Deck 11: Fiscal Policy

Question 1

FISCAL POLICY Define fiscal policy. Determine whether each of the following, other factors held constant, would lead to an increase, a decrease, or no change in the level of real GDP demanded:
a. A decrease in government purchases
b. An increase in net taxes
c. A reduction in transfer payments
d. A decrease in the marginal propensity to consume

Answer 1

Fiscal Policy:
Fiscal policy is made by the government, which includes government purchases, taxes, transfer payments, and borrowings. This policy affects directly or indirectly macroeconomic variables such as real GDP, employment, price level, and growth of the economy.
a.Impact of government purchases on real GDP:
If the government purchases decrease, then the consumption and investment of the economy also decreases. As a result, the real GDP of the economy will decrease.
B.Impact of net taxes on real GDP:
An increase in net tax will reduce the disposable income of the tax payers. The fall in disposable income will reduce both the consumption and saving of an economy. As a result, the real GDP of the economy will fall.
C.Impact of transfer payment on real GDP:
Transfer payment is the payment collected during the time of exchange of goods and services. Hence, reduction of transfer payment will increase the consumption level, thereby the real GDP of an economy will increase.
D.Impact of marginal propensity to consume on GDP:
Decrease in marginal propensity to consume implies that less proportion of income is spent for consumption. Hence, the demand for goods and services will reduce due to low income. As a result, real GDP of an economy will decrease.

Question 2

THE MULTIPLIER AND THE TIME HORIZON Explain how the steepness of the short-run aggregate supply curve affects the government's ability to use fiscal policy to change real GDP.

Answer 2

Fiscal policy under steeper supply curve:
A steeper supply curve indicates that the quantity supply is less sensitive to the change in price.
A steeper short-run aggregate supply curve would be less sensitive to the fiscal policy. It means expansionary fiscal policy (which aims to expand the level of output) will have less effect on output; as a result, price level will increase. Similarly, a contractionary fiscal policy (which is made to reduce the output level) will have less effect on output; as a result, price level will decrease.
Therefore, in case of steeper aggregate supply curve, the regulation of fiscal policy will have a less effect on real GDP and more effect on price level.

Question 3

EVOLUTION OF FISCAL POLICY What did classical economists assume about the flexibility of prices, wages, and interest rates? What did this assumption imply about the self-correcting tendencies in an economy in recession? What disagreements did Keynes have with classical economists?

Answer 3

Classical economists views on self-correcting mechanism:
According to classical economists, full employment can be achieved by altering price, wage, and rate of interest in an economy. Therefore, price, wage, and rate of interest should be more flexible to alter the disequilibrium aggregate demand and aggregate supply. Hence, at full employment level, aggregate demand-supply identity holds.
Classical theory believes in self-correcting mechanism. If the aggregate demand is less than aggregate supply, then decreasing price or rate of interest or increasing the wage would bring the aggregate demand to equilibrium level. Hence, the recession can be automatically adjusted.
On the contrary, Keynes assumed that achieving full employment is not possible because change in price or wage will affect the effective demand. If an economy reduces price or increases wage rate to remove the excess demand, then it would cause a fall in effective demand , which in turn will move the economy to recession. Hence, the disequilibrium in aggregate demand and aggregate supply should be adjusted by change in output level and not through price or wage levels.

Question 4

AUTOMATIC STABILIZERS Often during recessions, the number of young people who volunteer for military service increases. Could this rise be considered a type of automatic stabilizer? Why or why not?

Question 5

PERMANENT INCOME "If the federal government wants to stimulate consumption by means of a tax cut, it should employ a permanent tax cut. If the government wants to stimulate saving in the short run, it should employ a temporary tax cut." Evaluate this statement.

Question 6

FISCAL POLICY Explain why effective discretionary fiscal policy requires information about each of the following:
a. The slope of the short-run aggregate supply curve
b. The natural rate of unemployment
c. The size of the spending multiplier
d. The speed with which self-correcting forces operate

Question 7

AUTOMATIC STABILIZERS Distinguish between discretionary fiscal policy and automatic stabilizers. Provide examples of automatic stabilizers. What is the impact of automatic stabilizers on disposable income as the economy moves through the business cycle?

Question 8

FISCAL POLICY EFFECTIVENESS Determine whether each of the following would make fiscal policy more effective or less effective:
a. A decrease in the marginal propensity to consume
b. Shorter lags in the effect of fiscal policy
c. Consumers suddenly becoming more concerned about permanent income than about current income
d. More accurate measurement of the natural rate of unemployment

Question 9

FROM DEFICITS TO SURPLUSES TO DEFICITS What effect did the financial crisis of 2008 have on the federal budget deficit?

Question 10

Case Study: Cash for Clunkers
Studies indicate that the "Cash-for-Clunkers" program only shifted sales from later to earlier in 2009. Assuming that this is true, what was the spending multiplier for the program?

Question 11

FISCAL POLICY WITH AN EXPANSIONARY GAP Using the aggregate demand-aggregate supply model, illustrate an economy with an expansionary gap. If the government is to close the gap by changing government purchases, should it increase or decrease those purchases? In the long run, what happens to the level of real GDP as a result of government intervention? What happens to the price level? Illustrate this on an AD-AS diagram, assuming that the government changes its purchases by exactly the amount necessary to close the gap.

Question 12

FISCAL POLICY DURING THE GREAT RECESSION Using the aggregate demand-aggregate supply model, illustrate what President Obama was trying to accomplish with the $831 billion stimulus program. What were some costs and benefits of this program?

Question 13

CHANGES IN GOVERNMENT PURCHASES Assume that government purchases decrease by $10 billion, with other factors held constant, including the price level. Calculate the change in the level of real GDP demanded for each of the following values of the MPC. Then, calculate the change if the government, instead of reducing its purchases, increased autonomous net taxes by $10 billion.
a. 0.9
b. 0.8
c. 0.75
d. 0.6

Question 14

FISCAL MULTIPLIERS Explain the difference between the government purchases multiplier and the net tax multiplier. If the MPC falls, what happens to the tax multiplier?

Question 15

CHANGES IN NET TAXES Using the income-expenditure model, graphically illustrate the impact of a $15 billion drop in government transfer payments on aggregate expenditure if the MPC equals 0.75. Explain why it has this impact. What is the impact on the level of real GDP demanded, assuming the price level remains unchanged?

Question 16

FISCAL POLICY This appendix shows how increased government purchases, with taxes held constant, can eliminate a recessionary gap. How could a tax cut achieve the same result? Would the tax cut have to be larger than the increase in government purchases? Why or why not?