ECON 2030 Assignment 9: Fiscal Policy

In a certain economy, when income is $100, consumer spending is $60. The value of the multiplier for this economy is 4. It follows that, when income is $101, consumer spending is

$60.75.

Fiscal policy refers to the idea that aggregate demand is affected by changes in

government spending and taxes.

If households view a tax cut as temporary, then the tax cut

has less of an effect on aggregate demand than if households view it as permanent.

Suppose an increase in interest rates causes rising unemployment and falling output. To counter this, the Federal Reserve would

increase the money supply.

Suppose there is a tax increase. To stabilize output, the Federal Reserve could

increase the money supply.

When taxes decrease, interest rates

increase, making the change in aggregate demand smaller.

Other things the same, automatic stabilizers tend to

raise expenditures during recessions and lower expenditures during expansions.

Assume the MPC is 0.625. Assume there is a multiplier effect and that the total crowding-out effect is $12 billion. An increase in government purchases of $30 billion will shift aggregate demand to the

right by $68 billion.

Refer to Figure 34-5. An increase in government purchases will

shift aggregate demand from AD1 to AD2.

Refer to Figure 34-5. An increase in taxes will

shift aggregate demand from AD1 to AD3.

Suppose there are both multiplier and crowding out effects but without any accelerator effects. An increase in government expenditures would

shift aggregate demand right by a larger, equal, or smaller amount than the increase in government expenditures.

A tax cut shifts the aggregate demand curve the farthest if

the MPC is large and if the tax cut is permanent.

Assume there is a multiplier effect, some crowding out, and no accelerator effect. An increase in government expenditures changes aggregate demand more,

the larger the MPC and the weaker the influence of income on money demand.

If the MPC is 3/5 then the multiplier is

2.5, so a $100 increase in government spending increases aggregate demand by $250.

Scenario 34-1. Take the following information as given for a small economy: • When income is $10,000, consumption spending is $6,500. • When income is $11,000, consumption spending is $7,250. Refer to Scenario 34-1. The multiplier for this economy is

4.00

If the MPC = 4/5, then the government purchases multiplier is

5.

If a $1,000 increase in income leads to an $800 increase in consumption expenditures, then the marginal propensity to consume is

0.8 and the multiplier is 5.

Which of the following correctly explains the crowding-out effect?

An increase in government expenditures increases the interest rate and so reduces investment spending.

Which of the following events shifts aggregate demand rightward?

An increase in government expenditures, but not a change in the price level

Which of the following is an example of crowding out?

An increase in government spending increases interest rates, causing investment to fall.

During recessions, taxes tend to

Fall and thereby increase aggregate demand

Which of the following policies would be advocated by someone who wants the government to follow an active stabilization policy when the economy is experiencing severe unemployment?

Increase government expenditures

Which of the following policies would Keynes's followers support when an increase in business optimism shifts the aggregate demand curve away from long-run equilibrium?

Increase taxes

If net exports fall $40 billion, the MPC is 9/11, and there is a multiplier effect but no crowding out and no investment accelerator, then

aggregate demand falls by 11/2 × $40 billion.

Opponents of active stabilization policy

believe that the political process creates lags in the implementation of fiscal policy.

Suppose there was a large increase in net exports. If the Fed wanted to stabilize output, it could

decrease the money supply, which will increase interest rates.

The multiplier effect states that there are additional shifts in aggregate demand from expansionary fiscal policy, because it

increases income and thereby increases consumer spending.

A significant example of a temporary tax cut was the one announced in 1992 by President George H. W. Bush. The effect of that tax cut on consumer spending and aggregate demand was

likely smaller than if the cut had been permanent.

The government builds a new water-treatment plant. The owner of the company that builds the plant pays her workers. The workers increase their spending. Firms from which the workers buy goods increase their output. This type of effect on spending illustrates

the multiplier effect.

An example of an automatic stabilizer is

unemployment benefits.

Refer to Figure 34-7. Suppose the multiplier is 5 and the government increases its purchases by $15 billion. Also, suppose the AD curve would shift from AD1 to AD2 if there were no crowding out; the AD curve actually shifts from AD1 to AD3 with crowding out. Also, suppose the horizontal distance between the curves AD1 and AD3 is $55 billion. The extent of crowding out, for any particular level of the price level, is

$20 billion

If the marginal propensity to consume is 0.75, and there is no investment accelerator or crowding out, a $15 billion increase in government expenditures would shift the aggregate demand curve right by

$60 billion, but the effect would be larger if there were an investment accelerator.

If the MPC is 0.8 and there are no crowding-out or accelerator effects, then an initial increase in aggregate demand of $120 billion will eventually shift the aggregate demand curve to the right by

$600 billion.

Scenario 34-1. Take the following information as given for a small economy: • When income is $10,000, consumption spending is $6,500. • When income is $11,000, consumption spending is $7,250. Refer to Scenario 34-1. For this economy, an initial increase of $200 in net exports translates into a(n)

$800 increase in aggregate demand in the absence of the crowding-out effect.

Scenario 34-1. Take the following information as given for a small economy: • When income is $10,000, consumption spending is $6,500. • When income is $11,000, consumption spending is $7,250. Refer to Scenario 34-1. The marginal propensity to consume for this economy is

0.750

Suppose an economy's marginal propensity to consume (MPC) is 0.6. Then 1 + MPC + MPC2 + MPC3 = 2.176 and, if we continued adding up terms in this geometric series, we would get closer and closer to the multiplier value of

2.5

If the multiplier is 3, then the MPC is

2/3.

Scenario 34-2. The following facts apply to a small economy. • Consumption spending is $6,720 when income is $8,000. • Consumption spending is $7,040 when income is $8,500. Refer to Scenario 34-2. In response to which of the following events could aggregate demand increase by $1,500?

A stock-market boom stimulates consumer spending by $550, and there is a small operative crowding-out effect.

Initially, the economy is in long-run equilibrium. Aggregate demand then shifts leftward by $50 billion. The government wants to increase its spending in order to avoid a recession. If the crowding-out effect is always one-third as strong as the multiplier effect, and if the MPC equals 0.6, then by how much do government purchases have to increase in order to offset the $50 billion leftward shift?

By $30 billion

Refer to Figure 34-6. A shift of the money-demand curve from MD2 to MD1 is consistent with which of the following sets of events?

The government reduces government spending, resulting in a decrease in people's incomes.

If taxes

decrease, then consumption increases, and aggregate demand shifts rightward.

Critics of stabilization policy argue that

policy affects aggregate demand with a lag, but the effects on aggregate demand are long-lived