Deck 13: Fiscal Policy, Deficits, and Debt

Question 1

Refer back to the table in Figure 12.7 in the previous chapter. Suppose that aggregate demand increases such that the amount of real output demanded rises by $7 billion at each price level. By what percent will the price level increase? Will this inflation be demand-pull inflation or will it be cost-push inflation? If potential real GDP (that is, full-employment GDP) is $510 billion, what will be the size of the positive GDP gap after the change in aggregate demand? If government wants to use fiscal policy to counter the resulting inflation without changing tax rates, would it increase government spending or decrease it? LO1

Answer 1

Real Gross Domestic Production ( GDP ) refers to the total value of all final goods and services produced given a period of time or in a year.
Aggregate Demand refers to the total amount of goods and services demanded in the economy at a given general price level and given a period of time.
Table of increases in Aggregate Demand: The new equilibrium price level is 108, where the new demand equals the supply.
Before the change the equilibrium price level was 100. The price level increases by 8%. It showed as below: The inflation is caused by an increase in demand; thus, it is a Demand-pull Inflation.
If the potential GDP IS $510 billion and the equilibrium GDP is $513 billion, there is an inflationary GDP gap of $3 billion.
The government should implement contractionary fiscal policy to eliminate the inflation. It can reduce government spending.

Question 2

How do economists distinguish between the absolute and relative sizes of the public debt? Why is the distinction important? Distinguish between refinancing the debt and retiring the debt. How does an internally held public debt differ from an externally held public debt? Contrast the effects of retiring an internally held debt and retiring an externally held debt. LO4

Answer 2

The absolute sizes of the public debt are the total number of public debt, whereas the relative sizes are the ratio of public debt to GDP. It's calculated as shown below: The distinction is important because the absolute sizes ignore the fact that the wealth and productivity of an economy is positively related to its ability to sustain public debt. The wealthier the economy, the larger size of debt it can sustain.
Refinancing the debt means to pay back older debt with the preceding from newly issued debt.
Retiring the debt means to pay back debt with assets without refinancing.
The externally held public debt is a burden to an economy, because the payment of this debt is outside of the economy. The internally held public debt is not a burden to an economy because the holders are domestic citizens and the payment is just a transfer of ownership among domestic citizens.
Retiring an internally held debt is a transfer of ownership within an economy. The internally held debt is an asset to domestic citizens. Taxpayer would pay higher taxes, and holders would receive an equal amount. Purchasing power of the economy would not change.
Retiring an externally held debt would negatively impact purchasing power. The payment enables foreigners to buy some of the output of the economy.

Question 3

The economy is in a recession. A congresswoman suggests increasing spending to stimulate aggregate demand but also at the same time raising taxes to pay for the increased spending. Her suggestion to combine higher government expenditures with higher taxes is:

A) The worst possible combination of tax and expenditure changes.
B) The best possible combination of tax and expenditure changes.
C) A mediocre and contradictory combination of tax and expenditure changes.
D) None of the above.

Answer 3

When recession occurs, an expansionary fiscal policy is needed to help alleviate this concern. The characteristics of an expansionary fiscal policy are increased government spending and reduced taxes.
Hence, the correct answer is c. A mediocre and contradictory combination of tax and expenditure changes.
Option a. is incorrect because even though this is a bad combination, this most likely wouldn't worsen the economy. These two proposals would just offset each other.
Option b. isn't correct because taxes should be lowered, not raised.
Option d. isn't correct because the correct answer is c.

Question 4

True or false? If false, explain why.
a. The total public debt is more relevant to an economy than the public debt as a percentage of GDP.
b. An internally held public debt is like a debt of the left hand owed to the right hand.
c. The Federal Reserve and federal government agencies hold more than three-fourths of the public debt.
d. The portion of the U.S. debt held by the public (and not by government entities) was larger as a percentage of GDP in 2012 than it was in 2000.
e. As a percentage of GDP, the total U.S. public debt is the highest such debt among the world's advanced industrial nations.

Question 5

(For students who were assigned Chapter 11) Use the aggregate expenditures model to show how government fiscal policy could eliminate either a recessionary expenditure gap or an inflationary expenditure gap (Figure 11.7). Explain how equal-size increases in G and T could eliminate a recessionary gap and how equal-size decreases in G and T could eliminate an inflationary gap. LO1

Question 6

Why might economists be quite concerned if the annual interest payments on the U.S. public debt sharply increased as a percentage of GDP? LO4

Question 7

(For students who were assigned Chapter 28) Assume that, without taxes, the consumption schedule for an economy is as shown below: LO1
a. Graph this consumption schedule. What is the size of the MPC?
b. Assume that a lump-sum (regressive) tax of $10 billion is imposed at all levels of GDP. Calculate the tax rate at each level of GDP. Graph the resulting consumption schedule and compare the MPC and the multiplier with those of the pretax consumption schedule.
c. Now suppose a proportional tax with a 10 percent tax rate is imposed instead of the regressive tax. Calculate and graph the new consumption schedule and note the MPC (tax inclusive) and the multiplier.
d. Finally, impose a progressive tax such that the tax rate is 0 percent when GDP is $100, 5 percent at $200, 10 percent at $300, 15 percent at $400, and so forth. Determine and graph the new consumption schedule, noting the effect of this tax system on the MPC (tax inclusive) and the multiplier.
e. Use a graph similar to Figure 30.3 to show why proportional and progressive taxes contribute to greater economic stability, while a regressive tax does not.

Question 8

Trace the cause-and-effect chain through which financing and refinancing of the public debt might affect real interest rates, private investment, the stock of capital, and economic growth. How might investment in public capital and complementarities between public capital and private capital alter the outcome of the cause-effect chain? LO4

Question 9

During the recession of 2007-2009, the U.S. federal government's tax collections fell from about $2.6 trillion down to about $2.1 trillion while GDP declined by about 4 percent. Does the U.S. tax system appear to have builtin stabilizers?

A) Yes.
B) No.

Question 10

LAST WORD What do economists mean when they say Social Security and Medicare are "pay-as-you-go" plans? What are the Social Security and Medicare trust funds, and how long will they have money left in them? What is the key long-run problem of both Social Security and Medicare? Do you favor increasing taxes or do you prefer reducing benefits to fix the problem?

Question 11

Some politicians have suggested that the United States enact a constitutional amendment requiring that the Federal government balance its budget annually. Explain why such an amendment, if strictly enforced, would force the government to enact a contractionary fiscal policy whenever the economy experienced a severe recession. LO1

Question 12

Refer to the following table for Waxwania:
What is the marginal tax rate in Waxwania? The average tax rate? Which of the following describes the tax system: proportional, progressive, regressive?

Question 13

Last year, while an economy was in a recession, government spending was $595 billion and government revenue was $505 billion. Economists estimate that if the economy had been at its full-employment level of GDP last year, government spending would have been $555 billion and government revenue would have been $550 billion. Which of the following statements about this government's fiscal situation are true?

A) The government has a non-cyclically adjusted budget deficit of $595 billion.
B) The government has a non-cyclically adjusted budget deficit of $90 billion.
C) The government has a non-cyclically adjusted budget surplus of $90 billion.
D) The government has a cyclically adjusted budget deficit of $555 billion.
E) The government has a cyclically adjusted budget deficit of $5 billion.
F) The government has a cyclically adjusted budget surplus of $5 billion.

Question 14

Explain how built-in (or automatic) stabilizers work. What are the differences between proportional, progressive, and regressive tax systems as they relate to an economy's built-in stability? LO2

Question 15

Refer to the table for Waxwania in problem 4. Suppose that Waxwania is producing $600 of real GDP, whereas the potential real GDP (or full-employment real GDP) is $700. How large is its budget deficit? Its cyclically adjusted budget deficit? Its cyclically adjusted budget deficit as a percentage of potential real GDP? Is Waxwania's fiscal policy expansionary or is it contractionary?

Question 16

Label each of the following scenarios in which there are problems enacting and applying fiscal policy as being an example of either recognition lag, administrative lag, or operational lag.
a. To fight a recession, Congress has passed a bill to increase infrastructure spending-but the legally required environmental-impact statement for each new project will take at least two years to complete before any building can begin.
b. Distracted by a war that is going badly, inflation reaches 8 percent before politicians take notice.
c. A sudden recession is recognized by politicians, but it takes many months of political deal making before a stimulus bill is finally approved.
d. To fight a recession, the president orders federal agencies to get rid of petty regulations that burden private businesses-but the federal agencies begin by spending a year developing a set of regulations on how to remove petty regulations.

Question 17

Define the cyclically-adjusted budget, explain its significance, and state why it may differ from the actual budget. Suppose the full-employment, noninflationary level of real output is GDP3 (not GDP2) in the economy depicted in Figure 30.3. If the economy is operating at GDP2, instead of GDP3, what is the status of its cyclically-adjusted budget? The status of its current fiscal policy? What change in fiscal policy would you recommend? How would you accomplish that in terms of the G and T lines in the figure? LO3

Question 18

What is the role of the Council of Economic Advisers (CEA) as it relates to fiscal policy? Use an Internet search to find the names and university affiliations of the present members of the CEA. LO1

Question 19

Suppose that a country has no public debt in year 1 but experiences a budget deficit of $40 billion in year 1, a budget deficit of $20 billion in year 2, a budget surplus of $10 billion in year 3, and a budget deficit of $2 billion in year 4. What is the absolute size of its public debt in year 4? If its real GDP in year 4 is $104 billion, what is this country's public debt as a percentage of real GDP in year 4? LO4

Question 20

Assume that a hypothetical economy with an MPC of.8 is experiencing severe recession. By how much would government spending have to rise to shift the aggregate demand curve rightward by $25 billion? How large a tax cut would be needed to achieve the same increase in aggregate demand? Determine one possible combination of government spending increases and tax increases that would accomplish the same goal without changing the amount of outstanding debt. LO1

Question 21

In January, the interest rate is 5 percent and firms borrow $50 billion per month for investment projects. In February, the federal government doubles its monthly borrowing from $25 billion to $50 billion. That drives the interest rate up to 7 percent. As a result, firms cut back their borrowing to only $30 billion per month. Which of the following is true?

A) There is no crowding-out effect because the government's increase in borrowing exceeds firm's decrease in borrowing.
B) There is a crowding-out effect of $20 billion.
C) There is no crowding-out effect because both the government and firms are still borrowing a lot.
D) There is a crowding-out effect of $25 billion.

Question 22

Which of the following would help a government reduce an inflationary output gap?
a. Raising taxes.
b. Lowering taxes.
c. Increasing government spending.
d. Decreasing government spending.

Question 23

Briefly state and evaluate the problem of time lags in enacting and applying fiscal policy. Explain the idea of a political business cycle. How might expectations of a near-term policy reversal weaken fiscal policy based on changes in tax rates? What is the crowding-out effect, and why might it be relevant to fiscal policy? In view of your answers, explain the following statement: "Although fiscal policy clearly is useful in combating the extremes of severe recession and demand-pull inflation, it is impossible to use fiscal policy to fine-tune the economy to the full-employment, noninflationary level of real GDP and keep the economy there indefinitely." LO1

Question 24

What are government's fiscal policy options for ending severe demand-pull inflation? Which of these fiscal options do you think might be favored by a person who wants to preserve the size of government? A person who thinks the public sector is too large? How does the "ratchet effect" affect anti-inflationary fiscal policy? LO1

Question 25

Suppose that the investment demand curve in a certain economy is such that investment declines by $100 billion for every 1 percentage point increase in the real interest rate. Also, suppose that the investment demand curve shifts rightward by $150 billion at each real interest rate for every 1 percentage point increase in the expected rate of return from investment. If stimulus spending (an expansionary fiscal policy) by government increases the real interest rate by 2 percentage points, but also raises the expected rate of return on investment by 1 percentage point, how much investment, if any, will be crowded out? LO4