CH 16 Practice Quiz_ECON

The main goal of supply-side fiscal policy is:

both to shift LRAS and to change the level of full-employment output. Feedback Supply-side fiscal policy involves the use of government spending and taxes to shift long-run aggregate supply (LRAS), which moves the economy from one full-employment output level to a new full-employment output level.

The new classical critique of activist fiscal policy is theoretically different from the crowding-out critique. Crowding-out occurs when private spending __________ in response to government spending. Under the new classical critique, increased government spending leads people to __________ their current savings in order to help pay for higher taxes in the future.

decreases; increase Feedback Crowding-out occurs when increased government spending causes a decrease in private spending. The new classical critique explains how savings shifting occurs. As government spending increases, people know they will have to pay higher taxes eventually, which increases current savings.

If an economy is experiencing an unemployment rate less than the natural rate, which of the fiscal policies would you suggest in order to restore the economy to full employment?

either increase taxes or decrease government spending Feedback When the economy is expanding beyond its long-run capabilities, this implies that the economy is producing at levels higher than full-employment GDP. The unemployment rate is therefore too low - lower than the natural rate. The correct policy prescription here would be to reduce aggregate demand;which can be achieved by contractionary fiscal policy- either increasing taxes or lowering government spending.

Which of the following is impacted by supply-side fiscal policy, but not by demand-side fiscal policy?

the level of full-employment output. Feedback Refer to Fig. 16.8 in your textbook. Demand-side fiscal policy involves a rightward shift of the AD curve, while supply-side fiscal policy causes the LRAS to shift to the right. Thus, in both cases, equilibrium price level and real GDP will change. In the latter case, since the LRAS has shifted right, the level of full-employment output will change as well.

As an elected official, you have been informed that real GDP is below its potential and that action should be taken to encourage economic growth and bring the economy to its long-run equilibrium. If the marginal propensity to consume is 0.8 and the amount of new government spending is $600 billion, by how much would the economy be stimulated?

$3,000 billion FEEDBACK: First calculate the multiplier. This is found by using the equation, ms = 1 ÷ (1 - MPC). With a marginal propensity to consume of 0.8, the multiplier is 5. An increase in government spending of $600 billion multiplied by the multiplier results in a $3,000 billion increase in real GDP.

During a recession, the government spends $100 million to stimulate the economy. If the marginal propensity to consume is 0.8, what will be the potential increase in income in the economy as a result of the government's increase in the spending level?

$500 million Feedback The multiplier process suggests that an increase in government spending by $100 million will potentially create more than $100 million in income. The spending multiplier is given by 1 / (1 - MPC) = 1 / (1 - 0.8) = 1 / 0.2 = 5. Thus the income level will increase 5 times the initial change in government spending. So the total increase in income will be 5 x $100 million = $500 million.

When the economy is in a recession, expansionary fiscal policy can be used to stimulate and encourage economic growth. Which of the following scenarios represent expansionary fiscal policies from both a supply and demand perspective at the same time?

The government lowers tax rates and undertakes a replacement of old bridges and roads. Feedback From a supply-side perspective, the government can lower tax rates. This gives people the incentive to work harder and earn more income. In the process, more output is produced, thus shifting the short- and long-run aggregate supply curves. From a demand-side perspective, undertaking an infrastructure project (increasing government spending) should increase aggregate demand. Both represent an expansionary fiscal policy.

In a bid to be re-elected, you promise both a lower tax rate and greater tax revenue. Would you be able to back up this promise with economic reasoning? Use the Laffer curve, shown here, to support your answer.

Yes, but only if the current tax rate is in Region II of the Laffer curve. FEEDBACK: If the tax rate is in Region I of the Laffer curve, tax revenues would increase as the tax rate falls, and you wouldn't be able to back up your promise to voters. But if the tax rate is in Region II of the Laffer curve, tax revenue would increase as the tax rate falls, and you'd keep your promise. This is because very high taxes are a disincentive for earning income. Lowering those taxes will lead people to work more, earning enough extra taxable income that the government takes in more revenue than they did with the higher tax rate.

Lower income tax rates will affect

either AD or LRAS (or both). Feedback Demand-side fiscal policy predicts that a lower tax rate will leave more funds in the hands of consumers, who can then spend more on consumption. An increase in consumption will lead to a higher AD. On the other hand, supply-side fiscal policy claims that low tax rates create incentives for individuals to work harder and produce more, since they get to keep a larger share of their income. This has the permanent effect of increasing LRAS.

During the fall of 2007, the United States economy began a descent into deep recession. As a result, the federal government and the Federal Reserve took action to stimulate economic growth. Which of the following would have been an appropriate fiscal policy? CHECK ANY THAT APPLY.

the federal government providing tax refunds to all taxpayers the federal government spending more money to build more infrastructure FEEDBACK: Fiscal policy involves the use of spending or taxation by the federal government. During the Great Recession, the federal government provided tax refunds to all taxpayers and increased spending to build infrastructure. Both actions represent a form of fiscal policy. (Note: changing the money supply is MONETARY POLICY, not fiscal policy. Closing banks does not expand the economy, but also falls under the realm of monetary oversight.)

Which of the following function as an automatic stabilizer during business cycles?

unemployment compensation Feedback Automatic stabilizers are government programs that automatically implement countercyclical fiscal policy in response to economic conditions. Thus, unemployment compensation increases government spending automatically when the number of unemployed people rises, and decreases government spending when fewer people are unemployed. To the contrary, Social Security payments don't change with economic conditions, and tax rebates are deliberate rather than automatic policy prescriptions of the government in response to recessions.

If the MPC = 0.75, the spending multiplier is equal to:

4 Feedback The spending multiplier equals 1/(1-MPC) or 1/(1 - 0.75) = 1/0.25 or 4.

When fiscal policy is used to manage the economy, there are a number of factors that can delay its impact. Which of the following is an example of a recognition lag?

Although economic conditions seem bad enough to warrant government action, it takes time for economists to confirm that conditions are bad enough. FEEDBACK: A recognition lag occurs over the time period it takes to recognize and verify the existence of a situation that may require government action. A recognition lag occurs when economists take time to determine if conditions are bad enough.

Which of the following is an expansionary fiscal policy?

Both increase in government spending and decrease in taxes Feedback Expansionary fiscal policy is aimed at stimulating the economy toward expansion. This can be achieved by increasing government spending or by cutting taxes, which has the effect of increasing aggregate demand.

Which of the following lags associated with fiscal policy are expected to be alleviated by automatic stabilizers such as unemployment benefits?

Both recognition lags and implementation lags Feedback The policy prescription to address business cycles is to increase spending and cut taxes during a downturn and to lower spending and raise taxes during an expansion. But in the real world, it is difficult to recognize when expansion or contraction starts, and the appropriate fiscal policy intervention might get delayed. Similarly, since government spending and tax legislation need to be appropriated to law before implementation, such implementation is likely to get delayed by months after the advent of expansions or contractions. On the other hand, due to their very nature, unemployment benefits will automatically increase during downturns when the number of unemployed people rises and will decrease during expansions with lower unemployment rates. Thus, automatic stabilizers are expected to alleviate both recognition and implementation lags associated with fiscal policies.

Refer to the table below, which lists the U.S. federal income tax rates for the different income brackets. If the highest point on the Laffer curve corresponds to a tax rate of 30%, then which of the following statements is true? Taxable income brackets Tax rate 1 10% 2 15% 3 25% 4 28% 5 33% 6 35%

Increasing tax rates for the fifth and sixth income brackets will lead to lower tax revenue from those income brackets. Feedback As per the question, tax revenue reaches a maximum at the 30% rate. This implies that for tax rates lower than 30%, increasing tax rates will increase tax revenue (at least for small rate increases), while for tax rates higher than 30%, increasing tax rates will lower tax revenue.

The government of a country is considering two options to restore full-employment equilibrium for an economy stuck in a recession: Option (1): Allow the economy to self-adjust to full employment; Option (2): Administer an expansionary fiscal policy to restore full employment. If we compare the full-employment equilibrium achieved by either option 1 or option 2, which of the following is true?

Price level in option 1 equilibrium will be lower than that in option 2 equilibrium. Feedback Refer to Fig. 16.1 in your textbook. In both cases, when the economy moves to full-employment equilibrium, the unemployment level will be equal to the natural rate. Hence, in both cases, the employment level will be equal. On the other hand, a self-adjustment involves a rightward shift of the SRAS curve, while an expansionary fiscal policy involves a rightward shift of the AD curve. Price level will therefore be higher with the AD shift in the equilibrium achieved by option 2.

If the government decreases spending by $50 billion, predict the impact on real GDP if the MPC = 0.9.

Real GDP might fall by as much as $500 billion. Feedback The spending multiplier = 1/(1-MPC). The predicted change in real GDP from a decrease of $50 billion in government spending is: Change in Real GDP = (initial change in spending)x(spending multiplier) = (-$50 billion) x 1/(1-0.9) = -$50 billion x 10 =-$500 billion

The government of Fredonia increases its spending by $100 million to fight a recession during 2007. If the government's budget was balanced prior to the recession, which of the following is most likely to happen by the end of 2007? Assume that this policy has not yet had any positive effect by the end of 2007.

The government will have a budget deficit of more than $100 million. Feedback If the government had a balanced budget before the recession and it increases its spending by $100 million without any changes in tax rate with the onset of the recession, it seems that this will only lead to a deficit of $100 million. But remember that during the recession, income will fall with rising unemployment, resulting in lower tax revenue and thus further escalating the budget deficit.

Suppose that the president has decided to increase government spending by building more libraries. The legislation was rushed through Congress and enacted without any delay. From here, the libraries will take 10 months to plan and 2 years to build. Which of the following is true?

The planning and building of the libraries represents an impact lag of this policy. FEEDBACK: An impact lag would be present. An impact lag is the time it takes after a policy is enacted for its effects to be completely felt in the economy. In this case, the policy is all about government spending, but because it takes a long time to build the libraries, it's a while before all the money is completely paid to the construction workers and others doing the work.

For relatively lower tax rates, an increase in tax rates will __________ tax revenue.

increase Feedback Total income tax revenue depends on the level of income and the tax rate. For relatively lower tax rates, an increase in tax rates does not affect work incentives and hence doesn't change income. So increasing the tax rate in this region will lead to higher tax revenue.

The multiplier effect of fiscal policy predicts that an increase in government spending by $100 billion will increase total income by $400 billion if the marginal propensity to consume is 0.75. If we account for PARTIAL crowding out, then the increase in income will be

less than $400 billion. Feedback An increase in government spending has the effect of shifting the aggregate demand curve to the right. Crowding out has the opposite effect of reducing private spending and aggregate demand. Hence, the full impact of the increase in government spending on aggregate demand will not be realized in the presence of crowding out, and the total increase in income will be less than $400 billion.