Fiscal PolicyFiscal Policy

““G” & “T” Striking Out AG” & “T” Striking Out A Recession Recession

John Maynard KeynesJohn Maynard Keynes““Father of Fiscal Policy”Father of Fiscal Policy”

FISCAL FISCAL POLICYPOLICY

Even if I have to dig a hole and cover it back up, I do have a job.

IntroductionIntroduction• This chapter confronts the following questions:

1. Can government spendinggovernment spending and and tax tax policiespolicies help ensure full employment?

2. What policy actions will help fight inflationfight inflation?

3. What are the roles of roles of governmentgovernment interventionintervention?

TTaxes (“T”)axes (“T”) and and “G”“G”SpendingSpending

• Up until 1915, the federal government collected few taxes and spent little.

• In 19021902, it employed fewer than 350,000 people and spent $650 million.

• Today, it employs nearly 5 million people and spends more than $2.5 trillion.

Government RevenueGovernment Revenue• Government expansion started with the 16th

Amendment to the U.S. Constitution (1913)

which extended the taxing power to incomes.

• Today, the federal government collects over $2 trillion a year in tax revenues.

Re

al I

nte

res

t R

ate

, (p

erc

en

t)

Quantity of Loanable Funds

Loanable Funds MarketLoanable Funds Market[*Use this graph if there is a chg in savings by consumers or chg in fiscal policy][*Use this graph if there is a chg in savings by consumers or chg in fiscal policy]

[*[*Use theUse the Money Market graphMoney Market graph when there is awhen there is a change in MSchange in MS]]

IIRR==88%%

DD11

FF11

SS

Starting from a balanced budgetbalanced budget, if theG incr spendingG incr spending or decr Tdecr T to get out ofa recessionrecession, they would now be runninga deficitdeficit and have to borrow, pushing pushing up demand in the LFMup demand in the LFM and increasing increasing the interest ratethe interest rate.

DD22

IIRR==1010%%

FF22

EE11

EE22

Use the “real interest rate”“real interest rate” withLFMLFM, because it is long-termlong-term.Use “nominal interest rate”“nominal interest rate” withmoney marketmoney market, as it is short-termshort-term.

BorrowersBorrowers LendersLenders

Demand for Loanable Funds MarketDemand for Loanable Funds Market(a)(a) (b)(b)

Demand for Loanable

Funds at 3% [no G borrowing]

Business firms demand for

Loanable Funds at 3%[a lot of investment]

RateInterest

3%3%

SSDD1[1[nono G]G]

LFMLFM

AA AA

Trillions of DollarsTrillions of Dollars

3%3%

1.51.5

Trillions of DollarsTrillions of Dollars QIDQID

DDII

Low interest rates, so Low interest rates, so - a lot of investment- a lot of investment

Real

Demand for Loanable Funds MarketDemand for Loanable Funds Market(a)(a) (b)(b)

RateInterest

3%3%

SSDD1[1[nono G]G]

LFMLFM

AA

Trillions of DollarsTrillions of Dollars

3%3%

1.51.5

Trillions of DollarsTrillions of Dollars QIDQID11

DDII

With “G” borrowing, the With “G” borrowing, the

demanddemand for for LFLF at at 55%%

Business firms dBusiness firms demandemand for for

LoanableLoanable Funds at Funds at 55%%[not as much investment][not as much investment]

DD22(G)(G)

5%5% BB

QID2QID2 QID1QID1

Higher interest rates, soHigher interest rates, sonot as much investmentnot as much investment

5%5%

1.01.0

Government Demand for FundsGovernment Demand for Funds Business Demand for FundsBusiness Demand for Funds

AABB

Real

BBalancedalanced BBudget [$2 Tudget [$2 Tril. ril. “G” = $2 T“G” = $2 Tril. ril. “T”]“T”]

$2 $2 TrillionTrillion $2 $2 TrillionTrillion

GG TT

RecessionRecessionIncr G to $2.2 Incr G to $2.2

or or

Decr T to $1.8 Decr T to $1.8

DeficitDeficit so sohigher I.R.higher I.R.

InflationInflationDecr G to $1.8Decr G to $1.8

or or

Incr T to $2.2Incr T to $2.2

Surplus Surplus sosoLower I.R.Lower I.R.

BudgetBudget

So expansionary fiscal policySo expansionary fiscal policyleads to leads to higher interest rateshigher interest rates.. DeficitDeficit

Wow! AWow! Asurplussurplus

So, contractionary fiscal policySo, contractionary fiscal policy

leads to leads to lower interest rateslower interest rates..

Gonna have Gonna have to borrowto borrow

Real GDP Q

PL SRASSRASADAD22

YYRR YYFF

Expansionary Fiscal PolicyExpansionary Fiscal Policy [[Incr GIncr G; ; Decr TDecr T]]

PPL1L1

ADAD11

PLPL22

GG ADAD Y/Empl./PL;Y/Empl./PL; GG LFMLFM II.R..R.

TT DDII CC ADAD Y/Emp/PL;Y/Emp/PL; TT LFMLFM IIRR

Start from a Start from a Balanced BudgetBalanced BudgetG & T = $2 TrillionG & T = $2 Trillion

$$2 T 2 T $2 T$2 T

““I can’t I can’t get a job.”get a job.”

““NNowow, , this isthis is better.”better.”

GG TT EE11EE22

LRASLRAS

Real GDP Q

PL ASAS

ADAD22

YYIIYYFF

Contractionary Fiscal PolicyContractionary Fiscal Policy

[Decr G; [Decr G; Incr TIncr T to close ato close a contractionary gap contractionary gap]]

PPL1L1

ADAD11

PLPL22

GG ADAD Y/Empl./PL;Y/Empl./PL; GG LFMLFM II.R..R.

TT DDII CC ADAD Y/Emp/PL;Y/Emp/PL; TT LFMLFM IRIR

Start from a Start from a Balanced BudgetBalanced BudgetG & T = $2 TrillionG & T = $2 Trillion

$2T$2T $2T$2T GG TT [like we have [like we have

““money trees”money trees”]]

EE11

EE22

Everyone Wants To Go To HeavenEveryone Wants To Go To HeavenBut No One Wants To Die.But No One Wants To Die.

Everyone Wants Government SpendingEveryone Wants Government SpendingBut No One Wants To Pay Taxes.But No One Wants To Pay Taxes.

Expansionary Expansionary Fiscal PolicyFiscal Policy

Recessionary GapRecessionary Gap

TTGG

Fiscal Policy DuringFiscal Policy During RecessionRecession

SRASSRAS

AD2AD2

YYRR YY**

AD1AD1

Keynes and Lydia LopokovaKeynes and Lydia Lopokova

Expansionary Expansionary Fiscal PolicyFiscal Policy

Inflationary GapInflationary Gap

TT

GG

Fiscal Policy DuringFiscal Policy During InflationInflation

SRASSRAS

AD2AD2

YY** YYII

AD1AD1

Contractionary Contractionary Fiscal PolicyFiscal Policy

GG

TT

Nondiscretionary Fiscal Policy (Automatic stabilizers)Nondiscretionary Fiscal Policy (Automatic stabilizers)1. Transfer PaymentsTransfer Payments

A. Welfare checks B. Unemployment checks C. Food Stamps D. Social SecurityE. Corporate dividends F. Veteran’s benefits

2. Progressive Income TaxesProgressive Income Taxes

Automatic StabilizersAutomatic Stabilizers The automatic stabilizers may be called the automatic pilotautomatic pilot of our economyof our economy, not very well suited for takeoffs and landings, but fine for the smooth part of the flight. But when the going getsgoing gets roughrough, the economy must use manual controlsmust use manual controls. [discretionary G&Tdiscretionary G&T]

Automatic stabilizersAutomatic stabilizerstake take 33-50%33-50% out. out.SStabilizerstabilizers are like aare like a thermostat thermostatmaintaining temperature.maintaining temperature.

YYRR ; ; TT ; ; ADAD22

YYII ; T ; AD ; T ; AD33

ADAD22

ADAD22

ADAD33

YYR R Y* Y* YYII

ASAS

3333%%-50-50%%

A pilot may take a stroll thrupilot may take a stroll thru & let the co-pilot cruiseco-pilot cruise. If there is turbulenceturbulence, the pilot will rush back to the cockpitpilot will rush back to the cockpit [President & Congress] and use manualuse manual controlscontrols to to correct correct economic turbulenceeconomic turbulence. Discretionary Discretionary fiscal policy is our manual control systemfiscal policy is our manual control system.

BUILT-IN STABILITYBUILT-IN STABILITY

GDPGDP11 GDPGDP22 GDPGDP33

Real Domestic Output, GDP

Go

ve

rnm

en

t E

xp

end

itu

res,

G, a

nd

Tax

Re

ven

ues

, T

DeficitDeficit

Surplus

TaxesTaxes

GG

YYRR Y*Y* YYii

More vertical [more progressive], More vertical [more progressive], the more stability for the economy.the more stability for the economy.

TransfersTransfers

SurplusSurplus

Fewer Fewer TransfersTransfers

MoreMoreTransfersTransfers

Less TaxLess TaxMoneyMoney

Keynesian Keynesian ModelModel

Recess.

GapInflat.Gap

Discretionary Discretionary Fiscal Policy Fiscal Policy

Deliberate use of government spending and/or taxing.

““G” and “T”G” and “T”

Nondiscretionary Nondiscretionary Fiscal PolicyFiscal Policy

Automatic StabilizersAutomatic Stabilizers1.Welfare & food stamps1.Welfare & food stamps2. Unemploy. insurance2. Unemploy. insurance3. Social security3. Social security4. Corporate Dividends4. Corporate Dividends5. ProgressiveProgressive Tax System Tax System

Unempl. checkUnempl. check

Discretion of CongressDiscretion of Congress

Suppose the economy is in Suppose the economy is in recessionrecession::

Real GDPReal GDPTaxTax

collectionscollections

Transfer Transfer paymentspayments

GG > TTThe deficit growsThe deficit grows

Fiscal PolicyFiscal Policy Automatic stabilizersAutomatic stabilizers..

ASAS

ADAD22ADAD11

““Recession”Recession”YYRR Y*Y*

PL

If the economy If the economy has anhas an inflationaryinflationary gap: gap:

TaxTaxcollectionscollections

Transfer Transfer paymentspayments

GG < TTThe surplus growsThe surplus grows

Fiscal PolicyFiscal Policy Automatic stabilizers.Automatic stabilizers.

Real GDPReal GDPASAS

““Inflationary Gap”Inflationary Gap”

ADAD22

ADAD11

Y*Y* YYII

PL

Discretionary Fiscal PolicyDiscretionary Fiscal Policy

DiscretionaryDiscretionary

Contractionary Contractionary Fiscal PolicyFiscal Policy

1.1. Decrease “G”Decrease “G”2.2. Increase “T”Increase “T”

Expansionary Fis. PolicyExpansionary Fis. Policy1.1. Increase “G”Increase “G”2.2. Decrease “T”Decrease “T”

The Kennedy/Johnson $10 Bil. Tax Cuts of The Kennedy/Johnson $10 Bil. Tax Cuts of 19641964

The The “Golden Age of Fiscal Policy”“Golden Age of Fiscal Policy”

When Kennedy came into office:

1. The top marginal tax rate was 9191%%

and drops to 52%drops to 52% compared to 35%35% today.2. The unemployment rate was 6.76.7%%

and drops below 5%below 5%.3. A recessionrecession becomes a very

good low unemployment-low low unemployment-low inflation inflation (2%)(2%) economy economy

4. The expansionexpansion continued to 1969.

Fiscal Policy and Tax CutsFiscal Policy and Tax Cuts.

BUILT-IN STABILITYBUILT-IN STABILITY

Tax ProgressivityTax Progressivity• Progressive Tax System–takes more from high income high income

groupsgroups• Proportional Tax System – flat rate tax takes same takes same

from all income groupsfrom all income groups• Regressive Tax System – takes more from low income low income

groupsgroups

The more progressive the tax system, the The more progressive the tax system, the greater the economy’s built-in stabilitygreater the economy’s built-in stability

Keynesian Policy: Keynesian Policy: ““Balance Balance the the Economy, Economy, not thenot the Budget Budget.”.”

DeficitsDeficits SurplusesSurpluses““Even if the jobsEven if the jobsareare digging holes digging holes and filling them upand filling them up.”.”

2. Just print the money2. Just print the money [Money creation – lower interest rates[Money creation – lower interest rates so this would be more expansionary]so this would be more expansionary]

FINANCING OFFINANCING OF DEFICITSDEFICITS [Should we[Should we borrowborrow or or justjust printprint the the moneymoney?]?]

1. Borrowing 1. Borrowing from thefrom the public public [results in higher interest rates[results in higher interest rates which crowds out investmentwhich crowds out investment]]

7%7%4%4%

MS1 MS1 MS2MS2

ASASADAD22

YY** Y Y

But the LR increase in MS resultsBut the LR increase in MS results

in an in an increase in inflationincrease in inflationPLPL11

PLPL22 ADAD11

Lower Lower II.R..R.

HigherHigherI.R.I.R.

How To Dispose of SurplusesHow To Dispose of Surpluses[Should we [Should we hold the surplushold the surplus or or give it backgive it back]]

1. Debt Retirement1. Debt Retirement [Give the surplus back during recessions to get lower interest rates and expand the economy]

ASASADAD22

Y*Y* YYII

2. Impound The Surplus2. Impound The Surplus [Keep the surplus during inflations and give it back during recessions]

PLPLADAD11

DDII

Investment (billions of dollars)

Rea

l in

tere

st r

ate

(%)

THE “CROWDING OUT” THE “CROWDING OUT” EFFECT EFFECT [Incr G incr I.R. [Incr G incr I.R. Decr IgDecr Ig]]

16

14

12

10

8

6

4

2

05 10 1515 20 25 30 35 40

CrowdingCrowdingOutOut

EffectEffect

ASAS

ADAD11AD2AD2

44%%

22%%

YYRR

GG

IIGG

G can finance a deficit by:G can finance a deficit by:1. 1. Borrowing Borrowing - this raises interest rates in- this raises interest rates in the LFM and the LFM and “crowds out”“crowds out” investment. investment.2. 2. MoneyMoney Creation Creation - - no “crowding outno “crowding out” so is ” so is more expansionarymore expansionary than borrowing. than borrowing.

FriedmanFriedmanJust follow theJust follow the

““monetary rule.”monetary rule.”

YY**

+G +C +Ig

-XN

YR Y*

-I g -C -G +Xn

Y* Yi

AS AS

Ex pansionar y Fiscal Policy & “ Negative X n”

Contr actionar y

Fiscal Policy &

“Negative X n”

Negative Net Export Effect of Fiscal PolicyNegative Net Export Effect of Fiscal Policy

YYRR Y*Y*

Due to lowerDue to lowerinterest rates,interest rates,dollar deprec.dollar deprec.

Expansionary Fiscal Policy

““Negative Xn”Negative Xn” ““Negative Xn”Negative Xn”CContractionaryontractionary

Fiscal PolicyFiscal PolicyDue to higherDue to higherinterest rates,interest rates,dollar apprec.dollar apprec.

Liberal (“Liberal (“GG”)”) oror Conservative Conservative (“(“GG”)”)

LiberalsLiberalsRecession: Recession: Increase “G”;Increase “G”; Inflation: Increase T “Inflation: Increase T “GG

GG ConservativesConservativesRecession: Recession: Decrease “T”; Inflation: Decrease “G”Decrease “T”; Inflation: Decrease “G”

Fiscal Policy LagsFiscal Policy Lags

“The shower starts out starts out too coldtoo cold, because the pipes have not yet warmed up. So the fool turns up the hot waterturns up the hot water. nothing happens, so he turns up the hotturns up the hot water furtherwater further. The hot water comes on and scalds himscalds him. He turns up the turns up the cold watercold water. Nothing happens right away, so he turns up turns up the cold furtherthe cold further. When the cold finally starts to come up, he finds the shower too coldtoo cold, and so it goes.”

Fiscal Policy lagsFiscal Policy lags1.1. Data (recognition) lagData (recognition) lag2.2. ““Wait-and-see” lag – short runWait-and-see” lag – short run3.3. Legislative lag (political)Legislative lag (political)4.4. Effect lag [takes months]Effect lag [takes months]

The The GG is like a “ is like a “Fool in the ShowerFool in the Shower.”.”

YYFFYYRR YYII

ADAD22ADAD11

LRASLRASSRASSRAS11

SRASSRAS22

EE44

EE44

EE22

EE11

EE22

EE33

Traditional Traditional Fiscal PolicyFiscal Policy [“G”[“G” & “T”]& “T”]will not work with will not work with StagStagflationflation

ADAD11LRASLRAS

4%4%

55%%

1010%%

1010%%

YYRR

SRASSRAS22

StagStagflationflation

ADAD22

15%15%

1515%%

AD3AD3

YYFFYYRR

AD1 AS2 AS1

E2 E1

10% 6% Unemployment

10%

3%

STAGFLATION

SUPPLY-SIDE ECONOMICS [Voodoo Economics?]

1. Shift AS curve rightward 2. Accelerated depreciation 3. Reduce corporate taxes 4. Reduce individual income taxes by $250 billion 5. Tax credits for R&D

Laffer Curve

Arthur Laffer

Laffer Curve and Supply-Side EconomicsLaffer Curve and Supply-Side Economics

Was Reagan a “closet Keynesian”“closet Keynesian” with all the “G” & “T”?Perhaps he was a “Keynesian in drag.”“Keynesian in drag.”

0

100

l

THE LAFFER CURVETHE LAFFER CURVE

Tax revenue (dollars)

Tax

rat

e (p

erce

nt)

0

100

m

l

THE LAFFER CURVETHE LAFFER CURVE

Tax revenue (dollars)

Tax

rat

e (p

erce

nt)

0

100

m

n

l

THE LAFFER CURVETHE LAFFER CURVE

Tax revenue (dollars)

Tax

rat

e (p

erce

nt)

0

100

m m

n

l

THE LAFFER CURVETHE LAFFER CURVE

Tax revenue (dollars)

Tax

rat

e (p

erce

nt)

MaximumTax

Revenue

0 100100m

m

nl

THE LAFFER CURVETHE LAFFER CURVE

Tax

rev

enu

e (d

oll

ars)

Tax rate (percent)

Maximum Tax Revenue

President Reagan said he was on the Laffer curve. He said that after WWII, when he started making big money, that he could do 4 movies before hittingthe top marginal tax rate of 90%. After 4, because he could only keep 10%,he would quit making movies until the next year.

““Yes, I was on the Yes, I was on the Laffer cuve. I Laffer cuve. I couldn’t couldn’t

shoot my way out”shoot my way out”

The “Gipper”The “Gipper”BonzoBonzo

For rich peoplerich people, there would be a disincentive to quitdisincentive to quit workingworking when they hit the top marginal tax rate. For most workersmost workers, this was not the casenot the case.

RReaganeagan

SUPPLY-SIDE FISCAL POLICYSUPPLY-SIDE FISCAL POLICY

Emphasis Emphasis on on Expansionary Tax CutsExpansionary Tax Cuts[which shifts AD to the right, increasing Y & PL]

Impact upon...Impact upon...

•Saving and InvestmentSaving and Investment [Lower taxes increase DI & S; less business taxes will

increase investment. Our “national factory” will increase.]

• Work IncentivesWork Incentives [Keeping more of our money makes us work harder and longer]

• Risk TakingRisk Taking [Lower tax rates promise a larger potential after-tax reward]

So, the AS Curve will shift right bringing prices downAS Curve will shift right bringing prices down..

SUPPLY-SIDE FISCAL POLICYSUPPLY-SIDE FISCAL POLICY

0

Pri

ce le

vel

Real domestic output, GDP

AD1

AD2

ASAS11 ASAS22

P1

P2

P3

QQ11 QQ22 QQ33

Can sustain a much greaterCan sustain a much greaterincrease in AD if the AS curve increase in AD if the AS curve is also shifting to the right.is also shifting to the right.

Pric

e Le

vel

ASAS

AD2

Inflation and the Multiplier [4]Inflation and the Multiplier [4]

GDPGDP11 GDPGDP22

MULTIPLIER WITH PRICE-LEVEL CHANGESMULTIPLIER WITH PRICE-LEVEL CHANGES

P1

AD1

AD3

GDPGDP33

P2

Full Multiplier EffectFull Multiplier EffectReducedReducedMultiplierMultiplierEffect DueEffect Dueto Inflationto Inflation

+20+20

+ 80 bil.+ 80 bil.

+20+20

+ 40 + 40 bil.bil.

M(4)=chg.Y/chg.EM(4)=chg.Y/chg.E [80] [20][80] [20]

M(2)=chg.Y/chg. EM(2)=chg.Y/chg. E [40] [20][40] [20]

Pric

e le

vel

Real GDP (billions)

EXPANSIONARY FISCAL POLICYEXPANSIONARY FISCAL POLICY

Full $20 billionFull $20 billionincrease in ADincrease in AD

AD2AD1

$5 billion initial direct increase in spending$5 billion initial direct increase in spending

[MPS=.25MPS=.25] the multiplier at work...

P1

$485 $505

Pri

ce le

vel

Real GDP (billions)

CONTRACTIONARY FISCAL POLICYCONTRACTIONARY FISCAL POLICY[MPS=.25MPS=.25] the multiplier at work...

P3

$515

Full $20 billionFull $20 billiondecrease in ADdecrease in AD AD4

AD3

$5 billion initial$5 billion initialdirect decrease in direct decrease in

spendingspending

P4

LEGISLATIVE MANDATES

Employment Act of 1946Employment Act of 1946

CCouncil of ouncil of EEconomic conomic AAdvisorsdvisors(CEA)(CEA)

JJoint oint EEconomic conomic CCommittee ommittee (JEC)(JEC)

Legislative Mandates for Remedial Fiscal MeasuresLegislative Mandates for Remedial Fiscal Measures

1. Employment Act of 1946Employment Act of 1946 – a law promoting economic stability (by promoting “maximum employment, production, and “maximum employment, production, and purchasing power”purchasing power”) through monetary and fiscal policiesmonetary and fiscal policies. This act was a government commitmentgovernment commitment to ensure prosperity after WWII. [not only “could”“could” but “would”“would” – no more laissez faire] This act gave the Keynesians economistsKeynesians economists the theoretical and legal justificationlegal justification to use fiscal policyuse fiscal policy to stabilize the economy.

2. Council of Economic Advisers (CEA)Council of Economic Advisers (CEA) [for the PresidentPresident] – 3 distinguished economists3 distinguished economists (on leave from

universities) who assist & advise the Presidentassist & advise the President on economic matters. Their staff is made up of 11 senior and 6 junior economists. They forecast & project the deficit, inflation, GDP growth, deficit, inflation, GDP growth, foreign exchange rates, immigration, & antitrust legislationforeign exchange rates, immigration, & antitrust legislation. The President must submit an annual economic report describing the current economic state with recommendations.““TThe he President’s intelligencePresident’s intelligence arm arm in the warin the war against the against the business cycle.” business cycle.”

Head Head of theof the CEA CEA

Greg MankiwGreg Mankiw of Harvard has ridiculed of Harvard has ridiculed

supply-side tax cuts as supply-side tax cuts as “fad economics”“fad economics” conceived by conceived by ““charlatanscharlatans and cranks,” and cranks,” in his textbook.in his textbook.

Harvey S. RosenHarvey S. Rosen of Princetonof Princetonsucceeded Mankiw.succeeded Mankiw. Ben BernankeBen Bernanke,,

Former Board Governor, succeeded Rosen. [scored 1590 on SAT]

Joint Economic Committee of CongressJoint Economic Committee of Congressand Humphrey-Hawkins Act of 1978and Humphrey-Hawkins Act of 1978

3. J oint Economic Committee(J EC) of Congress – an advisory group or intelligence arm in the war against contractions in the business cycle. After gathering and analyzing economic data, they make forecasts and formulate programs to improve employment.

4. Humphrey-Hawkins Act of 1978 – (Full Employment & Balanced Growth Act) - requires the government to establish 5-year economic goals and formulate plans to achieve it. The goals were to seek 4% unemployment and zero inflation. If you look at my “C” If you look at my “C”

average college grades, average college grades, the CEA can help me.the CEA can help me.

President Bush’s College TranscriptPresident Bush’s College Transcript

President Bush’s College Transcript – Cumulative 77 Ave.President Bush’s College Transcript – Cumulative 77 Ave.

““So - - If you are having a hard time in So - - If you are having a hard time in Economics, don’t worry about it. You can Economics, don’t worry about it. You can always be President of the United States.”always be President of the United States.”

John Kerry had only a John Kerry had only a 76 cumulative average76 cumulative average, , including 4 Ds as a freshman in geology(61), including 4 Ds as a freshman in geology(61), American History(63 & 68), & government(69). American History(63 & 68), & government(69). His highest grade was 89.His highest grade was 89.

Keynesians Return To Washington Keynesians Return To Washington [1993][1993]

Nobel Prize inNobel Prize inEconomics-2001Economics-2001

ADDING THE PUBLIC SECTOR[“ ”]ADDING THE PUBLIC SECTOR[“ ”]

Ag

gre

gat

e E

xpen

dit

ure

s (b

illio

ns

of

do

llars

)

o45

o

Real domestic product, GDP (billions of dollars)

390390 470470 550550

C

C + Ig + Xn

C + IC + Ig g + X+ Xn n + G+ GGovernmentGovernmentSpending ofSpending of$20 Billion$20 Billion

$20 Billion Government Purchases and Equilibrium GDP$20 Billion Government Purchases and Equilibrium GDP

SS

Mixed - openMixed - open

$$2020 bil. for Nat. Defense bil. for Nat. Defense

““M” = 4M” = 4

$15 B decrease in “C”$15 B decrease in “C”[[&& $60 B $60 B total decreasetotal decrease

in Y from a $20 billionin Y from a $20 billion

increase in taxesincrease in taxes

ADDING THE PUBLIC SECTOR[“ ”]ADDING THE PUBLIC SECTOR[“ ”]Incr. T by $20 bil.[Incr. T by $20 bil.[MTMT = 3] Equilibrium GDP[-60] = 3] Equilibrium GDP[-60]

Ag

gre

gat

e E

xpen

dit

ure

s (b

illio

ns

of

do

llars

)

o45

o

Real domestic product, GDP (billions of dollars)

550550

C + IC + Ig g + X+ Xn n + G+ G

CCaa + I + Ig g + X+ Xn n + G+ G

490490

SS

Mixed-OpenMixed-Open

$20 bil. increase in “T”$20 bil. increase in “T”

Balanced Budget Multiplier [$20 billion]Balanced Budget Multiplier [$20 billion][[“T” affects AD indirectly thru “C“T” affects AD indirectly thru “C”; ”; “G” affects AD directly“G” affects AD directly]]

GDP = $80

Net Change in GDP = Net Change in GDP = The increase in “T” means we The increase in “T” means we would have consumed $15 and would have consumed $15 and kept $5 in our pockets. kept $5 in our pockets.

The increase in “G” The increase in “G” flows directly into flows directly into the economy.the economy.

MME = 1/MPSE = 1/MPS

MME = 1/.25 = 4E = 1/.25 = 4

So, 4 x $20 = So, 4 x $20 = $80$80

G $20

MT = MPC/MPS=.75/.25=MT = MPC/MPS=.75/.25=33So, 3 x -$20So, 3 x -$20 = = -$60-$60

GDP = -$60

Ca= -$15

Sa= -$5

T $20

$470 billion$470 billion

ASAS

AD1AD1

$490 $490 billionbillion

PLPL

ADAD22

+$20+$20

1. With the Employment Act of 1946Employment Act of 1946, the federal government committed itself to accept (total/some) degree of responsibility for employment/prices.2. Fiscal policyFiscal policy is carried out primarily by the (local/state/federal) government.3. Discretionary fiscal policyDiscretionary fiscal policy [G & T] (does/does not) require congressional action.4. In a mixedmixed [private & public) closed economyclosed economy, taxes & (savings/government spending) are leakagesleakages, while Ig and (savings/government spending) are injectionsinjections.5. In a mixed economy, the equilibrium GDP exists where (C+Ig/C+Ig+G+Xn) = GDP.6. The balanced budget multiplierbalanced budget multiplier indicates that equal increases in G&T tend to (decrease/increase/not change) the equilibrium GDP. [MBB is “1”]7. Assume in a private economy that equilibrium GDP is $400 billionequilibrium GDP is $400 billion & the MPC is .80. Suppose the G collects new taxes of $50 bil.G collects new taxes of $50 bil. & spends the entire amount spends the entire amount on our infrastructure. As a result equilibrium GDP will be ($400/$450/$500) bil.

8. Suppose a constitutional amendmentconstitutional amendment requires that the G always balanceG always balance its budgetits budget. If it desired to increase GDP by $40 billionincrease GDP by $40 billion, G should (increase/decrease) government spending & taxes by ($30/$40/$50) billion.

Fiscal Policy NS 1-8Fiscal Policy NS 1-8

12. If the F.E. GDP is OCF.E. GDP is OC, then it would be appropriate fiscal policy for government to (increase/decrease) “G”“G” and (increase/decrease) “T”“T”.

13. If the F.E. GDP is OAF.E. GDP is OA, then it would be appropriate fiscal policy for government to (increase/decrease) “G”“G” and (increase/decrease) “T”“T”.

10. If the government tries to eliminate a budget deficit during a depressioneliminate a budget deficit during a depression, these efforts will (help/hurt) the depression.

11. A conservative economistconservative economist who advocates an active fiscal policy

would recommend taxtax (increases/decreases) during a recessionrecession and

(increases/decreases) in government spendinggovernment spending during inflationinflation.

9. In a severe recessionsevere recession, Keynesians would favor a(n) (increase/decrease) in taxes.

YYCC AA

45°45°

45°45°

AEAE11

AEAE22PLPL

YYR R Y*Y*800 800 ? ?

AEAEPLPL

OO

14. If G increases its spending during a recessionduring a recession to assist the economy, the funds must come from some source. (Additional taxes/Borrowing from the public/Creating new money) would tend to be the most expansionarymost expansionary.

15. The following fiscal actionsfiscal actions, (incurring a budget surplusand allowing it to accumulate as idle Treasury balances/incurring a budget surplus which is used to retire debt held by the public) is likely to be most effective in curbing inflationcurbing inflation.

16. The greatest anti-inflationary impact of a budgetgreatest anti-inflationary impact of a budget surplussurplus will occur when the G (impounds/uses) the surplus funds & lets them (stand idle/pay off the debt).

17. In describing the built-in stabilizersbuilt-in stabilizers, we can say that

personal & corporate income tax collectionspersonal & corporate income tax collectionsautomatically (incr/decr) as GDP increasesas GDP increases and transfers transfers & subsidies& subsidies (incr/decr) as GDP increasesas GDP increases.

Should I Should I give it back?give it back?

Recognition, Action, & Effect Lags of Fiscal PolicyRecognition, Action, & Effect Lags of Fiscal Policy

Recognition Lag A ction Lag Eff ect Lag 1. Data lag 2. “Wait-and-see” lag-short run? 3. Legislative lag 4. Effectiveness lag[AD doesn’t move the next day][Takes months for the “M” to work]

Action LagAction Lag

Political Business Cycles?Political Business Cycles?

Political Business Cycles: Politicians manipulate fiscal policy to get voter support. No politician wants to go into the next election known as the “tax-raising, project -cancelling boom killer.” These policies can lead to “Made in Washington” recessions after the election to slow down the inflationary economy . The economy can be corrected prior to the next election.

“The economy is largely a toy to be pulled this way and that for political purposes.”

0 YP Real GDP

Presidential Elections and U.S. Recessions, 1948 -2002 Election Winner Next Recession Election winner Next Recession Nov, 48 Truman Nov. 48 -Oct. 49 Nov. 72 Nixon Dec. 73 -Mar. 75 Nov. 52 Ike June, 53 -May 45 Nov. 76 Carter Jan. 80 - July 80 Nov. 56 Ike June, 57 -Apr. 58 Nov. 80 Reagan May 81 -Nov. 82 Nov. 60 Kennedy Apr. 60 -Feb. 61 Nov. 84 Reagan Incr bor. by $2 tr. Nov. 64 Johnson Viet Nam War Nov. 88 Bush 41 July 90 -Mar. 91 Nov. 68 Nixon Oct. 69 -Nov. 70 Nov. 92 Clinton None Nov. 01 Bush 43 Jan. 01 -Sept. 01

“Voters tend to remember the last one or two years prior to an election.”

*Tell them what they want to hear.*Tell them what they want to hear.

FISCAL POLICY – Pure and SimpleFISCAL POLICY – Pure and Simple

Fiscal Policy:Fiscal Policy:No ComplicationsNo Complications

Pri

ce le

vel

Real GDP (billions)

ADAD11 ADAD22

P1

$490 $490 YRYR

ASAS

There are 2 things that could “diminish AD.” “diminish AD.”

$510$510Y*Y*

Fiscal Policy: ShowingCrowding-out Effector Net Export Effect

Pri

ce le

vel

Real GDP (billions)

AD1 AD2

P1

$490$490 $510$510

AS

AD’2

$504$504

There are 2 things that could “diminish AD.” “diminish AD.”[Crowding-out and net export effect][Crowding-out and net export effect]

FISCAL POLICY AND INFLATIONFISCAL POLICY AND INFLATION

Pri

ce level

Real GDP (billions)

AS

AD2

$495 $515

P1

AD1

$505

Answer the next 3 questions(18-21) based on the diagram.18. DeficitsDeficits will be realized at GDP levels (below/above) C, and surpluses (below/above) C.19. If the F.E. GDP for the economy is at DD, the F.E. budget will entail a (deficit/surplus).20. If the tax line had a greater slopetax line had a greater slope [more progressive tax system], stabilitystability would be (less/greater).21. If government adhered strictly to an annually balanced budgetadhered strictly to an annually balanced budget then the government’s budget would tend to (destabilize/stabilize) the economy.

T2

NS 18-21NS 18-21

11

NSNS 22-3022-30For Questions 22-2422. (T1/T4) tax system is characterized by the least built-in stabilityleast built-in stability.23. (T1/T4) tax system is characterized by the most built-in stability.24. (T1/T4) tax system will generate the largest cyclical deficitslargest cyclical deficits.25. NondiscretionaryNondiscretionary Fiscal Policy (does/does not) require congressional action.

26. If the MPC is .5, a $10 B increase in “G”$10 B increase in “G” will increase “C”increase “C” [not incomenot income] by ($20/$10/$5) billion.[G increase in spending of $10 B increases income (Y) by $20 B. With MPC of .5, C increases $10 B]

27. If government tries to give back a surplus during an inflationary FE year, this will be (pro-cyclical/counter-cyclical). 28. When politicians use fiscal policy to cause an improvementimprovement in the economy just prior to an electionin the economy just prior to an election, this is called a (presidential/Congressional/political) business cycle.29. When G incurs a deficit which is financed by borrowingG incurs a deficit which is financed by borrowing, causing interest rates to increase which decreases Iginterest rates to increase which decreases Ig, this is called the (crowding-in/crowding out) effect.30. Supply-sidersSupply-siders argue that the primary effect of tax cutsprimary effect of tax cuts is to shift the AS curve (leftward/rightward).

34. If the MPS is .2MPS is .2 and the economy has a

recessionaryrecessionary spending gap of $5spending gap of $5 billionbillion, we may conclude that the equilibriumequilibrium levellevel of GDP is ($5/$20/$25) below the FE GDP.

33. In a private-closed economy, the MPS is .2MPS is .2,

consumption equals income at $200 consumption equals income at $200 billionbillion, and the level of investmentinvestment is is $10 $10 billionbillion. The equilibrium level of income at the new level is ($200/$250) billion.

31. If the MPC is .8MPC is .8, a $2 billion increase in “G”$2 billion increase in “G” will increase

““consumption”consumption” by ($10/$8/$6) billion. [When G increases by $2 billion, Y does increase by $10, but *8 (80%) is consumed, or $8 billion]

32. If the MPC is .9MPC is .9, a $1 billion increase in “G”$1 billion increase in “G” will increase “consumption” by ($10/$9/$8) billion.

NS 31-34NS 31-34

45°45°

45°45°

C+IgC+Ig

200200

200 200 ??

““C”C”

+$10 Ig+$10 Ig

AEAE

AE1AE1

AE2AE2

YYR R ??

AEAE

+$5+$5

NS 35 - 38NS 35 - 38

-$6-$6

45°45°

AE1AE1

AE2AE2

Y* Y* YYII

35. If the MPS is .5MPS is .5 and the economy has an

inflationaryinflationary spending gap of $6 spending gap of $6 billionbillion, we may conclude that the equilibrium level equilibrium level of GDPof GDP is ($6/$12/$18) billion above the FE GDP.

AEAE

36. If the government decreases G&T by $10 billiongovernment decreases G&T by $10 billion, then a

MPS of .10MPS of .10, the equilibrium GDPequilibrium GDP would (increase/decrease) by ($5/$10/$100) billion.

37. With a MPC of .75MPC of .75, Government increases G&T by $8 billionGovernment increases G&T by $8 billion.

The equilibrium GDPequilibrium GDP (increases/decreases) by ($75/$32/$8) billion.

38. If the government runs a budget surplus and desires to government runs a budget surplus and desires to curb inflationcurb inflation, it should (give the surplus back/keep it in storage).

1. Expansionary Expansionary fiscal policyfiscal policy will be most effective [increase GDP] when the AS curve is (vertical/horizontal)

& (incr/decr) “C” and (incr/decr) unemployment.

2. The paradox of thriftparadox of thrift indicates that an increase in saving (matched/ unmatched) by an increase in investment will lower equilibrium GDP.

3. A contractionary fiscal policycontractionary fiscal policy [decr G, incr Tdecr G, incr T] would cause a[an] (incr/decr) in output[GDP] and a[an] (incr/decr) in interest rates. An expansionary fiscal policyexpansionary fiscal policy [incr G, decr Tincr G, decr T] would cause a[an] (incr/decr) in output[GDP] and a[an] (incr/decr) in interest rates.

4. In the AE model, if AE[AD]doesn’t buy up FE output(GDP)AE[AD]doesn’t buy up FE output(GDP), then the equilibrium output is (less than/more then) full employment output.

Fiscal Policy Test Review 1-4Fiscal Policy Test Review 1-4

[G ; LFM ; In. Rates ][G ; LFM ; In. Rates ]

[G ; LFM ; In. Rates ][G ; LFM ; In. Rates ]

G G $2 Tr.$2 Tr. T T $2 Tr$2 Tr..[On #3, start froma balanced budget]

““Recessionary Gap”Recessionary Gap” ““Inflationary Gap”Inflationary Gap”

5. To decrease AD the greatest amountdecrease AD the greatest amount, the government should: (decrease “G” only/increase “T” only/both decr G & incr T)6. To increase AD the greatest amount, the “G” should: (increase “G” only/increase “T” only/both incr G and decr T)7. In a recessionaryrecessionary gapgap (AE model) at the equilibrium point[actualequilibrium point[actual GDP]GDP] planned investmentplanned investment is (greater than/equal to/less than) savingsaving,, but at the FEFE GDP levelGDP level, planned investment[backup] is (greater than/equal to/less than) savingsaving.8. In an inflationaryinflationary gapgap(AE model), at the equilibrium point [actual GDP]

planned investment [backup] is (greater than/equal to/less than) saving, but at the FE level, planned investment is (greater than/equal to/less than) saving.9. If businesses are experiencing an unplanned increase in inventoriesunplanned increase in inventories, AE is (less than/greater than) FE output & spendingFE output & spending will (increase/decrease).10. If businesses are experiencing an unplanned decrease in inventoresunplanned decrease in inventores [disinvestmentdisinvestment] AE is (less than/greater than) FE output & spendingFE output & spending will (increase/decrease)

11. If “C” equals income at $500 billion“C” equals income at $500 billion, & MPC is .9MPC is .9, then an increase in Ig of $10 billion will change equilibrium GDP to ($400/$490/$510/$600) billion.12. A conservative conservative economisteconomist would want tax (incr/decr) during a recessionrecession & (incr/decr) in “G” during inflationary timesinflationary times.13. A liberal economistliberal economist would want tax (incr/decr) during an inflationinflation & (incr/decr) in “G” during recessionary periodsrecessionary periods.14. An inflationary gapinflationary gap indicates AE[actual GDP] (exceeds/falls short of) FE GDP.

15. A recessionary gaprecessionary gap indicates AE[actual GDP] (exceeds/falls short of) FE GDP.

16. To increase GDP[but reduce military spending]increase GDP[but reduce military spending], we would combine two (domestic/overseas) bases into one (domestic/overseas) base.17. A tax cut to expand the economytax cut to expand the economy would (incr/decr) Y & (incr/decr) in. rates.18. A tax increase to contract the economytax increase to contract the economy would (incr/decr) Y & (incr/decr) IR.

500500

500500

19.To increase equilibrium GDP by increase equilibrium GDP by $400,000$400,000, with a MPC of .5, a Keynesian economist would (decrease “T”/increase “G”) by $200,000.

20. Assume equilibrium GDP is equilibrium GDP is $500$500 billion billion & MPS is .4. Now “G” collects taxes of of “G” collects taxes of of $22$22 billion and spends billion and spends the entire amountthe entire amount. As a result, equilibrium GDP will change to: ($445/$478/$522/$555).21. With a MPC of .5MPC of .5, a $12 billion$12 billion increase in “G” will increaseincrease “C” “C” by ($12/$24/$36) bil.

22. With a MPC of .5MPC of .5 and the economy in a recessionaryrecessionary spending gapspending gap of of $$1212 billion billion, we may conclude that the equilibrium is ($12/$24/$36) billion short of FE GDPshort of FE GDP.

Test Review 19-22Test Review 19-22

23. An increase in Ig of $25 increase in Ig of $25 billionbillion results in an increase in equilibrium income(GDP) of $50B, so the MPS is?24. A contractionary fiscal policycontractionary fiscal policy results in a(n) (incr/decr)

in output, and a(n) (incr/decr) in interest rates.

25. Increasing T or decreasing GIncreasing T or decreasing G will (increase/decrease) consumption, and (increase/decrease) unemployment.

26. With a MPC of .5.5, and the economy with an inflationaryinflationary GDP GDP GapGap of $50B, G could eliminate this inflationaryinflationary GDP GapGDP Gap by reducing government spendingreducing government spending by?

27. With a MPC of .5.5 and current output at $500 bil. but FEcurrent output at $500 bil. but FE output is $700 biloutput is $700 bil., correct fiscal policy would be to

(increase G/decrease T) by $100 billion.

[Incr T or Decr G][Incr T or Decr G]

Test Review – AE & Fiscal PolicyTest Review – AE & Fiscal Policy

.5.5

$25 bil.$25 bil.

Test Review – AE & Fiscal PolicyTest Review – AE & Fiscal Policy28. An increase in Igincrease in Ig in an economy

(increase)/decrease) GDP & (increase/decrease) C.

29. In a recessionary economyrecessionary economy, at

FEFE GDPGDP, savingsaving is (less than/more than) IgIg.

30. In a recessionary economyrecessionary economy,

(actual Y/potential Y) exceeds (actual Y/potential Y).

31. In a mixed-closed economymixed-closed economy (no Xnno Xn), the leakagesleakages are?

and the injectionsinjections are?

32. If the economy has an inflationary Gapinflationary Gap, at

FE GDPFE GDP, savingsaving (exceeds/is less than) Ig.

33. If there is an equal increase in G&T of $25 bilequal increase in G&T of $25 bil., then

outputoutput will (increase/decrease) & interest ratesinterest rates [based on PL][based on PL]

will (increase/decrease).

[S & T][S & T] [G & Ig][G & Ig]

The EndThe End

E-conE-conE-conE-con

Review for Review for AE AE && Fiscal Policy Fiscal Policy

““Econ, econ”Econ, econ”

TheThe MMEE,, M MTT,, & & MMBBBB MultipliersMultipliersMME[G, Ig, E[G, Ig, or or Xn] = Xn] = 1/MPS = 1/.25 = 41/MPS = 1/.25 = 4So, G increaseincrease of $20 bil. will incr Y by $80 bil. [$20x4=$80]And a G decreasedecrease of $20 bil. will decrease Y by $80 bil. [-$20x4=-$80 bil.]

MMT = T = MPC/MPSMPC/MPS = . = .75/.25 = 375/.25 = 3So, T decreasedecrease of $20 bil. will incr Y by $60 bil. [$20 x 3=$60]And a T increaseincrease of $20 bil. will decr Y by $60 bil. [-$20x3=-$60]

MMBB = BB = 11So, an increaseincrease in G&T of $20 bil. will incr Y by $20 bil. [$20x1=$20]

And a decreasedecrease in G&T of $20 bil. will decr Y by $20 bil.[-$20x1=-$20]

Any increase in expendituresincrease in expenditures x the M will increase GDPincrease GDP.Any decreasedecrease in in expendituresexpenditures x the M will decrease GDPdecrease GDP.

AE

AE

[[ CC ++

Ig

Ig

]] (b

illion

s o

f d

ollars

)

o45

o

CConsumptiononsumption

C + IC + Igg

Ig = $20 BillionEquilibriumEquilibrium

Real domestic product, GDP (billions of dollars)370 390390 410 430 450 470470 490 510 530 550

Equilibrium GDP Equilibrium GDP afterafter $20 bil. Ig [MPC=.75] $20 bil. Ig [MPC=.75]AE[C+Ig] [AE[C+Ig] [“Basic”“Basic” or or “Simple”“Simple” economy] economy]

C =$450 Billion

$530

510

490

470470

450

430

410

390390

370+ 2

0 Ig

+ 20 Ig

+80+80

SS

PrivatePrivate ClosedClosed

AE [

C+

Ig]

AE [

C+

Ig] (

billion

s o

f d

ollars

)

o45

o

Consumption

C + Ig+XnC + Ig+Xn

IIg g = $20 = $20 BillionBillion

EquilibriumEquilibrium

Real domestic product, GDP (billions of dollars) 370 390390 410 430 450 470470 490 510 530 550

(C[450] + Ig[20] +M[10] + X[10] = GDP)Equilibrium GDP after X of $10 & M of $10Equilibrium GDP after X of $10 & M of $10

C = $450 BillionC = $450 Billion

$530

510

490

470470

450

430

410

390390

370

SPrivatePrivate OpenOpen

ADDING THE PUBLIC SECTOR[“ ”]ADDING THE PUBLIC SECTOR[“ ”]

Ag

gre

gat

e E

xpen

dit

ure

s (b

illio

ns

of

do

llars

)

o45

o

Real domestic product, GDP (billions of dollars)

390390 470470 550550

ConsumptionConsumptionC + IC + Ig g + X+ Xnn

C + IC + Ig g + X+ Xn n + G+ GGovernmentGovernmentSpending ofSpending of$20 Billion$20 Billion

$20 $20 Billion GovernmentBillion Government Purchases and Equilibrium Purchases and Equilibrium GDPGDP SS

Mixed - OpenMixed - OpenPrivate-public - ROW

$20 bil. on National Defense

$20 bil. incr in T$20 bil. incr in T[-$20 x 3 = -$60][-$20 x 3 = -$60]

ADDING THE PUBLIC SECTOR[“ ”]ADDING THE PUBLIC SECTOR[“ ”]Incr. T by $20 bil.[Incr. T by $20 bil.[MMT = 3] Equilibrium GDP[-60]T = 3] Equilibrium GDP[-60]

Ag

gre

gat

e E

xpen

dit

ure

s (b

illio

ns

of

do

llars

)

o45

o

Real domestic product, GDP (billions of dollars)

550550

C + IC + Ig g + X+ Xn n + G+ G

CCaa + I + Ig g + X+ Xn n + G+ G

490490

SS

Mixed-OpenMixed-OpenPrivate–public-ROWPrivate–public-ROW

$20 billion$20 billion

BBalancedalanced BBudgetudget [$2 [$2 Tril.Tril. “G”=$2 “G”=$2 Tril.Tril. “T”]“T”]

$2 $2 TrillionTrillion $2 $2 TrillionTrillion

GG TT

RecessionRecessionIncr G to $2.2 Incr G to $2.2

or or

Decr T to $1.8 Decr T to $1.8

DeficitDeficit so sohigher I.R.higher I.R.

InflationInflationDecr G to $1.8Decr G to $1.8

or or

Incr T to $2.2Incr T to $2.2

Surplus Surplus sosoLower I.R.Lower I.R.

BudgetBudget

So expansionary fiscal policySo expansionary fiscal policyleads to leads to higher interest rateshigher interest rates.. DeficitDeficit

Wow! AWow! Asurplussurplus

So, contractionary fiscal policySo, contractionary fiscal policy

leads to leads to lower interest rateslower interest rates..

Gonna have Gonna have to borrowto borrow

1. An increase in Igincrease in Ig of $75Bof $75B results in an increase in equilibrium income(GDP) of $300B$300B, so the MPS is?

2. An expansionary fiscal policyexpansionary fiscal policy results in a(n) (incr/decr) in output, and a(n) (incr/decr) in interest rates.

3. Increasing T or decreasing GIncreasing T or decreasing G will (increase/decrease) consumption, and (increase/decrease) unemployment.

4. With a MPC of .75.75, and the economy with an inflationaryinflationary GDP GDP GapGap of $80B$80B, G could eliminate this positive equilibriumpositive equilibrium GDP GDP GapGap by reducing government spendingreducing government spending by?

5. With a MPC of .60.60 & current output at $650 bil. but FEcurrent output at $650 bil. but FE output is $700output is $700 billion billion, correct fiscal policy would be to (increase G/decrease T) by $20 billion.

Test Review – AE & Fiscal PolicyTest Review – AE & Fiscal Policy

.25.25

$20 bil.$20 bil.

[Decr T or Incr G][Decr T or Incr G]

$2 Tr.$2 Tr. $2 Tr.$2 Tr.

GG TT

Test Review – AE & Fiscal PolicyTest Review – AE & Fiscal Policy6. An increase in Igincrease in Ig in an economy will

(incr)/decr) GDPGDP and (incr/decr) CC.

7. In a recessionaryrecessionary economy economy, at

FE GDPFE GDP, savingsaving is (less than/more than) Ig.

8. In an inflationary economyinflationary economy,

(actual Y/potential Y) exceeds (actual Y/potential Y).

9. In the complex complex economyeconomy (C+Ig+G+IgC+Ig+G+Ig), the leakagesleakages are?

and the injectionsinjections are?

10. If the economy has an inflationary Gapinflationary Gap, at at

FE GDPFE GDP, saving (exceeds/is less than) Ig.

11. If there is an equal increase in G&T of $10 bilequal increase in G&T of $10 bil., then

output will (incr/decr) & interest rates will (incr/decr).

[S, T, & M][S, T, & M] [G, Ig, X][G, Ig, X]

1. At income level “OT”“OT”, the volume of consumptionconsumption is _____.2. At income level “OT“OT””, the volume of savingsaving is _____.3. The “APC”“APC” is equal to “1” at income level _____.4. If Ig is Ig1Ig1, then “equilibrium GDP”“equilibrium GDP” is _____.5. If Ig is Ig2Ig2, then “equilibrium GDP”“equilibrium GDP” is _____.6. If Ig increases from Ig1Ig1 to Ig2Ig2, equilibrium GDPequilibrium GDP increases by _____.7. If Ig increases from Ig1Ig1 to Ig2Ig2, the “MPC”“MPC” is equal to __________.8. As we move from income level OVOV to OUOU, the “MPS”“MPS” is ________.9. The economy is “dissaving”“dissaving” at income level _____.10. Consumption will be equal to incomeConsumption will be equal to income at income level _____.

TCTCCFCF

OVOVOUOUOTOT

UTUTBC/UTBC/UT

AEAE//VUVUOWOW

OVOV

W W V V UU TT

BBAA

00

AE

(C

+Ig

)A

E (

C+

Ig)

AE (C+Ig2)AE (C+Ig2)AE (C+Ig1)AE (C+Ig1)ConsumptionConsumption

FF

EE DDCC

Real GDPReal GDP

[Revised]

45°45°

The next 3 slides The next 3 slides will get you ready will get you ready for the AE Quizfor the AE Quiz

Hard Quiz AheadHard Quiz Ahead

SS

200200 400400 1,0001,000 1,6001,600 2,2002,200 bil. bil. 00 N N Q Q K L MK L M

$2,200$2,200

$1,600$1,600

$1,000$1,000$700$700$400$400 JJ PP

II

HH

GG

EEFF

AA

BB

CC

DD

AEAE33[C[C++IIg+g+GG++XXnn]]

AEAE22[C+Ig+G][C+Ig+G]AEAE11[C+Ig][C+Ig]ConsumptionConsumption

Real GDP

AE[C+Ig+G+Xn]

Inflat.Inflat.GapGap

RRecessecess..GapGap

1. The APC is “one”APC is “one” at letter: (J/H/G/A).2. Consumption will be equal to income(GDP)Consumption will be equal to income(GDP) at (200/400/1000).3. A shift from AE2 to AE3shift from AE2 to AE3 would be caused by a[an] (appreciation/depreciation) of the dollar.4. If there is a shift from J to HJ to H, , the simple multiplierthe simple multiplier is: (2/3/4/5)

5. If the FE GDP is OL & we are at AE2FE GDP is OL & we are at AE2 then there is a(an): a. recessionary gap b. inflationary gap c. no gap6. If the FE GDP is OL & we are at AE1FE GDP is OL & we are at AE1, the (reces./inflat.) gap is (AB/BC).

45°45°

SS

200200 400400 1,0001,000 1,6001,600 2,2002,200 bil. bil. 00 N N Q Q K L MK L M

$2,200$2,200

$1,600$1,600

$1,000$1,000$700$700$400$400 JJ PP

II

HH

GG

EEFF

AA

BB

CC

DD

AEAE33[C[C++IIg+g+GG++XXnn]]

AEAE22[C+Ig+G][C+Ig+G]AEAE11[C+Ig][C+Ig]ConsumptionConsumption

Real GDP

AE[C+Ig+G+Xn]

Inflat.Inflat.GapGap

RRecessecess..GapGap

7. If the FE GDP is OL & we are at AE3FE GDP is OL & we are at AE3, the (recessionary/inflationary) gap is: (BC or AB).8. The equil. level of GDP at AE3 is ($1,000/$1,600/$2,200).9. If FE is OL & we are at AE1FE is OL & we are at AE1, , correct fiscal policycorrect fiscal policy would be to (incr/decr) “G” &/or (incr/decr) “T”.10. If FE is OL & we are at AE3FE is OL & we are at AE3, correct fiscal policy would be to (incr/decr) “G” &/or (incr/decr) “T”.11. At income level OKOK, the volume of savingsaving is: ($300/$700/$1,000).12. The economy is dissavingdissaving GDP level: ($200/$400/$600).

45°45°

15. If the FE GDPFE GDP is is OL & we OL & we are atare at AE1 AE1, a (recess/inflat) gap, we can conclude that at the equilibrium point, savingsaving (is less than/equals/exceeds) planned investment, but at the FE level[$1,600FE level[$1,600], ], savingsaving (is less than/equals/exceeds) planned investment by (HI/GF).16. At AE1AE1, , savingssavings total ($200/$300/$700) & “C”“C” totals ($300/$700).17. At AE1AE1[$1,000],[$1,000], the G decreases both G & T by $400 billionG decreases both G & T by $400 billion to balance the budget. With a simple multiplier of 5, the GDP (increases/decreases) to ($600/$1,000/ $1,600/$1,800).18. At AE1($1,000AE1($1,000)),, the G spendsG spends $500$500 billionbillion & increases taxesincreases taxes by by $500 billion$500 billion to balance the budget. With a simple multiplier of 5 the GDP (increases/decreases) to ($500/$1,000/$1,500/$1,800).

*Revision of the previous *Revision of the previous questions that looked like this.questions that looked like this.

13. A shift from “J” to “H”“J” to “H” wouldresult in a MPC of: (HK/OK or IP/QK or HI/OK)14. A shift from “J” to “H” wouldresult in a MPS of:(HK/OK or IP/QK or HI/QK)

Hard Quiz Coming UpHard Quiz Coming Up

The AE QuizThe AE Quiz1.The economy is dissavingdissaving at a. OK b. OQ c. OM d. ON2. Aggregate saving saving will bewill bezerozero where GDP is a. $200 b. $400 c. $6003. At AE1, savings totalsAE1, savings totals a. $300 b. $700 c. $1,0004. If the FE GDP FE GDP is is OLOL & weare at AE3at AE3 the inflationarygap is a. BC b. AB c. CD

5. If the FE GDP is OLFE GDP is OL & we are at AE1at AE1 we can conclude that at the FE GDP: a. “S” exceeds Ig by GF b. Ig exceeds “S” by GF6. Moving from J to HJ to H, the MPCMPC is: a. FE/KL b. IP/OK c. IP/QK7. A movement from AE2 to AE3AE2 to AE3 would be caused bycaused by a(an) _______ of the dollar? A. appreciation b. depreciation8. If the FE GDP is OLFE GDP is OL & we are at AE1at AE1 the recessionary gap isrecessionary gap is: a. AB b. BC c. CD9. Consumption is equal to GDPConsumption is equal to GDP at: a. 200 b. $400 c. $60010. At AE1AE1($1,000 GDP)($1,000 GDP), G increases G&TG increases G&T by by $100 billion$100 billion. With a “M” of 2, GDP increases to: a. $1,000 b. $1,100 c. $1,200

1. D 2. b 3. a 4. b 5. a 6. c 7. b 8. b 9. b 10. b1. D 2. b 3. a 4. b 5. a 6. c 7. b 8. b 9. b 10. b

Hard QuizHard Quiz

AE AE & & Fiscal Policy QFiscal Policy Questions on uestions on 2000 AP E2000 AP Examxam

1. (81%) The value of the spending multipliervalue of the spending multiplier (ME) decreases when a. tax rates are reduced d. government spending increases b. exports decline e. the marginal propensity to save increases c. imports decline2. (75%) Which of the following policies would a Keynesian recommendKeynesian recommend during a period of high unemployment and low inflationhigh unemployment and low inflation? a. decreasing the MS to reduce AD b. decreasing taxes to stimulate AD c. decreasing government spending to stimulate AS d. balancing the budget to stimulate AS3. (47%) Which of the following best explains why equilibrium income willequilibrium income will increase by more than $100 in response to a $100 increase inincrease by more than $100 in response to a $100 increase in GG? a. Incomes will rise, resulting in a tax decrease. b. Incomes will rise, resulting in higher consumption. c. The increased spending raises the aggregate price level. d. The increased spending increases the money supply, lowering interest rates. e. The higher budget deficit reduces investment.4. (56%) Unexpected increases in inventoriesUnexpected increases in inventories usually precede a. increases in inflation b. increases in imports c. stagflation d. decreases in production e. decreases in unemployment

If MPS incr from .10 to .20, the If MPS incr from .10 to .20, the MMEE would decrease from 10 to 5. would decrease from 10 to 5.

The Multiplier ensures more Cmore Cwith each round.

5. (63%) The economy on the right iseconomy on the right is currently experiencingexperiencing a. inflation b. recession c. expansion d. stagflation e. rapid growth6. (77%) Correct monetary policymonetary policy to reach FE GDPreach FE GDP is to increase increase a. the MS b. the RR c. discount rate d. taxes e. exports7. (36%) The minimum increase in governmentminimum increase in government spendingspending to reach full employment reach full employment is a. $2,000 b. $1,000 c. $500 d. $200 e. $100

8. (58%) In the simple Keynesian AE modelsimple Keynesian AE model [not AD/AS][not AD/AS] of an economy, changes changes in in Ig or G Ig or G will lead to a change in whichlead to a change in which of the following? a. the price level b. the level of output and employment c. interest rates d. the AS curve 9. (83%) In a closed-privateclosed-private in which the APC is .75APC is .75, which of following is truetrue? a. If income is $100, then saving is $75. d. If income is $200, then “C” is $75 b. If income is $100, then “C” is $50 e. If income is $500, then saving is $100 c. If income is $200, then saving is $50

45°45° Fu

ll.E

mp

loy.

Fu

ll.E

mp

loy. CC

C+IgC+Ig

AEAE

$$500500

$400$400

0 0 $800$800 $1,000 $1,000 $2,000$2,000

SS

EE

AA

Determine what the “M” is goingfrom A to E; then M X ? = $1,000

10. (63%) Suppose that DI is $1,000DI is $1,000, consumption is $700consumption is $700, and the MPC is .6MPC is .6. If DI then increases by $100DI then increases by $100, consumption and savings will equal which of the following? ConsumptionConsumption SavingsSavings a. $420 $280 b. $600 $400 c. $660 $320 d. $660 $440 e. $760 $340

Fiscal Policy Questions from 2000 ExamFiscal Policy Questions from 2000 Exam

11. (73%) An inflationary gapinflationary gap can be eliminatedcan be eliminated by all of the following EXCEPTEXCEPT a. an increase in personal income taxes d. a decrease in G b. an increase in the MS e. a decrease in Xn c. an increase in the interest rate12. (56%) A major advantage of automatic stabilizersadvantage of automatic stabilizers in fiscal policy is that they a. reduce the public debt b. increase the possibility of a balanced budget c. stabilize the unemployment rate d. go into effect without passage of new legislation e. automatically reduce the inflation rate

If If $700 of $1,000 DI is consumed$700 of $1,000 DI is consumed, then , then saving is $300saving is $300. . MPC of .6MPC of .6 means if DI means if DI increases by $100, then increases by $100, then $60 more will be $60 more will be consumedconsumed & & $40(.4) $40(.4) more will be savedmore will be saved(40%).(40%).The The $60 $60 added to theadded to the $700 $700 already consumedalready consumed= $760= $760 consumedconsumed and the and the additional $40 additional $40 saved = $340 savedsaved = $340 saved..

Which answer doesWhich answer doesnot slow the economy?not slow the economy?

13. (70%) In the short run, a contractionary fiscal policycontractionary fiscal policy will cause ADAD, outputoutput, and the price levelprice level to change in which of the following ways?

ADAD OutputOutput Price levelPrice level a. decrease decrease decrease b. decrease increase increase c. increase decrease decrease d. increase increase increase 14. (52%) Crowding outCrowding out due to government borrowing occurs when a. lower interest rates increase private sector investment b. lower interest rates decrease private sector investment c. higher interest rates decrease private sector investment d. a smaller money supply increases private sector investment 15. (41%) If, at FE, the G wants to increase its spending by $100 billionG wants to increase its spending by $100 billion without increasing inflation in the short run, it must do which of the following? a. raise taxes by more than $100 billion c. raise taxes by less than $100 b. raise taxes by $100 billion d. lower taxes by $100 billion16. (42%) Compared to expansionary monetary policiesexpansionary monetary policies adopted to counteract a recession, expansionary fiscal policiesexpansionary fiscal policies tend to result in a. less public spending c. a high rate of economic growth b. higher interest rates d. lower prices

1995 AP Exam1995 AP Exam

17. (71%) An increase inincrease in which will increase the value of the Mincrease the value of the MEE? a. The supply of money d. The marginal propensity to consume b. Equilibrium output e. The required reserve ratio c. Personal income tax rates

18. (61%) An AS curve may be horizontal over some rangeAS curve may be horizontal over some range because within that range a. a higher PL leads to higher interest rates, which reduces the MS & “C” b. changes in the aggregate PL do not induce substitution c. output cannot be increased unless prices and interest rates increase d. rigid prices prevent employment from fluctuating e. resources are underemployed & an increase in AD will be satisfied without any pressure on the PL

19. (45%) What could cause simultaneous increases in inflation & unemploymentcause simultaneous increases in inflation & unemployment a. a decrease in government spending d. An increase in inflationary expectations b. A decrease in the money supply e. An increase in productivity c. A decrease in the velocity of money20. (85%) Which of the following will result in the greatest increase in ADgreatest increase in AD? a. A $100 increase in taxes b. A $100 decrease in taxes c. A $100 increase in government expenditures d. A $100 increase in government expenditures, coupled with a $100 increase in taxes e. A $100 increase in government expenditures, couples with a $100 decrease in taxes21. (65%) Which of the following will result from a decrease in government spendingdecrease in government spending? a. An increase in output d. A decrease in AS b. An increase in the price level e. A decrease in AD c. An increase in employment

23. (48%) If private investment of $100 is addedprivate investment of $100 is added to the economy, the equilibrium levels of incomeincome andand consumption consumption will changewill change in which of the following ways? Equil. LevelEquil. Level Equil. LevelEquil. Level of Incomeof Income of Incomeof Income a. Increasea. Increase DecreaseDecrease b. Increaseb. Increase IncreaseIncrease c. Increasec. Increase No changeNo change d. No changed. No change IncreaseIncrease e. No changee. No change No changeNo change

45°45°

CC

Exp

end

itu

res

Exp

end

itu

res

$700$700

0 0 $1,500$1,500 $2,000$2,000 Real IncomeReal Income

SSQuestions 22-23 refer to the diagram(rt),Questions 22-23 refer to the diagram(rt),which depicts an economy’s “C” function.which depicts an economy’s “C” function.

22. (56%) If the MPC increasesMPC increases, the equilibriumequilibrium levels of levels of incomeincome and and consumption consumption will will changechange in which of the following ways? Equil. LevelEquil. Level Equil. LevelEquil. Level of Incomeof Income of Consumptionof Consumption a. No changea. No change No change No change b. No changeb. No change Increase Increase c. Increasec. Increase No change No change d. Increased. Increase Increase Increase e. Decrease Decrease e. Decrease Decrease

A larger MPC means a smaller MPS, and a larger M. this will increase incomeincrease income and result in more “C”more “C” atthe new level of equilibrium income (GDP).

C+IgC+Ig

+ $100 Ig+ $100 Ig

CC11

CC22

45°45°

C+IgC+IgC+Ig+GC+Ig+GAEAE

$300$300$200$200

0 0 $1,000$1,000 $1,500$1,500 GDP

EE

FF22. (61%) The graph indicates equilibrium at Eequilibrium at E for a closed economyclosed economy without G. If the additionaddition of of G resultsG results in in equilibrium equilibrium atat FF, which of the following is true? a. G is $300 and the multiplier is 5.b. G is $100 and the multiplier is 5.c. G is $100 and consumption increased by $500.d. G and Ig increase by $500.e. Consumption and GDP increase by $500 each.

23. (84%) According to Keynesian theoryKeynesian theory, decreasing taxes and increasing Gdecreasing taxes and increasing G will most likely change consumptionchange consumption and unemploymentunemployment in which of the following ways? ConsumptionConsumption UnemploymentUnemployment a. Decrease No change b. Decrease No change c. Increase Decrease d. Increase Increase e. No change Decrease24. (79%) In an economy at full employmenteconomy at full employment, a presidential candidate proposes cutting the government debt in half in 4 years by increase T and reducing Gincrease T and reducing G. According to Keynesian theoryKeynesian theory, implementation of these policies is most likely to increaseincrease a. unemployment d. aggregate supply b. consumer prices e. the rate of economic growth c. aggregate demand

25. (79%) If the economy is in a severe recessionsevere recession, which of the following is the fiscal policyfiscal policy most effective inmost effective in stimulating production and employmentstimulating production and employment? a. Government spending increases. b. Government spending decreases. c. Personal income taxes are increased. d. The Fed sells bonds on the open market. e. The Fed buys bonds on the open market.

26. (27%) Faced with a large federal budget deficit, the government decides to decreasedecrease expenditures expenditures and tax revenuestax revenues by the same amountby the same amount. This action will affectaffect outputoutput and interest ratesinterest rates in which of the following ways? OutputOutput Interest RatesInterest Rates a. Increase Increase b. Increase Decrease c. No change Decrease d. Decrease Increase e. Decrease Decrease

27. (28%) If crowding outcrowding out only partially partially offsets the effects of a tax cuteffects of a tax cut, which of the following changeschanges in interest ratesinterest rates and GDPGDP are most likely to occur. IInterest nterest RRatesates GDPGDP a. Increase Increase b. Increase Remain unchanged c. Increase Decrease d. Remain unchanged Increase e. Decrease Decrease

An equal decrease in G & T [Let’s say by $10 billion] woulddecrease GDP by $10 billiondecrease GDP by $10 billion. The decrease in GDP woulddecrease PL which would cause a decrease in interest ratesdecrease in interest rates.

PartiallyPartially means GDP increasesGDP increases. Starting from a balanced budget, the tax cut would put the G in deficitand the G borrowing would increase demand for moneyin the LFM and push up interest ratespush up interest rates.