Deck 14: The Fiscal Policy Dilemma

Question 1

What is the difference between demand side policies and supply side policies?

Answer 1

Demand side policies are short-term policies that attempt to stimulate the economy by managing the demand (expenditures) side of the economy.They are conducted by shifting the aggregate demand of the economy.Supply side policies are long-term policies that attempt to change the long-run aggregate supply and, thus, the potential output of the economy.When conducted, they shift the long-run aggregate supply of the economy.

Question 2

What is the difference between "sound finance" and "functional finance"? Why did the advocates of each view of public finance take such different positions?

Answer 2

Sound finance was a view of public finance and fiscal policy that the government budget should always be balanced except in wartime.Functional finance held that as a theoretical proposition, governments should make spending and taxing decisions on the basis of their effect on the economy.Under functional finance if spending in the economy was too low, the government should run a deficit; if spending was too high, the Government should run a surplus.
Prior to the Great Depression, economists favored sound finance primarily on political grounds.Economists at the time viewed government with suspicion, so any policy that would make it easier to increase government spending during peacetime was seen as undesirable.The advocates of functional finance were totally focused on the need for government to steer the economy.In their writings, there was no discussion of politics or whether the recession was a major one or a minor one.

Question 3

Six key assumptions underlie models of fiscal policy.All of them are likely to be violated in the context of real world macroeconomic problems.Explain how any three of the following assumptions are likely to fail in the real world.
(a) Financing the deficit doesn't have any offsetting effects.
(b) The government knows what the current situation is.
(c) The government knows the economy's potential income level.
(d) The government has great flexibility in changing spending and taxes.
(e) The size of the government debt doesn't matter.
(f) Fiscal policy doesn't negatively affect other government goals.

Answer 3

(Any three of the following)
(a) Financing a deficit often crowds out private investment expenditure.The crowding out effect is caused by the government's sale of bonds to finance expansionary fiscal policy.The crowding out effect also works in reverse with contractionary fiscal policy.
(b) Most economic data are published quarterly and it takes six to nine months of data to know which way the economy is moving.So we could be halfway through a recession before we know it.We try to solve this problem with forecasting models but: "Economic forecasting is an art, not a science."
(c) Okun's rule of thumb tells us that if we push income above its potential level, we are likely to cause inflation.If we push income below its potential level, we are likely to cause a recession.But no one knows what the potential level of income really is.Most estimates of the level of unemployment at the potential level of income range from 3 to 6 percent.And the true value may be constantly changing.
(d) Putting fiscal policy in place takes time and has serious implementation problems.The budget process begins almost 18 months before actual changes in spending or taxes are implemented.Furthermore, almost two thirds of government spending is non-discretionary (e.g.Medicare and Social Security), Finally, politicians are under intense pressure to increase spending even as they cut taxes and even in the face of inflationary pressures.
(e) The size of the government debt matters because interest payments on the debt are a major form of non-discretionary spending.The larger the national debt, the harder it will be to cut government expenditures in response to inflationary pressures.
(f) We are currently engaged in a costly "War on Terror".Even if rising prices in important sectors, such as housing and transportation, signal the creation of dangerous inflationary expectations, it may not be possible to cut military spending as part of an anti-inflationary fiscal policy.

Question 4

What is the difference between a policy and a policy regime?

Question 5

Why did proponents of sound finance oppose deficit spending?

Question 6

What is the Ricardian equivalence theorem? What is the significance of this theorem for government deficit financing?

Question 7

What is the crowding out effect? Using the AS/AD model, demonstrate graphically and explain in words the impact of expansionary fiscal policy on the crowding out effect.

Question 8

Empirical evidence over the past two decades suggests that the percentage of unemployed who receive unemployment insurance has been declining, and in 2017 only about 27% of unemployed persons collected benefits.What does this decline do to the impact of unemployment insurance as an automatic stabilizer?

Question 9

Many economists argue that certain rules must guide the use of economic policies.What are the benefits and costs of economic policies conducted by rules?

Question 10

What fiscal policy was implemented in response to the financial crisis of 2008? How does this fit into the broader discussion of sound versus functional finance?

Question 11

What is the Ricardian Equivalence Theorem and why is it important to debates about fiscal policy?

Question 12

What is meant by "sound finance"?

Question 13

Why is unemployment insurance an automatic stabilizer and how does it work? How does the decline in the percentage of unemployed who receive unemployment insurance in the 2000s impact the effectiveness of unemployment insurance as an automatic stabilizer?

Question 14

Consider the following quote from your text, "Some economists argue that crowding out can totally offset the expansionary effect of fiscal policy..." Demonstrate graphically the case where the crowding out effect does "completely negate" the effect of expansionary fiscal policy.Explain your diagram, making sure to define the crowding out effect in your answer.

Question 15

What is meant by "functional finance"?

Question 16

What are three advantages and disadvantages of expansionary fiscal policy?