Edge Ex: Fiscal Policy

Output in Econoland falls $100 billion short of full employment output. What is the minimum increase in government expenditures necessary to bring output up to the full-employment level if the marginal propensity to save is 0.20?

$20 billion

The government of Econoland decides to spend $10 billion on road repair. As a result, equilibrium income rises by a total of $50 billion (without any crowding out). Based on this information, calculate the marginal propensity to save (MPS) in Econoland.

.2

State the numerical value of the initial impact of the increase in government spending on aggregate demand?

100

The government of Econoland decides to spend 100 billion dollars on road and bridge repair. What is the initial impact to aggregate demand?

100 billion initial increase to aggregate demand

You can use the spending multiplier = 1/(1-MPC). If the MPC = 0.75, what is the maximum amount output could increase from this increase in government spending?

400

If the marginal propensity to consume (MPC) is equal to 0.75, calculate the maximum possible change in real gross domestic product that could result from the $100 billion increase in government spending.

400 Billion Multiplier - 4

If the Marginal Propensity to Consume (MPC) equals .75, what is the maximum potential impact of the spending on road and bridge repair on Output and RGDP?

400 billion maximum increase to Output (RGDP)

A politician promises to cut taxes and to cut spending by an equal amount. The candidate assures voters that there will be no impact on the economy, since the tax cut and the spending cut are equal. Explain to your friend the problem with the candidate's assertion.

A tax cut with an equal spending cut has a negative impact on output in the short run. Since the tax cut will increase incomes, it is true that people will spend more. But, they won't spend all of the tax cut: they will save a portion of their increased after-tax income. The spending cut, however, will cause output to fall by the full amount of the spending reduction, so more jobs will likely be lost from the spending cut than are gained from the tax cut.

The economy in Econoland is operating in the Classical range of the aggregate supply curve. If the government increases transfer payments, what happens to aggregate demand, output, and the price level?

AD & Prices increases but output stays the same

If the government increases transfer payments, what is the most likely impact on aggregate demand, the price level, and short-run output?

All 3 increase

Now assume that instead of financing the $100 billion increase in government spending through borrowing, the government increases taxes by $100 billion. With this equal increase in government spending and taxes, will the real gross domestic product increase, decrease, or remain the same? Explain.

An increase in government purchases combined with an increase in taxes will still have a positive effect on aggregate demand and output. The balanced budget multiplier equals 1, so the $100 billion spending increase, combined with a $100 billion tax increase will raise AD by $100 billion.

What is the relationship between real interest rates and investment?

As real interest rates fall, investment spending rises

Which of the following is NOT a drawback of fiscal policy?

Fiscal policy can be used to enhance the effects of monetary policy.

How will the increase in government spending affect cyclical unemployment and the natural rate of unemployment?

Government spending will increase aggregate demand, output, and employment. This causes cyclical unemployment to fall. There is no change in the natural rate of unemployment.

In a closed economy with no taxes in which the average propensity to consume is 0.75, which of the following is true?

If income is $100, then saving is $25.

If the marginal propensity to consume (MPC) in Econoland is 0.9, what is the maximum amount that the equilibrium gross domestic product could change if government purchases (G) increase by $1 billion?

If the MPC is .9 then the MPS is .1. The multiplier in this case is 10, calculated by 1/MPS or 1/.1=10. With a $1 billion increase in government spending, the maximum change in real GDP in this case is $1 billion X 10 or $10 billion.

Output in Econoland falls $100 billion short of full-employment output. What is the minimum decrease in personal income taxes necessary to bring output up to the full-employment level if the marginal propensity to save is 0.20?

If the MPS = 0.20, then the spending multiplier = 1/0.2 = 5. The tax multiplier equals -MPC/MPS or the spending multiplier minus 1. In this case, the tax multiplier equals -0.80/0.20 equals -4. Since a $100 billion increase in output would close the unemployment gap, we divide $100 billion by the tax multiplier (4) and get $25 billion. To check: a $25 billion decrease in personal income taxes with an MPS of 0.20 can yield an increase in output of $25 billion times 4 = $100 billion.

Calculate the amount of government purchases (G) necessary to close the unemployment gap. Is this an increase or a decrease in G?

Increase

If government spending causes government budget deficits to add to the public debt and push up interest rates, how would an increase in government spending of $100 million affect output if the marginal propensity to consume equals 0.5?

Investment may be crowded out, and AD and output would increase by less than $200 million

Calculate the amount of a tax change necessary to close the unemployment gap. Is this a larger or smaller change in taxes than the change in G (in question above)?

Larger

If government spending causes government budget deficits to add to the public debt and push up interest rates, how would an increase in G of $100 million affect net exports?

Net Exports would fall because the higher interest rates make U.S. dollar assets more attractive to foreign savers and the value of the U.S. Dollar would rise

If the government spends $1 billion on infrastructure improvements and the marginal propensity to consume is 0.75, which of the following is true?

Output may increase by as much as $4 billion

In what portion of the aggregate supply curve must the economy be operating in order for real gross domestic product to expand the maximum?

The full multiplier effect would only be reflected in output if prices did not rise. That only happens in the horizontal, or Keynesian, portion of the curve.

Which of the following will occur if the federal government runs a budget deficit?

The size of the national debt will increase

Suppose the government raises taxes by $600 million. If the MPC is .75, what is the initial impact of the tax increase on aggregate demand? What is the maximum amount output could decrease from this increase in taxes?

The tax increase reduces after-tax income which, in turn, reduces consumption by the MPC. $600 million times .75 = $450 million. Consumption and aggregate demand decrease by $450 million initially. Using the autonomous spending multiplier, the change in consumption spending of $450 can be multiplied by 4, giving us a maximum change in output of $1800 million. Using the tax multiplier of 3, the ultimate impact on aggregate demand and output is 3 times $600 million = $1,800 million.

Government Spending generally falls into two categories, spending on goods and services and:

Transfer Payments

In an economy at full employment, a presidential candidate proposes cutting the government debt in half in four years by increasing income tax rates and reducing government expenditures. According to Keynesian theory, implementation of these policies is most likely to increase: consumer prices.

Unemployment

Which of the following will result in the greatest increase in aggregate demand?

a $100 increase in government expenditures coupled with a $100 decrease in taxes

Which of the following fiscal policy actions would have the largest impact on aggregate demand and RGDP?

a $100 million increase in government purchases of goods and services when the economy is in short-run equilibrium with output below full-employment output

Which of the following would result in the largest increase in aggregate demand?

a $30 billion increase in military expenditure and a $30 billion decrease in personal income taxes

Which of the following would increase the value of the spending multiplier?

a decrease in the Marginal Propensity to Save (MPS)

Which of the following changes would cause an economy's aggregate demand curve to shift to the right?

an increase in autonomous consumption spending correct

The sum of which of the following expenditures is equal to the value of the gross domestic product?

consumer purchases, investment for capital goods, government purchases and net exports

Econoland is experiencing high inflation rates. What fiscal policy would be appropriate to address the inflationary gap?

decrease government purchases and increase taxes

If the economy was in a severe recession, the most expansionary fiscal policy would be to:

decrease personal income taxes and increase government spending by equal amounts

When government budget deficits lead to higher public debt, interest rates may rise. A rise in interest rates may lead to which of the following?

decreased private investment, known as "crowding out" correct

Which of the following explains why higher interest rates from a U.S. government budget deficit can decrease exports?

dollar-denominated financial assets become more attractive, increasing demand for the dollar, and the stronger dollar makes exports relatively less affordable

"Crowding out" occurs when:

government borrowing leads to higher interest rates which discourages private investment

Crowding out occurs when:

government borrowing to finance its spending decreases private sector investment

Under which of the following circumstances would expansionary fiscal policy be most effective?

high unemployment and low inflation

Econoland is in short-run equilibrium with output below full employment. Which of the following would be an appropriate fiscal policy to increase output and decrease unemployment?

increase government purchases and decrease taxes

What are the three primary goals for every economy?

price stability, full employment, economic growth

When people with higher incomes pay a higher tax rate and those with lower incomes pay a lower tax rate, we say that the income tax is:

progressive

Expansionary fiscal policy will be most effective when

the aggregate supply curve is horizontal.

If a large increase in total spending has no effect on real gross domestic product, it must be true that:

the price level is rising.