both Social Security and Medicare is the increasing number of immigrants entering the United States. poor health of current U.S. retirees. aging population and the age distribution of the U.S. population. lack of funding for these programs.

a. most of the current revenues from the Social Security tax are paid to current Social Security retirees. b. assets held by these programs to help pay for future projected tax revenue shortfalls. c. 2033 and 2024, respectively. d. aging population and the age distribution of the U.S. population. Explanation a. Social Security and Medicare are largely annual "pay-as-you-go" plans, meaning that most of the current revenues from the Social Security tax are paid to current Social Security retirees. b. Social Security and Medicare trust funds are assets held by these programs to help pay for future projected tax revenue shortfalls. These trust funds hold special-issue Treasury bonds purchased using the revenue in excess of payouts in past years. c. The Social Security trust fund is projected to be depleted by 2033. The Medicare trust fund is expected to be depleted by 2024. d. The key problem is that the U.S. population is aging. That is, the fraction of the population over the age of 65 is increasing due to increased longevity and the retirement of the baby boom generation (post-WWII births).

a. Built-in (or automatic) stabilizers work by changing ______ so that changes in GDP are reduced. interest rates and investment wages and prices taxes and government payouts government payouts and interest rates b. What type of tax system would have the most built-in stability? A progressive tax because it increases at an increasing rate as incomes rise, thus having more of a dampening effect on rising (or falling) incomes. A regressive tax since it acts as a cushion on declining incomes—the tax bite is less, which leaves more of the lower income for spending. A proportional tax because individuals pay more in taxes if they have higher incomes, thus having more of a dampening effect on rising (or falling) incomes. A regressive tax because those with higher incomes pay a smaller proportion of their income in tax and thus can spend more.

a. taxes and government payout b. A progressive tax because it increases at an increasing rate as incomes rise, thus having more of a dampening effect on rising (or falling) incomes. Explanation a. In a phrase, "net tax revenues vary directly with GDP." When GDP is rising so are tax collections, both income taxes and sales taxes. At the same time, government payouts—transfer payments, such as unemployment compensation and welfare—are decreasing. Since net taxes are taxes less transfer payments, net taxes definitely rise with GDP, which dampens the rise in GDP. On the other hand, when GDP drops in a recession, tax collections slow down or actually diminish while transfer payments rise quickly. Thus, net taxes decrease along with GDP, which softens the decline in GDP. b. A progressive tax system would have the most stabilizing effect of the three tax systems and the regressive tax would have the least built-in stability. A progressive tax increases at an increasing rate as incomes rise, thus having more of a dampening effect on rising incomes and expenditures than would either a proportional or regressive tax. The latter rate would rise more slowly than the rate of increase in GDP, with the least effect of the three types. Conversely, in an economic slowdown, a progressive tax falls faster because not only does it decline with income, it becomes proportionately less as incomes fall. This acts as a cushion on declining incomes—the tax bite is less, which leaves more of the lower income for spending. The reverse would be true of a regressive tax that falls, but more slowly than the progressive tax, as incomes decline.

The Council of Economic Advisers (CEA) advises the president on social matters and provides recommendations for discretionary social policy action. economic matters and provides recommendations for discretionary fiscal policy action. foreign policy matters and provides recommendations for discretionary foreign policy action. monetary matters and provides recommendations for discretionary monetary policy action.

economic matters and provides recommendations for discretionary fiscal policy action. Explanation The CEA advises the president on economic matters and provides recommendations for discretionary fiscal policy action.

Assume that, without taxes, the consumption schedule for an economy is as shown in the first two columns of the table below. The MPC without taxes is 0.8. Suppose a proportional tax with a 10 percent tax rate is imposed instead of the regressive tax. a. Calculate the new consumption schedule. b. What are the MPC (tax inclusive) and the multiplier? Instructions: Round your answers to 2 decimal places.

GDP, BillionsConsumption Before Tax, BillionsTax, BillionsDisposable Income, BillionsConsumption After Tax, Billions$100$1201090112200200201801843002803027025640036040360328500440504504006005206054047270060070630544 .72 3.57 Explanation a. With the 10 percent tax rate, we find the tax revenue by taking 10 percent of GDP, column 3. We then find disposable income by subtracting the tax revenue from GDP (Disposable income = GDP - tax revenue), column 4. Now to find after tax consumption, we use the provided MPC of 0.8. Note that this must be done at each level of GDP, because the taxes paid increase with GDP. For example, since disposable income falls by $10 billion after the tax at the GDP level of $100 billion, consumption falls by $8 billion (the MPC is 0.8). When GDP equals $200 billion, the taxes paid equal $20 billion, so disposable income falls by $20 billion and consumption falls by $16 billion. The computed values are found in column 5. b. The net (tax inclusive) marginal propensity to consume is 0.72 (= ($184 billion - $112 billion)/($200 billion - $100 billion)) and the multiplier is 3.57 (= 1/(1 - 0.72) = 1/0.28). Here the MPC (tax inclusive) and multiplier are different because the tax revenue increases as GDP increases, reducing the amount of disposable income households have to consume.

During the recession of 2007−2009, the U.S. federal government's tax collections fell from about $2.6 trillion down to about $2.1 trillion while GDP declined by about 4 percent. Does the U.S. tax system appear to have built-in stabilizers? Yes No

Yes Explanation The U.S. tax system does appear to have built-in stabilizers. In particular, it appears to have a tax system that collects more money when the economy is doing well and less money when the economy is doing poorly. That combination is helpful in stabilizing the business cycle because large amounts of taxes will be collected when the economy is doing well (and perhaps in need of contractionary fiscal policy), while smaller amounts of taxes will be collected when the economy is doing poorly (and definitely in need of expansionary fiscal policy). Note how GDP decreased by 4 percent while taxes decreased by 19 percent. The much larger decrease in taxes helps ease the effects of lost income when GDP falls.

Refer to the data below. Real Output Demanded, Billions Price Level Real Output Supplied, Billions $506 108 $513 508 104 512 510 100 510 512 96 507 514 92 502 Instructions: Enter your answers as whole numbers. a. What is the equilibrium level of output? What is the equilibrium price level? b. Suppose that aggregate demand increases such that the amount of real output demanded rises by $7 billion at each price level. Insert the new values for real output demanded in the table below. What is the new equilibrium level of output? What is the new equilibrium price level? By what percentage will the price level increase? Will this inflation be demand-pull inflation or will it be cost-push inflation? (Click to select) Demand-pull inflation Cost-push inflation c. If potential real GDP (that is, full-employment GDP) is $510 billion, what will be the size of the positive GDP gap after the change in aggregate demand? d. If government wants to use fiscal policy to counter the resulting inflation without changing tax rates, would it increase government spending or decrease it? (Click to select) Increase Decrease

a. $510 billion 100 b. [506] [513] [108] [513] [508] [515] [104] [512] [510] [517] [100] [510] [512] [519] [96] [507] [514] [521] [92] [502] 513 billion 108 8% Demand-pull inflation c. 3 billion d. Decrease Explanation Real Output Demanded, Original, BillionsReal Output Demanded, New, BillionsPrice LevelReal Output Supplied, Billions$506$513108$5135085151045125105171005105125199650751452192502 b. After the increase in real output demanded by $7 billion at each price level, we see that the new equilibrium is $513 billion (quantity demanded equals quantity supplied) at the price level of 108. The increase in the price level is 8 percent (= (108 - 100)/100 = 0.08, or 8 percent)). Since this inflation is the result of an increase in aggregate demand, this is demand-pull inflation. c. If potential real GDP (full-employment GDP) is $510 billion, the size of the positive GDP gap after the change in aggregate demand is $3 billion (= $513 billion - $510 billion). d. If government wants to use fiscal policy to counter this inflation without changing tax rates, it would decrease government spending.

Refer to the following table for Waxwania: Government Expenditures, GTax Revenues, TReal GDP $160 $100 $500 160 120 600 160 140 700 160 160 800 160 180 900 Instructions: Enter your answers as whole numbers. a. What is the marginal tax rate in Waxwania? b. What is the average tax rate? c. Which of the following describes the tax system: proportional, progressive, or regressive? (Click to select) Proportional Progressive

a. 20% b. 20% c. Proportional Explanation a. The marginal tax rate is 20 percent. Marginal tax rate = Δtax revenue/Δreal GDP. We apply this to every change in real GDP and find that it is the same for each incremental change of $100 (in a more general setting this does not need to be the case). b. The average tax rate is also 20 percent. Average tax rate = tax revenue/real GDP. We apply this to every level of real GDP and find that it is the same for each level (in a more general setting this does not need to be the case). c. Since the average tax rate does not change as income (real GDP) increases, the tax system is proportional.

Assume that a hypothetical economy with an MPC of 0.8 is experiencing severe recession. a. By how much would government spending have to rise to shift the aggregate demand curve rightward by $25 billion? How large a tax cut would be needed to achieve the same increase in aggregate demand? Instructions: Round your answer to 2 decimal places and enter your answer as a positive number. b. Determine one possible combination of government spending increases and tax increases that would accomplish the same goal without changing the amount of outstanding debt.

a. 5billion Tax cut =$6.25billion. b. Increase government spending by$25billion. Increase taxes by$25billion. Explanation a. By how much would government spending have to rise to shift the aggregate demand curve rightward by $25 billion? The first step is to find the expenditure multiplier. Expenditure multiplier = 1/(1 - MPC) = 1/(1 - 0.8) = 1/0.2 = 5. The second step is to find the change in government spending required to shift the aggregate demand schedule rightward by $25 billion. Here we use the following relationship: ΔAD = expenditure multiplier × Δgovernment spending. Rearranging: ΔGovernment spending = ΔAD/expenditure multiplier. ΔGovernment spending = $25 billion/5 = $5 billion. Thus, we should increase government spending by $5 billion. How large a tax cut would be needed to achieve the same increase in aggregate demand? The first step is to calculate the tax multiplier. Here we need to recognize that a tax cut will need to move through consumption before impacting the economy. Therefore, we need to multiply the tax cut by the MPC before applying the multiplier process. Tax multiplier = - (MPC/(1 - MPC)) = - (0.8/(1 - 0.8)) = - (0.8/0.2) = - 4. Note that the tax multiplier is negative because changes in taxes and aggregate demand (and aggregate expenditures) are inversely related. The second step is to find the change in taxes required to shift the aggregate demand schedule rightward by $25 billion. Here we use the following relationship: ΔAD = tax multiplier × Δtaxes. Rearranging: ΔTaxes = ΔAD/tax multiplier. ΔTaxes = $25 billion/(- 4) = - ($25 billion/4) = - $6.25 billion. Thus, we should cut taxes by $6.25 billion. b. Determine one possible combination of government spending increases and tax increases that would accomplish the same goal without changing the amount of outstanding debt. To answer this question, we want to use the balanced budget multiplier concept. First, we increase government spending by $25 billion. This results in an increase in aggregate demand of $125 billion (= 5 (expenditure multiplier) × $25 billion). Second, to finance this government spending of $25 billion, we raise taxes by an equivalent amount to ensure the level of outstanding debt does not change. That is, we also increase taxes by $25 billion. This results in a decrease in aggregate demand of $100 billion (= - 4 (tax multiplier) × $25 billion = - $100 billion (decline in AD)). Combining the two effects above, we have an increase in aggregate demand of $25 billion (= $125 billion (increase from government spending) - $100 billion (decrease from increase in taxes)). This increase was achieved without increasing the debt.

True or false? a. The total public debt is more relevant to an economy than the public debt as a percentage of GDP: (Click to select) True False . b. An internally held public debt is like a debt of the left hand owed to the right hand: (Click to select) True False . c. The portion of the U.S. debt held by the public (and not by government entities) was larger as a percentage of GDP in 2015 than it was in 2000: (Click to select) True False . d. As a percentage of GDP, the total U.S. public debt is the highest such debt among the world's advanced industrial nations: (Click to select) True False .

a. False b. True c. True d. False Explanation a. False: There are two ways of measuring the public debt: (1) measure its absolute dollar size and (2) measure its relative size as a percentage of GDP. The distinction is important because the absolute size doesn't tell you about an economy's capacity to repay the debt. The United States has the largest public debt of any country, but as a percentage of GDP has a smaller debt than some other nations. This means that the United States has greater ability (more income) to service that debt than those countries whose debt is a higher percentage of GDP. b. True: The statement is true about a national debt held internally, but this does not mean a large debt is entirely problem free. c. True: The portion of the U.S. debt held by the public was about 30 percent in 2000, but was much higher in 2015. d. False: There are a number of countries with a higher public debt as a percentage of GDP.

Match each of the following scenarios in which there are problems enacting and applying fiscal policy with the correct type of problem. a. To fight a recession, Congress has passed a bill to increase infrastructure spending—but the legally required environmental-impact statement for each new project will take at least two years to complete before any building can begin. (Click to select) Recognition lag Administrative lag Operational lag b. Distracted by a war that is going badly, inflation reaches 8 percent before politicians take notice. (Click to select) Recognition lag Administrative lag Operational lag c. A sudden recession is recognized by politicians, but it takes many months of political deal making before a stimulus bill is finally approved. (Click to select) Recognition lag Administrative lag Operational lag d. To fight a recession, the president orders federal agencies to get rid of petty regulations that burden private businesses—but the federal agencies begin by spending a year developing a set of regulations on how to remove petty regulations. (Click to select) Recognition lag Administrative lag Operational lag

a. Operational lag b. Administrative lag c. Recognition lag d.Operational lag Explanation a. Operational lag: The two-year-long process to complete environmental-impact statements is an example of an operational lag because even after the stimulus policy has been ordered, there is a time lag before it is actually made operational. b. Recognition lag: The situation in which the war distracted politicians from inflation is an example of a recognition lag, in which the correct fiscal policy is slow to be implemented because there is a delay in even recognizing that there is a problem. c. Administrative lag: The many months of political haggling needed before a stimulus bill is finally enacted is an example of an administrative lag because there is a delay between when the problem is first recognized and when the necessary administrative processes are finally completed and a policy decision is reached. d. Operational lag: The delay caused by the bureaucrats wanting to develop a formal set of regulations to implement the president's order is an example of an operational lag because there is a delay between when a policy has been decided upon and when it is actually implemented.

a. Refinancing of the public debt might drive up real interest rates because government borrowing to finance the debt increases demand for funds and competes with private borrowing. the Treasury charges the government more than the private sector. borrowing rates are higher than lending rates. bonds have higher interest rates than other assets. b. Refinancing of the public debt might cause higher interest rates, which can lower investment and economic growth. lower interest rates, which can lower investment and economic growth. higher interest rates, which can raise investment and economic growth. lower interest rates, which can raise investment and economic growth. c. If public investment financed through borrowing complements private investment, there will be less public borrowing needed and less pressure on interest rates. private borrowers may be willing to pay higher interest rates associated with financing the public debt. there will be lower prices than otherwise would occur. private borrowers will be more resistant to paying higher interest rates associated with financing the public debt.

a. government borrowing to finance the debt increases demand for funds and competes with private borrowing. b. higher interest rates, which can lower investment and economic growth. c. private borrowers may be willing to pay higher interest rates associated with financing the public debt. Explanation a. Government borrowing to finance the debt competes with private borrowing and drives up the interest rate. b. Cause-and-effect chain: Government borrowing to finance the debt competes with private borrowing and drives up the interest rate; the higher interest rate causes a decline in private capital and economic growth slows. c. If public investment complements private investment, private borrowers may be willing to pay higher interest rates for positive growth opportunities. Productivity and economic growth could rise.

a. The problem of time lags in enacting and applying fiscal policy is that discretionary fiscal policy only works in particular economic situations. for a policy to have its full effect on the economy, it must be enacted in three months; however, it usually takes longer. in the time it takes to identify the situation, enact a policy, and allow it to work, economic circumstances may have changed. there are offsetting circumstances that can occur in the private market. b. A political business cycle is the concept that the economy usually expands during election years because there is extra spending. the economy usually contracts during election years because there is intense scrutiny on spending. politicians are more interested in re-election than in stabilizing the economy. politicians are more interested in adding spending programs than in getting elected. c. Expectations of a near-term policy reversal weaken fiscal policy because people tend to make decisions based on pre-tax income. interest rates will usually rise, offsetting any change in fiscal policy. tax cuts are combined with spending increases so there is no real effect. consumers may hesitate to increase their spending because they believe that tax rates will rise again. d. The crowding-out effect is the increase in investment spending caused by the decrease in interest rates arising from an increase in government spending. the increase in investment spending caused by the increase in interest rates arising from an increase in government spending. the reduction in investment spending caused by the decrease in interest rates arising from an increase in government spending. the reduction in investment spending caused by the increase in interest rates arising from an increase in government spending. e. Consider the following statement: "Although fiscal policy clearly is useful in combating the extremes of severe recession and demand-pull inflation, it is impossible to use fiscal policy to fine-tune the economy to the full-employment, noninflationary level of real GDP and keep the economy there indefinitely." This statement recognizes that there are lags in the use of discretionary fiscal policy. the economy does not usually experience severe recession and demand-pull inflation. tax cuts and spending changes are made in the political arena. the impact of fiscal policy will affect the economy differently depending on the timing of the policy and the severity of the situation.

a. in the time it takes to identify the situation, enact a policy, and allow it to work, economic circumstances may have changed. b. politicians are more interested in re-election than in stabilizing the economy. c. consumers may hesitate to increase their spending because they believe that tax rates will rise again. d. the reduction in investment spending caused by the increase in interest rates arising from an increase in government spending. e. the impact of fiscal policy will affect the economy differently depending on the timing of the policy and the severity of the situation. Explanation a. It takes time to ascertain the direction in which the economy is moving (recognition lag), to get a fiscal policy enacted into law (administrative lag), and for the policy to have its full effect on the economy (operational lag). Meanwhile, other factors may change, rendering inappropriate a particular fiscal policy. Nevertheless, discretionary fiscal policy is a valuable tool in preventing severe recession or severe demand-pull inflation. b. A political business cycle is the concept that politicians are more interested in re-election than in stabilizing the economy. Before the election, they enact tax cuts and spending increases to please voters even though this may fuel inflation. After the election, they apply the brakes to restrain inflation; the economy will slow and unemployment will rise. In this view, the political process creates economic instability. c. A decrease in tax rates might be enacted to stimulate consumer spending. If households receive the tax cut but expect it to be reversed in the near future, they may hesitate to increase their spending. Believing that tax rates will rise again (and possibly concerned that they will rise to rates higher than before the tax cut), households may instead save their additional after-tax income in anticipation of needing to pay taxes in the future. d. The crowding-out effect is the reduction in investment spending caused by the increase in interest rates arising from an increase in government spending that is financed by borrowing. The increase in G is designed to increase AD, but the resulting increase in interest rates may decrease I. Thus, the impact of the expansionary fiscal policy may be reduced. e. While fiscal policy is useful in combating the extremes of severe recession with its built-in "safety nets" and stabilization tools, and while the built-in stabilizers can also dampen spending during inflationary periods, it is undoubtedly not possible to keep the economy at its full-employment, noninflationary level of real GDP indefinitely. There is the problem of timing. Each period is different, and the impact of fiscal policy will affect the economy differently depending on the timing of the policy and the severity of the situation. Fiscal policy operates in a political environment in which the unpopularity of higher taxes and specific cuts in spending may dictate that the most appropriate economic policies are ignored for political reasons. Finally, there are offsetting decisions that may be made at any time in the private and/or international sectors. For example, efforts to revive the economy with more government spending could result in reduced private investment or lower net export levels. Even if it were possible to do any fine-tuning to get the economy to its ideal level in the first place, it would be virtually impossible to design a continuing fiscal policy that would keep it there, for all of the reasons mentioned above.

a. The government's fiscal policy options for ending severe demand-pull inflation include increasing interest rates, reducing government spending, or both. increasing taxes, raising interest rates, or both. reducing government spending, increasing interest rates, or both. reducing government spending, increasing taxes, or both. b. For a person who wants to preserve the size of government, the fiscal options for ending severe demand-pull inflation would include a cut in government spending. an increase in taxes. a cut in prices. an increase in the interest rate. c. For a person who thinks the public sector is too large, the fiscal options for ending severe demand-pull inflation would include an increase in the interest rate. a cut in prices. an increase in taxes. a cut in government spending. d. The "ratchet effect" makes anti-inflationary policy

a.reducing government spending, increasing taxes, or both. b. an increase in taxes. c. a cut in government spending. d. more difficult Explanation a. Options for ending severe demand-pull inflation are to reduce government spending, increase taxes, or some combination of both. See the figure below. If the price level is flexible downward, it will fall. In the real world, the goal is to reduce inflation—to keep prices from rising so rapidly—not to reduce the price level. b. A person who wants to preserve the size of government might favor a tax hike and would want to preserve government spending programs. c. Someone who thinks that the public sector is too large might favor cuts in government spending since this would reduce the size of government. The ratchet effect implies that prices are rigid downward. d. The "ratchet effect" implies that prices are rigid downward. This would make any anti-inflationary policy more difficult.

Some politicians have suggested that the United States enact a constitutional amendment requiring that the federal government balance its budget annually. Such an amendment, if strictly enforced, would force the government to enact a contractionary fiscal policy whenever the economy experienced a severe recession. This is because when the economy enters a recession, net tax revenue rises and transfer payments fall. Balancing the budget would require raising transfer payments and lowering taxes. net tax revenue rises and transfer payments fall. Balancing the budget would require lowering transfer payments and lowering taxes. net tax revenue falls and transfer payments rise. Balancing the budget would require lowering transfer payments and raising taxes. net tax revenue falls and transfer payments rise. Balancing the budget would require raising transfer payments and raising taxes.

net tax revenue falls and transfer payments rise. Balancing the budget would require lowering transfer payments and raising taxes. Explanation When the economy enters a recession, net tax revenue falls. Specifically, revenues from income and excise taxes decline as unemployment rises and consumer spending falls. At the same time, transfer payments to help the poor and/or unemployed rise. If tax revenue falls and the government is required to balance the budget, it will be forced to either cut spending or increase taxes—both of which are contractionary policies likely to worsen the recession.