Econ 102 Chapter 16

Government purchases multiplier equation=

(Change in equilibrium real GDP)/ (Change in government purchases)

Tax multiplier equation=

(Change in equilibrium real GDP)/ (Change in taxes)

The long-run effect of a permanent increase in government spending...

(most economists agree that...) is the result of complete crowding out; if government spending is taking a larger share of GDP, then private spending must take a smaller share

Two reasons deficits occur automatically during recessions:

1) During a recession, wages and profits fall, causing government tax revenues to fall 2) the government automatically increases its spending on transfer payments when the economy moves into a recession (existing laws already specify who is eligible for unemployment insurance and other programs)

A cut in the tax rate affects equilibrium real GDP through two channels:

1) a cut in the tax rate increases the disposable income of households, which leads them to increase their consumption spending 2) a cut in the tax rate increases the size of the multiplier effect

Three other categories of federal government expenditures:

1) interest on the national debt 2) grants to state and local governments 3) Transfer payments

Two reasons that getting the timing right can be more difficult with fiscal policy than with monetary policy

1) the President and a majority of the 535 members of Congress have to agree on the changes in fiscal policy, whereas control over monetary policy rests at the hands of the Federal Open Market Committee 2) even after a change in fiscal policy has been approved, it takes time to implement it

About ___ of the stimulus package took the form of increases in government expenditures, and ___ took the form of tax cuts.

2/3; 1/3

Fiscal Policy

Changes in federal taxes and purchases that are intended to achieve macroeconomic policy goals.

Automatic stabilizers

Government spending and taxes that automatically increase or decrease along with the business cycle (changes in these types of spending and taxes happen without actions by the government)

Table 16.1 summary of how fiscal policy affects aggregate demand

Problem:Recession-->Type of Policy Required: Expansionary Fiscal Policy-->Actions by the Congress and President: Increase government purchases or decrease taxes--> Result: Real GDP and the price level rise Problem: Rising inflation--> Type of Policy Required: Contractionary Fiscal Policy-->Actions by the Congress and President: Decrease government purchases and increase taxes-->Result: Falling GDP and price level

The largest and fastest category of federal government expenditures:

Transfer payments

American Recovery and Reinvestment Act of 2009

a $840 billion package of spending increases and tax cuts that was by far the largest fiscal policy action in United States history

Crowding out

a decline in private/ nongovernment expenditures as a result of an increase in government purchases (consumption, investment, net exports)

Most of the increase in the federal budget deficit during a typical recession takes place without Congress and the president taking action, but is instead due to the effects of _____________.

automatic stabilizers

Economists call the initial increase in government purchases as _________ because...

autonomous; it is a result of a decision by the government and is not directly caused by changes in the level of real GDP

Economists working for the administration estimated that the increase in aggregate demand resulting from the stimulus package would increase real GDP by 3.5% by the end of 2010 and increase employment by 3.5 million but in reality...

between the beginning of 2009 and the end of 2010, real GDP increase by 4.0%, while employment declined by 3.3%.

In 1970, the federal government entered a long period of continuous __________.

budget deficits

From 1998 to 2001, there were four years of _______

budget surpluses

The tax multiplier is a negative number because...

changes in taxes and changes in the real GDP move in opposite directions; an increase in taxes reduces disposable income, consumption, and real GDP, and a decrease in taxes increases disposable income, consumption, and real GDP

Most fiscal policy actions that attempt to increase aggregate supply do so by...

changing taxes to increase the incentives to work, save, invest, and start a business

The stimulus package reduced the increase in the unemployment rate that might otherwise have occurred, but did not...

come close to bringing the economy back to full employment.

The federal government debt increases whenever the federal government runs a budget _______

deficit

When the federal government runs an expansionary fiscal policy, the result is a cyclically adjusted budget ________

deficit

In the long run, a debt that increases in size relative to GDP, as happened after 2008, can pose a problem. Crowding out of investment spending may occur if an increasing debt....

drives up interest rates

When the government runs a budget surplus, the Treasury pays of _________ bonds.

existing

Other fiscal policy actions are intended to have long-run effects by...

expanding the productive capacity of the economy and increasing rate of economic growth

A consumer's permanent income reflects the consumer's...

expected future income

The multiplier effect will continue through a number of periods, with the additional consumption spending in each period being...

half of the income increase from the previous period

Largest category of the major categories of spending increases in the stimulus plan

health care, social services, and education

Because of the upward sloping SRAS, the shift in aggregate demand results in a _______ price level.

higher

Federal government expenditures

includes federal government purchases plus federal government spending that does not involve a purchase (ex. Social Security)

Largest category for tax cuts in the stimulus plan

individuals

The increases in consumption spending that result from the autonomous government purchases are _______ because...

induced; they are caused by the initial increase in autonomous spending

If government debt was incurred to finance improvements in ________, the effects of lower investment spending is offset.

infrastructure- bridges, ports, highways; financing of research and development; financing of education

Contractionary fiscal policy

involves decreasing government purchases or increasing taxes; policymakers use contractionary fiscal policy to reduce increases in aggregate demand that seem likely to lead to inflation

Expansionary fiscal policy

involves increasing government purchases or decreasing taxes

During major wars, higher taxes only partially offset massive increases in government expenditures,

leaving large budget deficits

The extra spending by the government helps reduce the ________ and ________ of the recession.

length; severity

A tax rebate is likely to increase consumption ____ than would a permanent tax cut.

less; rebates increase a consumers' current income

In general, economists believe that the smaller the tax wedge for any economic activity-such as working, saving, investing, or starting a business- the _____ of that economic activity will occur.

more

The value of a tax rate affects the size of the ______

multiplier effect

Most economists agree that in the short run, an increase in government purchases results in ____ crowding out

partial

Grants to state and local governments

payments made by the federal government to support government activity at the state and local levels

Many economists believe that consumers base their spending on their _______ income rather than just on their _________ income.

permanent; current

Supply-side economics

policy actions that are intended for long-run effects which primarily affect aggregate supply rather than the aggregate demand

Any permanent increase in government spending in the long run must come at the expense of...

private expenditures

Lower investment spending means a lower capital stock in the long run and a reduced capacity of the economy to

produce goods and services

A change in the tax ___ has a more complicated effect on equilibrium real GDP than does a tax cut of a fixed amount

rate

Because changes in the government purchases and taxes lead to changes in aggregate demand, they can affect the level of...

real GDP, employment, and the price level

Interest on the national debt

represents payments to holders of the bonds the federal government issued to borrow money

Every time the federal government runs a budget deficit, the Treasury must borrow funds from investors by _____ selling Treasury securities.

selling

Recessions accompanied by financial crises tend to be more ____ than recessions that do not involve financial crises.

severe

The higher the tax rate, the ________ the multiplier effect

smaller

Some fiscal policy actions are intended to meet the short-run goal of...

stabilizing the economy

When the federal government runs an contractionary fiscal policy, the result is a cyclically adjusted budget ________

surplus

Cyclically adjusted budget deficit or surplus

the deficit or surplus in the federal government's budget if the economy were at potential GDP

Tax wedge

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

Economists typically use the term fiscal policy to refer only to the actions of...

the federal government

Federal government purchases

the federal government receives a good or service in return (ex. aircraft carrier to fight in a war)

Marginal Tax Rate

the fraction of each additional dollar income that must be paid in taxes

Most economists believe that the federal government should not attempt to balance its budget every year because...

the government may have to take actions that would destabilize the economy; when in a recession= the budget automatically moves into a deficit and to bring it back, the government would have to raise taxes or cut spendings, which would reduce aggregate demand, making the recession worse; when in expansion= the budget automatically moves into surplus and to bring it back, the government would have to cut taxes or increase government spending, further increasing aggregate demand and having the risk of higher inflation

Discretionary fiscal policy

the government takes actions to change spending or taxes

Government purchases multiplier

the ratio of the change in equilibrium real GDP to the initial change in government purchaes

Multiplier effect

the series of induced increases in consumption spending that results from an initial increase in autonomous expenditures

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

Since there are more years of budget deficits than years of budget surpluses,

the total number of Treasury bonds outstanding has grown over the years

Federal government debt (or national debt)

the total value of U.S Treasury bonds outstanding

The federal government makes many decisions about taxes and spending but not all are considered fiscal policy actions because

they are not intended to achieve macroeconomic policy goals

State and local governments sometimes change their taxing and spending policies to aid their local economies, but these are not fiscal policy actions because...

they are not intended to effect the national economy

Behavioral response occurs when...

when workers, savers, investors, or entrepreneurs change their actions as a result of a tax change