Chapter 7

Budget Deficit

the difference between what the federal government spends (called outlays) and what it takes in (called revenue or receipts)

7.2.2 The government can buy back Treasury bills and increase the supply of loanable funds when tax revenue exceeds government spending. Select one: True False

True A budget surplus (an excess of tax revenue over government spending) provides the government with the opportunity to buy back T-bills and pay off its debt while increasing the supply of loanable funds.

7.1.1 Fiscal and monetary policies are often useful in pulling an economy out of a recession. Select one: True False

True Expansionary fiscal and monetary policies can often induce spending and shift the aggregate demand curve outward to help an economy out of a recession.

7.2.4 The volatile fluctuations of the business cycle occur because of the multiplier effect. Select one: True False

True The multiplier effect causes increases and decreases in real GDP to have greater impacts on the business cycle. Because of the multiplier effect, the fluctuations are much more volatile. Automatic stabilizers, such as the progressive tax system, keep the business cycle relatively stable.

7.1.2 Demand-driven deflation is often referred to as bad deflation. Select one: True False

True When the aggregate demand curve shifts inward, prices and output fall. However, supply-driven deflation decreases prices and increases output, improving the economy's standard of living.

7.2.3 The implementation of fiscal policy might be delayed because of constituent-supported programs that are difficult to retract. Select one: True False

True Suppose the government must retract a government subsidy in order to slow down the economy. Taking away a program from which a politican's body of voters benefits is difficult and may cost that politician his / her office. For this reason, politicans are often reluctant to retract such programs and may ultimately delay the implementation of fiscal policy.

7.2.3 The theory of implementing fiscal policy always works in practice. Select one: True False

False Because of the operational, recognition, and administration lags, implementing fiscal policy according to theory does not always work in practice.

7.3.1 New classical economists believe that the rationality of people who save in preparation for higher future taxes shifts the aggregate demand curve outward. Select one: True False

False New classical economists believe that when people save rather than spend to prepare for higher future taxes, the aggregate demand curve will never truly shift, and there would be no change in either price or output.

Consider the Laffer curve below. If t* is the point of maximum tax revenue, people will tend to work harder at a tax rate of t2 than at a tax rate of t1. Select one: True False

False The Laffer curve is based on the premise that as tax rates increase, people's work incentives decrease. They work less, and the government collects less tax revenue. According to Laffer, cutting taxes might actually increase tax revenue.

7.1.1 "Bad deflation" refers to the process in which Select one: a. prices and output fall. b. prices fall and output increases. c. prices fall too rapidly. d. none of the above.

a. "Bad deflation" occurs when aggregate demand declines at every price (that is, the aggregate demand curve shifts to the left). It is considered bad because output falls.

7.1.2 In the short run, what happens to the level of output and the level of prices as a result of a technological improvement? Select one: a. Prices fall, and output rises. b. Prices and output rise. c. Prices fall, and output falls. d. None of the above

a. An improvement in technology can be represented by an outward shift of the short-run aggregate supply curve. The short-run effect is to reduce prices and increase output ("good deflation").

7.2.1 What effect does expansionary fiscal policy have on aggregate demand? Select one: a. It shifts the aggregate demand curve outward. b. It causes an upward movement along the aggregate demand curve. c. It shifts the aggregate demand curve inward. d. It causes a downward movement along the aggregate demand curve.

a. Expansionary fiscal policy shifts the aggregate demand curve outward, because at every price level, output is higher than it was.

7.2.3 Which of the following is one of the factors that makes the use of fiscal policy difficult? Select one: a. Once programs have been established, it is difficult to cut spending. b. Increases in government spending often have no effect on aggregate demand. c. Government programs tend to be less efficient than private sector programs. d. All of the above.

a. Government policymakers can stimulate the economy by increasing government spending. The problem is reducing government spending once the increase in aggregate demand is no longer necessary. Because programs create constituency support, taking away programs can cost politicians their jobs.

7.3.1 According to new Keynesians, fiscal policy can have an effect on output because of which of the following factors? Select one: a. Wages are sticky. b. Prices adjust instantly. c. Producers cut back production when faced with rising prices. d. People save more when government spending increases.

a. If prices and wages do not adjust quickly, increases in aggregate demand can increase output. According to new Keynesians, wages do not fall in response to increases in the rate of inflation for two reasons. First, many wages are determined by labor contracts negotiated by unions. These wages cannot change in response to changing economic conditions. Second, even if firms could lower wages, many choose not to for fear of losing their best workers or reducing the incentive workers have to produce.

7.2.2 Which of the following forms of savings can mitigate the effects of crowding out? Select one: a. Household savings b. A government deficit c. A trade surplus d. All of the above

a. Recall the savings function: I = S + (T − G) − NX. Additional savings from households; the government in the form of a government surplus; or foreigners in the form of a trade deficit can increase the pool of savings for businesses and mitigate the crowding out of investment spending.

7.2.3 The "recognition lag" refers to the fact that Select one: a. it takes a while before policymakers recognize that aggregate demand has shifted inward. b. politicians are often unwilling to recognize the fact that a decline in aggregate demand hurts people, especially the poor. c. government statistics may be inaccurate. d. all of the above.

a. The AD / AS model makes it easy to see the effects of a shift in aggregate demand. In practice, however, these shifts are not so easy to identify. It may be many months before government statistics reveal declines in output, prices, and employment.

7.1.2 What would happen if the government cut taxes to stimulate aggregate demand during a period of stagflation? Select one: a. Prices, output, and employment would all rise. b. Prices, output, and employment would all fall. c. Prices would fall, but output and employment would rise. d. Prices would rise, but output and employment would fall.

a. The government could cause output and employment to rise by increasing aggregate demand if the level of output were below the full-employment level as it is during stagflation. Unfortunately, the price level would also rise.

7.2.2 In the early 1990s, the budget deficit was high, but interest rates were lower than in the 1980s. Which of the following best explains the reason this occurred? Select one: a. Foreign savings increased, offsetting the effects of the budget deficit. b. Government spending decreased, reducing the demand for loanable funds. c. Household savings increased. d. The government sold Treasury bills.

a. The increase in foreign savings increased the supply of loanable funds and kept interest rates low.

7.3.1 According to the new classical view of economics, when the aggregate demand curve shifts outward, Select one: a. prices and output automatically adjust to the long-run equilibrium. b. the short-run equilibrium occurs at higher price and output levels. c. the short-run aggregate supply curve will not adjust immediately, creating profit opportunities for suppliers. d. none of the above.

a. The new classical view of economics is based on the beliefs of Adam Smith. New classical economists believe that when the aggregate demand curve shifts outward, the automatic adjustment results in a higher aggregate price level with no change in output.

7.2.4 What effect would a decrease in aggregate demand have on output, given the presence of automatic stabilizers? Select one: a. Output would fall but by less than it would without stabilizers. b. Output would fall, but prices would rise. c. Output would remain constant despite the drop in aggregate demand. d. Output would rise but by less than it would without stabilizers.

a. The purpose of automatic stabilizers is to buffer the effects of increases or decreases in aggregate demand. When aggregate demand falls, prices decline and output falls. As incomes fall, consumer spending drops, exacerbating the decline. Automatic stabilizers help buffer this process.

7.2.4 How does the tax system act as an automatic stabilizer? Select one: a. When income rises, people move into higher tax brackets, reducing somewhat the amount of money available for consumption. b. People in higher tax brackets tend not to pay taxes, which gives them more money to spend on consumption. c. Taxes are automatically withdrawn from most people's paychecks, giving the government an immediate source of income. d. When income rises, people increase their spending dramatically in order to avoid taxation, increasing the effect of a boom.

a. When income rises, people have more money to spend on consumption. Under a progressive tax system, however, earning more money pushes some people into higher income tax brackets, and they keep proportionally less of their income than they did before. They still increase their consumption, but they do so by less than they would have had the higher tax bracket not bitten into their earnings. As a result, output increases by less in a boom and falls by less in a recession.

7.1.2 What was the effect on prices and output when oil prices rose in the 1970s? Select one: a. The short-run aggregate supply curve shifted to the right, output declined, and prices fell. b. The short-run aggregate supply curve shifted to the left, output declined, and prices rose. c. The short-run aggregate supply curve remained unchanged, causing prices and output to fall. d. The short-run aggregate supply curve remained unchanged, causing prices to rise and output to remain at the full-employment level.

b. As a result of the rise in oil prices, producers were willing to produce less at every price. Graphically, the short-run aggregate supply curve shifted inward as illustrated by the graph below. The result was a decline in output (from Yf to Y1 ) and an increase in prices (from P0 to P1 ).

7.2.4 Automatic stabilizers control Select one: a. the supply of money in an economy. b. the fluctuations of the business cycle. c. the volatility of changing interest rates. d. the volume of imports.

b. Automatic stabilizers ensure the relative stability of the business cycle by minimizing the impacts of the multiplier effect. Policies such as the progressive tax system and unemployment insurance keep a booming economy from expanding into an inflationary economy and a slowing economy from contracting into a recessionary economy.

7.1.1 Which policy tools could be used to deal with an autonomous decrease in aggregate demand? Select one: a. The Federal Reserve could decrease the money supply. b. The government could offset the drop in consumer spending with spending of its own. c. The government could raise taxes. d. All of the above are correct.

b. Confronted with a decline in consumer spending (one of the components of aggregate demand), the government could increase its own spending (a second component of aggregate demand). The increase in government spending could shift the aggregate demand curve back to its original position.

7.2.3 The fact that it may take months to actually distribute government spending once that spending has been approved is known as the Select one: a. administration lag. b. operational lag. c. recognition lag. d. bureaucratic lag.

b. Even after funding has been approved, it takes time to actually disburse government spending.

7.2.2 Which of the following will occur if the U.S. government purchases Treasury bills? Select one: a. The national debt increases. b. The national debt declines. c. The federal budget deficit increases. d. The federal budget deficit decreases.

b. Government runs a budget surplus, the government can use the surplus to pay off the national debt. It does so by buying back government obligations in the form of T-bills.

7.3.1 What is the effect on prices and output if people recognize that an increase in government spending will have to be paid for by an increase in taxes? Select one: a. Only the price level will increase. b. Prices and output will not change. c. Only output will increase. d. Both prices and output will increase.

b. If consumers instantly recognize that the increase in government spending will be paid for by an increase in taxes, they reduce their consumption in anticipation of the tax increase. The aggregate demand curve thus never shifts, and neither prices nor output changes.

7.1.2 Which of the following statements regarding the long-run aggregate supply (LRAS) curve is true? Select one: a. An inward shift of the LRAS curve will improve an economy's standard of living. b. Increased immigration can shift the LRAS curve outward. c. Bad weather can shift the LRAS curve outward. d. All of the above are true.

b. Increasing immigration increases the labor pool, which will in turn increase the amount of efficient productivity. When the level of full employment increases, the economy's standard of living improves.

7.3.1 Which of the following statements is false? Select one: a. Keynesians believe that fiscal policy can be effective. b. Keynesians believe that prices and wages adjust quickly to new economic conditions. c. The new classical economists believe that the economy quickly returns to the full-employment level of output. d. The new classical economists believe that increases in government spending can affect prices but cannot affect the level of output.

b. Keynesians believe that prices and particularly wages are "sticky." That is, prices and wages do not immediately adjust to reflect increases or decreases in aggregate demand. As a result, fiscal policy can have real effects on output.

7.2.3 Which of the following will not occur during a recession? Select one: a. Output declines. b. Prices rise. c. Unemployment rises. d. Consumption spending falls.

b. Looking at the graph below, we can see that prices fall during a recession because of the decline in aggregate demand.

Which political party has supported the idea of the Laffer curve? Select one: a. The Democratic Party b. The Republican Party Correct c. Both major parties d. Neither major party

b. President Reagan was a strong believer in supply-side economics. He cut taxes sharply, claiming that total tax revenues would actually increase.

7.1.1 An example of fiscal policy is Select one: a. buying securities. b. raising taxes. c. raising the discount rate. d. lowering the required reserve ratio.

b. Raising taxes is a tool used by the government to slow down an expanding economy. Conversely, this fiscal policy tool can be reversed to stimulate a slow economy.

The curve that illustrates the relationship between tax revenue and tax rates is called the Select one: a. Reagan curve. b. Laffer curve. Correct c. Phillips curve. d. Keynes curve.

b. The Laffer curve, named for economist Arthur Laffer, illustrates that as the tax rate increases, work incentives and income tax revenue decreases.

7.2.2 The federal budget deficit increased substantially under which of the following administrations? Select one: a. The Kennedy Administration b. The Reagan Administration c. The Ford Administration d. The Clinton Administration

b. Under President Reagan, the budget deficit soared as a result of large tax cuts and major increases in defense spending.

7.2.4 Which of the following represents an automatic stabilizer? Select one: a. Medicare b. Unemployment insurance c. Social Security d. All of the above

b. Unemployment insurance is known as an automatic stabilizer because it is a form of countercyclical government spending that does not need to be approved by Congress. During a recession, unemployment rises and incomes decline. Unemployment insurance helps ensure that consumption drops by less than income, moderating the effect of unemployment on aggregate demand.

7.2.1 The phenomenon of crowding out occurs when Select one: a. sticky wages, sticky prices, and confusion crowd out competition. b. increases in government spending raise the interest rate and crowd out investment spending. c. increases in taxes crowd out consumption. d. downward pressure on prices crowds out aggregate demand.

b. When the government increases spending, the aggregate demand curve shifts outward. The increased demand for money raises the interest rate. At higher interest rates, businesses find investments less profitable and cut back spending. This chain of events is known as the crowding-out effect.

Supply-side economists hold the belief that decreasing the tax rate can Select one: a. increase prices and decrease output. b. increase both prices and output. c. decrease prices and increase output. d. decrease both prices and output.

c. According to supply-side economists, decreasing the tax rate will raise work incentives. As people begin working more, production increases, and the supply curve shifts outward at a new equilibrium of lower prices and higher output.

7.2.1 What would be the effect of an increase in government spending of $50 million? Select one: a. GDP would increase by $50 million. b. GDP would increase by less than $50 million. c. GDP would increase by more than $50 million. d. GDP would decrease by $50 million.

c. Because of the multiplier effect, an increase in government spending of $50 million increases GDP by more than $50 million.

7.1.1 According to classical economists, what happens to prices and output in the long run if there is an autonomous decline in aggregate demand? Select one: a. Prices fall, and output increases. b. Prices rise, and output increases. c. Prices fall, and output returns to the full-employment level of output. d. The full-employment level of output shifts to the left.

c. Classical economists believe that wages and prices always adjust, so that the economy always returns to the full-employment level of output. A decrease in demand would cause prices to fall, which would induce producers to increase production. In the long run, output would remain unchanged from its original level and the price level would

7.1.1 According to supporters of rational expectations, which of the following explains why increases in government spending do not cause output to rise? Select one: a. The increase in interest rates caused by the increase in government spending crowds out private investment. b. The decrease in interest rates caused by the increase in government spending crowds out private investment. c. Consumers recognize that government spending today will have to be paid for by an increase in taxes tomorrow. d. Consumers believe that the increase in government spending will not affect output.

c. If consumers are fully rational, they recognize that today's government spending must be paid for by an increase in taxes tomorrow. To prepare for that increase, they increase their savings (decrease their consumption) today in order to be able to pay the higher taxes that will come due tomorrow. This decrease in consumer spending offsets the increase in government spending, leaving the level of output unchanged.

7.2.1 Increasing government spending is an example of Select one: a. expansionary monetary policy. b. contractionary monetary policy. c. expansionary fiscal policy. d. contractionary fiscal policy.

c. Increasing government spending will stimulate the economy and shift the aggregate demand curve outward. Expansionary fiscal policy works to increase employment, output, and income.

7.2.1 Which of the following does not represent a form of expansionary fiscal policy? Select one: a. Increasing government spending b. Reducing taxes c. Increasing the money supply d. Providing incentives to businesses and households to spend more

c. Increasing the money supply is a form of monetary policy.

7.1.2 A supply shock will shift the short-run aggregate supply curve __________ and create __________. Select one: a. inward; excess supply b. outward; excess supply c. inward; excess demand d. outward; excess demand

c. Look at the graph below. When a supply shock occurs, the short-run aggregate supply curve shifts inward. At the original price level of P0, there is excess demand.

7.3.1 Suppose the government purchased a $10 million satellite. New Keynesian economists predict that Select one: a. a short-run equilibrium would occur at a higher aggregate price level at full employment. b. in the short run, there would be downward pressure on prices. c. prices would be slow to adjust and create profit opportunities for suppliers. d. none of the above.

c. New Keynesian economists believe that sticky wages, sticky prices, and confusion will slow the adjustment from the short run to the long run. The lag will create profit opportunities for suppliers.

7.2.2 If government spending exceeds government revenues, the government runs a deficit, which it can pay for by Select one: a. reducing spending. b. increasing taxes. c. issuing Treasury bills. d. raising interest rates.

c. The government can finance its deficit by issuing Treasury bills. These bills are purchased by firms, banks, and households, providing the government with the money needed to pay for programs it cannot fund through tax revenues.

7.1.2 What would happen if the government decided to reduce inflation by cutting government spending during a period of stagflation? Select one: a. Unemployment and prices would fall, and the level of output would rise. b. Unemployment and prices would rise, and the level of output would fall. c. Unemployment would rise while output and prices would fall. d. Unemployment and output would fall, and prices would rise.

c. The government can reduce prices or increase output during stagflation, but it cannot do both. If it reduces government spending, the price level and output will fall, but unemployment will rise. Cutting government spending during a period of stagflation would thus help reduce inflation, but it would exacerbate the recession.

7.2.2 Which of the following statements is true? Select one: a. The government runs a budget deficit when its tax revenue exceeds its spending. b. The sum of each year's budget deficit equals the national debt. c. The government finances its debt by issuing Treasury bills. d. The sum of each year's issuance of Treasury bills equals the government surplus.

c. The government debt is the sum of each year's budget deficit (an excess of government spending over tax revenue). To finance its spending, the government borrows from its citizens by issuing Treasury bills.

7.2.2 How is investment spending affected by an increase in the budget deficit? Select one: a. Investment spending increases to finance the deficit. b. Investment spending increases as a result of the increase in government spending. c. Investment spending is crowded out by the increase in the budget deficit. d. Investment spending is unaffected by the increase in the budget deficit which affects only government spending.

c. To finance a budget deficit, the government issues Treasury bills which it sells to the public to raise the money to pay for its deficit spending. These T-bills increase the demand for loanable funds, causing interest rates to rise. The increase in interest rates makes some businesses decide not to invest. Their investment is said to have been "crowded out" by government borrowing.

7.2.4 Which of the following represents an aim of automatic stabilizers? Select one: a. To increase consumer spending in a boom and stimulate the economy b. To reduce consumer spending in a recession and stimulate the economy c. To reduce consumer spending in a boom in order to avoid overheating the economy d. To reduce government spending in a recession in order to avoid overheating the economy

c.During a boom, automatic stabilizers moderate consumer spending, reducing the effect of increases in income on aggregate demand.

7.3.1 According to the new classical view of the macroeconomy, what might be the effect on output of an increase in aggregate demand? Select one: a. Output rises, and prices rise. b. Output rises, and prices fall. c. Output falls, and prices fall. d. Output remains unchanged, and prices rise.

d. According to the new classical economics and illustrated by the graph below, increases in aggregate demand (expansionary fiscal policy) have no effect on output in the long run, because prices and wages adjust very quickly to eliminate excess demand. As a result of the increase in aggregate demand, prices rise, causing the short-run aggregate supply curve to shift inward until equilibrium is achieved.

7.1.1 Which of the following factors would cause aggregate demand to fall? Select one: a. A decrease in consumer confidence b. A decrease in investor confidence c. A decrease in demand by foreigners d. All of the above

d. Aggregate demand is made up of four components: government spending, consumption, investment, and exports. Any factor that reduces a component of aggregate demand reduces total aggregate demand.

7.2.1 According to the crowding-out effect, an increase in government spending will Select one: a. decrease employment. b. increase investment spending. c. decrease the demand for money. d. increase interest rates.

d. An increase in government spending will shift the aggregate demand curve outward and increase the aggregate price level. The demand for money increases and raises interest rates.

Which of the following factors could induce a supply-side response? Select one: a. Increases in the tax rate b. Decreases in the tax rate c. Changes in regulations d. All of the above

d. Any change in the tax rate or in regulations would affect individuals' and firms' willingness to work. Imposing regulations on businesses would make it more costly for them to produce, thus forcing them to cut back on output. Increases or decreases in the tax rate would encourage or discourage individuals and businesses from earning more income.

7.2.4 Which of the following does not occur as a result of automatic stabilizers? Select one: a. Recessions are milder than they would otherwise be. b. Output grows by less than it otherwise would during economic booms. c. The business cycle varies less than it would in the absence of automatic stabilizers. d. Increases in income cause greater increases in consumer spending than they otherwise would.

d. As a result of the progressive income tax---an automatic stabilizer---the increase in consumption as a result of increases in income is muted, because part of the increase in income goes to higher taxes.

7.1.1 Which of the following policies should be used to stimulate the economy? Select one: a. Raising the required reserve ratio b. Raising the discount rate c. Reducing government spending d. Buying government securities

d. Buying government securities, such as T-bills, increases the money supply. Interest rates drop, and the economy is stimulated by the increase in investment spending.

7.3.1 What is the likely effect of an increase in government spending if prices and wages are very flexible? Select one: a. Both output and prices will rise. b. Output will rise, and prices will remain unchanged. c. Both output and prices will fall. d. Prices will rise, and output will remain unchanged.

d. If prices and wages adjusted instantly, increases in government spending would have no effect on output. If aggregate demand increased at all, the economy would immediately adjust to its new long-run equilibrium at a higher price level at full employment.

7.1.2 Which of the following factors would not cause the equilibrium level of output to increase? Select one: a. Technological developments b. Immigration c. Capital accumulation d. Increases in the money supply

d. Increases in the money supply have no effect on the long-run level of output, which is determined by the resources in an economy and the ways they are used.

7.2.3 The time between the realization of economic conditions and the implementation of fiscal policy is called the _____________ lag. Select one: a. operational b. recognition c. political d. administrative

d. Otherwise known as "red tape," an administrative lag is the time it takes to recognize a problem and take action to remedy it.

7.2.1 Which of the following is not a tool of fiscal policy? Select one: a. Government spending b. Taxes c. Tax incentives d. Private investment

d. Private investment is not controlled by the government, although government can affect private investment through tax credits and incentives, for example.

According to economist Arthur Laffer, tax revenues would increase if the tax rate were lowered, because Select one: a. income would rise because the lower tax rate would motivate people to work more, offsetting the decline in the tax rate. b. very high tax rates discourage people from working, reducing the level of income and tax revenues. c. as the tax rate rises from zero, tax revenues first rise and then fall. d. all of the above.

d. Proponents of supply-side economics contend that lowering the tax rates encourages people to work harder, because they get to keep more of their earnings. They say that even though the taxes per hour worked decrease, the additional amount people will work under a lower tax rate will more than make up the difference. Under these assumptions, tax revenues would rise as a result of the decrease in taxes.

How much tax revenues would be collected if total income were $4 trillion and the tax rate were zero? Select one: a. $4 trillion b. $2 trillion c. $1 trillion d. None of the above

d.A tax rate of zero means that the government does not collect tax revenue, and workers keep 100% of their income earned.

National Debt

the result of the federal government borrowing money to cover years and years of budget deficits.