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					Chapter 27—Fiscal Policy


TRUE/FALSE

  1. The government can use fiscal policy to stimulate the economy out of a recession or to try to bring
     inflation under control.

      ANS: T                PTS: 1

  2. When tax revenues are greater than government spending, a budget surplus exists.

      ANS: T                PTS: 1

  3. A budget surplus is the most common result of government fiscal policy.

      ANS: F                PTS: 1

  4. An increase in government purchases of goods and services will stimulate the economy by increasing
     aggregate demand.

      ANS: T                PTS: 1

  5. An increase in taxes will increase aggregate demand.

      ANS: F                PTS: 1

  6. Contractionary fiscal policy will tend to reduce a federal budget surplus or increase a federal budget
     deficit.

      ANS: F                PTS: 1

  7. Real GDP will tend to change anytime the amount of consumption, investment, government purchases,
     or net exports changes.

      ANS: T                PTS: 1

  8. If policymakers are unhappy about the present short-run equilibrium GDP, they can deliberately
     manipulate the level of government purchases in order to obtain a new short-run equilibrium value.

      ANS: T                PTS: 1

  9. Expansionary fiscal policy has the potential to move an economy out of recession.

      ANS: T                PTS: 1

 10. The effect of an increase in aggregate demand depends on the position of the macroeconomic
     equilibrium prior to the government stimulus.

      ANS: T                PTS: 1

 11. Starting from an initial recession equilibrium, expansionary fiscal policy could potentially increase
     employment to RGDPNR.
     ANS: T                 PTS: 1

12. Starting from an initial recession equilibrium, a government tax increase would tend to reduce the
    severity of the recession.

     ANS: F                 PTS: 1

13. An increase in government spending and/or a tax cut will tend to move the economy up along its short-
    run aggregate supply curve.

     ANS: T                 PTS: 1

14. Contractionary fiscal policy has the potential to offset an overheated, inflationary boom.

     ANS: T                 PTS: 1

15. Contractionary fiscal policy will tend to increase a current government budget deficit.

     ANS: F                 PTS: 1

16. When an initial increase in government purchases of goods and services occurs, the ultimate increase
    in total purchases will tend to be greater than the initial increase.

     ANS: T                 PTS: 1

17. If the marginal propensity to consume is two-thirds, a $6 million increase in disposable income to
    certain households will lead them to increase their consumption spending by $18 million.

     ANS: F                 PTS: 1

18. The multiplier is equal to 1 divided by the marginal propensity to consume.

     ANS: F                 PTS: 1

19. The multiplier would be smaller if the marginal propensity to consume were smaller.

     ANS: T                 PTS: 1

20. If the MPC were equal to two-thirds, the multiplier would be equal to 3.

     ANS: T                 PTS: 1

21. The multiplier may be written as 1/(1 - MPC) or as 1/MPS.

     ANS: T                 PTS: 1

22. A person’s MPC and MPS can be equal only if MPC = 0.5.

     ANS: T                 PTS: 1

23. The multiplier effect of a reduction in taxes is larger than the multiplier effect of an equal increase in
    government spending on goods and services.
     ANS: F                PTS: 1

24. If MPC = 0.67, the effects of a change in taxes on AD would be two-thirds the magnitude of the effects
    of an equal change in government spending.

     ANS: T                PTS: 1

25. The effect of a $5 billion change in government spending on AD would be greater than that of an equal
    change in taxes, regardless of the MPC.

     ANS: T                PTS: 1

26. The multiplier process is virtually instantaneous.

     ANS: F                PTS: 1

27. Savings and money spent on imported goods will each reduce the size of the multiplier because each
    reduces the fraction of a given increase in income that will go to additional purchases of domestically
    produced consumption goods.

     ANS: T                PTS: 1

28. Supply-siders would encourage government to reduce individual and business taxes, deregulate, and
    increase spending on research and development.

     ANS: T                PTS: 1

29. Supply-siders’ primary focus is on stabilizing aggregate demand in the short run.

     ANS: F                PTS: 1

30. A lower marginal tax rate will raise after-tax earnings, improving productive incentives.

     ANS: T                PTS: 1

31. Higher marginal tax rates will lead investors to spend more scarce resources looking for tax shelters,
    which harms the economy as high-return but highly taxed investments give way to lower-return tax
    shelters.

     ANS: T                PTS: 1

32. Although all economists believe that incentives matter, they disagree considerably on the shape of the
    Laffer curve and where the economy actually is on the Laffer curve.

     ANS: T                PTS: 1

33. If greater research and development leads to new technology and knowledge, it will shift the short- and
    long-run aggregate supply curves to the right.

     ANS: T                PTS: 1

34. If tax rates are reduced, it will affect aggregate supply but not aggregate demand.
     ANS: F                PTS: 1

35. One of the advantages of automatic stabilizers is that they take place without the necessity for
    deliberations in Congress or the executive branch of the government.

     ANS: T                PTS: 1

36. Unemployment compensation and public assistance payments act as automatic stabilizers, stimulating
    aggregate demand during recessions and reducing aggregate demand during booms.

     ANS: T                PTS: 1

37. Starting at a full-employment equilibrium, the gains in employment that result from expansionary
    fiscal policy will not be sustainable in the long run.

     ANS: T                PTS: 1

38. Starting at full employment, contractionary fiscal policy could cause a recession in the short run.

     ANS: T                PTS: 1

39. Starting at full employment, the long-run result of contractionary fiscal policy includes a lower price
    level and reduced real output.

     ANS: F                PTS: 1

40. The crowding-out effect will tend to reduce the magnitude of the effects of increases in government
    purchases.

     ANS: T                PTS: 1

41. The crowding-out effect implies that expansionary fiscal policy will tend to reduce private purchases
    of interest-sensitive goods.

     ANS: T                PTS: 1

42. The crowding-out effect does not occur with a tax change.

     ANS: F                PTS: 1

43. Critics of the crowding-out effect argue that an increase in government purchases (or a tax cut),
    particularly if the economy is in a severe recession, could improve consumer and business expectations
    and actually encourage private investment spending.

     ANS: T                PTS: 1

44. Expansionary U.S. fiscal policy will tend to move funds out of the United States.

     ANS: F                PTS: 1

45. Expansionary fiscal policy will tend to be partly crowded out by a reduction in net exports.
     ANS: T                 PTS: 1

46. Sometimes fiscal policy designed to stabilize the economy may actually destabilize the economy.

     ANS: T                 PTS: 1

47. Time lags in the legislative process are a serious problem in the implementation of fiscal policy.

     ANS: T                 PTS: 1

48. After expansionary fiscal policy legislation is signed into law, it takes time to bring about the actual
    fiscal stimulus desired.

     ANS: T                 PTS: 1

49. The sum total of the values of all bonds outstanding constitutes the federal debt.

     ANS: T                 PTS: 1

50. Printing money to finance government activities is inflationary.

     ANS: T                 PTS: 1

51. If public debt is created intelligently, the “burden” of the debt should be less than the benefits derived
    from the resources acquired as a result.

     ANS: T                 PTS: 1

52. If the U.S. government has a large current federal debt, it must be running a current year deficit.

     ANS: F                 PTS: 1

53. One way the federal government can finance deficits is to print money.

     ANS: T                 PTS: 1

54. When the federal government spends more, other things being equal, it tends to increase both that
    year’s deficit and the federal debt.

     ANS: T                 PTS: 1

55. Sometimes special emergencies, such as military involvements and natural disasters, may lead
    governments to run deficits.

     ANS: T                 PTS: 1

56. The U.S. federal government has never run a surplus in the last decade.

     ANS: F                 PTS: 1

57. If the economy were in an unsustainable boom, appropriate countercyclical policy would be to
    increase the budget deficit.
      ANS: F                PTS: 1

 58. If the economy were in recession, a fiscal policy that decreased the budget deficit would make the
     recession worse.

      ANS: T                PTS: 1

 59. If the federal debt rises as a result of increasing government spending, the burden of the debt will
     necessarily be greater than the benefit.

      ANS: F                PTS: 1


MULTIPLE CHOICE

  1. Traditionally, government has used ____ to influence ____.
     a. taxing and spending; the demand side of the economy
     b. spending; the supply side of the economy
     c. supply management; the demand side of the economy
     d. demand management; the supply side of the economy
      ANS: A                PTS: 1

  2. Contractionary fiscal policy consists of
     a. increased government spending and increased taxes.
     b. decreased government spending and decreased taxes.
     c. decreased government spending and increased taxes.
     d. increased government spending and decreased taxes.
      ANS: C                PTS: 1

  3. Budget deficits are created when
     a. government spending exceeds its tax revenues.
     b. government tax revenues exceed its spending.
     c. government spending equals its tax revenues.
     d. none of the above
      ANS: A                PTS: 1

  4. If the government wanted to move the economy out of a current recession, which of the following
     might be an appropriate policy action?
     a. decrease taxes
     b. increase government purchases of goods and services
     c. increase transfer payments
     d. any of the above
      ANS: D                PTS: 1

      Using the accompanying graph (from page 785), answer the following question.
5. In order for the economy pictured here to return to RGDPNR, this economy could use
   a. decreased taxes and increased government purchases.
   b. increased taxes and increased government purchases.
   c. decreased taxes and decreased government purchases.
   d. decreased taxes and increased government purchases.
   ANS: A                PTS: 1

6. If government policymakers were worried about the inflationary potential of the economy, which of
   the following would not be a correct fiscal policy change?
   a. increase consumption taxes
   b. increase government purchases
   c. reduce government purchases
   d. increase the budget deficit
   ANS: B                PTS: 1

7. In the short run, expansionary fiscal policy can cause a rise in real GDP
   a. in combination with a rise in the price level.
   b. in combination with no rise in the price level.
   c. in combination with a reduction in the price level.
   d. in combination with a rise or reduction in the price level, depending on the economy.
   ANS: A                PTS: 1

8. If the government wanted to offset the effect of a boom in consumer and investor confidence on AD, it
   might
   a. decrease government purchases.
   b. decrease taxes.
   c. increase taxes.
   d. do either a or c.
   ANS: D                PTS: 1

9. An increase in taxes combined with a decrease in government purchases would
   a. increase AD.
   b. decrease AD.
   c. leave AD unchanged.
   d. have an indeterminate effect on AD.
     ANS: B                PTS: 1

10. A combination of an increase in government purchases and a decrease in taxes would
    a. increase AD.
    b. decrease AD.
    c. leave AD unchanged.
    d. have an indeterminate effect on AD.
     ANS: D                PTS: 1

11. AD will shift to the right, other things being equal, when
    a. the government budget deficit increases because government purchases rose.
    b. the government budget deficit increases because taxes fell.
    c. the government budget deficit increases because transfer payments rose.
    d. any of the above circumstances exist.
     ANS: D                PTS: 1

12. If the marginal propensity to consume is two-thirds, the multiplier is
    a. 30.
    b. 66.
    c. 1.5.
    d. 3.
     ANS: D                PTS: 1

13. The multiplier effect is based on the fact that ____ by one person is (are) ____ to another.
    a. income; income
    b. expenditures; expenditures
    c. expenditures; income
    d. income; expenditures
     ANS: C                PTS: 1

14. The expenditure multiplier is
    a. 1/MPC.
    b. 1/(1 - MPC).
    c. (1 - MPC)/1.
    d. 1/change in MPC.
     ANS: B                PTS: 1

15. The federal government buys $20 million worth of computers from Dell. If the MPC is 0.60, what will
    be the impact on aggregate demand, other things being equal?
    a. Aggregate demand will increase $12 million.
    b. Aggregate demand will increase $13.33 million.
    c. Aggregate demand will increase $20 million.
    d. Aggregate demand will increase $50 million.
    e. Aggregate demand will not change.
     ANS: D                PTS: 1

16. When taxes are increased, disposable income ____, and hence consumption ____.
    a. increases; increases
    b. increases; decreases
    c. decreases; increases
     d. decreases; decreases
     e. stays the same; stays the same
     ANS: D                PTS: 1

17. If the MPC is 0.5, a $1 million change in taxes will have ____ effect as a $1 million change in
    government spending.
    a. the same
    b. half the
    c. double the
    d. none of the above
     ANS: B                PTS: 1

18. Lower marginal tax rates stimulate people to work, save, and invest, resulting in more output and a
    larger tax base. This statement most closely reflects which of the following views?
    a. the Keynesian
    b. the crowding-out theory of budget deficits
    c. the aggregate demand theory
    d. the supply-side view
     ANS: D                PTS: 1

19. Other things being constant, an increase in marginal tax rates will
    a. decrease the supply of labor and reduce its productive efficiency.
    b. decrease the supply of capital and decrease its productive efficiency.
    c. encourage individuals to buy goods that are tax deductible instead of those that are more
       desired but nondeductible.
    d. do all of the above.
     ANS: D                PTS: 1

20. According to the Laffer curve,
    a. decreasing tax rates on income will always increase tax revenues.
    b. decreasing tax rates on income will always decrease tax revenues.
    c. decreasing tax rates are more likely to increase tax revenues the higher tax rates are to start
       with.
    d. decreasing tax rates are more likely to increase tax revenues the lower tax rates are to start
       with.
     ANS: C                PTS: 1

21. Automatic stabilizers
    a. reduce the problems caused by lags, using fiscal policy as a stabilization tool.
    b. are changes in fiscal policy that act to stimulate AD automatically when the economy goes
       into recession.
    c. are changes in fiscal policy that act to restrain AD automatically when the economy is
       growing too fast.
    d. All of the above are correct.
     ANS: D                PTS: 1

22. During a recession, government transfer payments automatically ____ and tax revenue automatically
    ____.
    a. fall; falls
    b. increase; falls
     c. increase; increases
     d. fall; increases
     ANS: B                PTS: 1

23. One of the real-world complexities of countercyclical fiscal policy is that
    a. fiscal policy is based on forecasts, which are not foolproof.
    b. a lag occurs between a change in fiscal policy and its effect.
    c. how much of the multiplier effect will take place in a given amount of time is uncertain.
    d. All of the above are correct.
     ANS: D                PTS: 1

24. According to the crowding-out effect, if the federal government borrows to finance deficit spending,
    a. the demand for loanable funds will decrease, driving interest rates down.
    b. the demand for loanable funds will increase, driving interest rates up.
    c. the supply for loanable funds will increase, driving interest rates up.
    d. the supply for loanable funds will decrease, driving interest rates down.
     ANS: B                PTS: 1

25. If U.S. budget deficits (which require the borrowing of funds) raise interest rates and attract investment
    funds from abroad,
    a. the foreign exchange value of the dollar will appreciate, and U.S. net exports will
        decrease.
    b. the foreign exchange value of the dollar will depreciate, and U.S. net exports will
        decrease.
    c. the foreign exchange value of the dollar will depreciate, and U.S. net exports will increase.
    d. the foreign exchange value of the dollar will appreciate, and U.S. net exports (X - M) will
        increase.
     ANS: A                PTS: 1

26. When the crowding-out effect of an increase in government purchases is included in the analysis,
    a. AD shifts left.
    b. AD doesn’t change.
    c. AD shifts right, but by more than the simple multiplier analysis would imply.
    d. AD shifts right, but by less than the simple multiplier analysis would imply.
     ANS: D                PTS: 1

27. How does the government finance budget deficits?
    a. The Federal Reserve creates new money.
    b. It issues debt to government agencies, private institutions, and private investors.
    c. It is primarily financed by foreign investors.
    d. It does nothing to finance budget deficits.
     ANS: B                PTS: 1

28. When government debt is financed internally, future generations will
    a. inherit a lower tax liability.
    b. inherit neither higher taxes nor interest payment liability.
    c. inherit higher taxes.
    d. do none of the above.
     ANS: C                PTS: 1
29. After briefly running federal surpluses, in 2001 the budget returned to deficits because of
    a. a recession.
    b. the war on terrorism.
    c. a tax cut.
    d. all of the above.
     ANS: D                PTS: 1

30. Higher budget deficits would tend to
    a. raise interest rates.
    b. reduce investment.
    c. reduce the growth rate of the capital stock.
    d. do all of the above.
     ANS: D                PTS: 1

31. If the government budget deficit became a budget surplus because of cuts in federal government
    spending, other things being equal, which of the following would fall in the short run?
    a. interest rates
    b. investment
    c. unemployment
    d. the money supply
    e. None of the above would fall in the short run.
     ANS: A                PTS: 1

32. Deficit reduction will tend to
    a. decrease real output in both the short run and long run.
    b. decrease real output in the short run, but increase real output in the long run.
    c. increase real output in both the short run and long run.
    d. increase real output in the short run, but decrease real output in the long run.
     ANS: B                PTS: 1

33. A policy which increased the federal government deficit would tend to increase which of the following
    in the short run, other things being equal?
    a. aggregate demand
    b. real output
    c. the price level
    d. employment
    e. all of the above
     ANS: E                PTS: 1

34. Starting at full employment, if MPC = 2/3, an increase in government purchases of $10 billion would
    lead AD to ____ and ____ real output in the long run.
    a. increase $30 billion; increase
    b. increase $30 billion; not change
    c. decrease $30 billion; decrease
    d. decrease $30 billion; not change
    e. none of the above
     ANS: B                PTS: 1

35. A decrease in government purchases will do which of the following in the long run?
    a.   increase unemployment
    b.   decrease real output
    c.   decrease the price level
    d.   all of the above
    ANS: C                 PTS: 1


PROBLEM

 1. Answer the following questions:
    a. If the current budget shows a surplus, what would an increase in government purchases
        do to it?
    b. What would that increase in government purchases do to aggregate demand?
    c. When would an increase in government purchases be an appropriate countercyclical
        fiscal policy?

    ANS:
    a. An increase in government purchases would decrease a budget surplus.
    b. An increase in government purchases would increase aggregate demand.
    c. When the threat of a recession is developing.

    PTS: 1

 2. Answer the following questions:
    a. If the current budget shows a deficit, what would an increase in taxes do to it?
    b. What would that increase in taxes do to aggregate demand?
    c. When would an increase in taxes be an appropriate contractionary fiscal policy?

    ANS:
    a. An increase in taxes would decrease a budget deficit.
    b. An increase in taxes would decrease aggregate demand.
    c. When the threat of an unstable, inflationary boom is otherwise likely.

    PTS: 1

 3. Use the accompanying diagram (from page 789) to answer questions a–f.




    a.    At what short-run equilibrium point might expansionary fiscal policy make sense to help
          stabilize the economy?
    b.    What would be the result of appropriate fiscal policy in that case?
     c.                                                       What would be the long-run result if no fiscal policy action were taken in that case?
     d.                                                       At what short-run equilibrium point might contractionary fiscal policy make sense to
                                                              help stabilize the economy?
     e.                                                       What would be the result of appropriate fiscal policy in that case?
     f.                                                       What would be the long-run result if no fiscal policy action were taken in that case?

     ANS:
     a. At point E3.
     b. The economy would end up at a long-run equilibrium at point E2.
     c. The economy would end up at a long-run equilibrium at point E0.
     d. The economy would end up at a long-run equilibrium at point E1.
     e. The economy would end up in a long-run equilibrium at E0.
     f. The economy would end up in a long-run equilibrium at E2.

     PTS: 1

4. What would the multiplier be if the marginal propensity to consume was
   a.    1/3?
   b.    1/2?
   c.    3/4?

     ANS:
     a.   1/3?                                                                              1.5
     b.   1/2?                                                                                2
     c.   3/4?                                                                                4

     PTS: 1

5. If government purchases increased by $20 billion, other things being equal, what would be the
   resulting change in aggregate demand, and how much of that change would be a change in
   consumption, if the MPC were
                              Change in           Change in
                     Aggregate Demand         Consumption
   a. 1/3?
   b. 1/2?
   c. 2/3?
   d. 3/4?
   e. 4/5?

     ANS:
                                                                                                     Change in           Change in
                                                                                             Aggregate Demand         Consumption
     a.                                                    1/3?                                     $30 billion         $10 billion
     b.                                                    1/2?                                     $40 billion         $20 billion
     c.                                                    2/3?                                     $60 billion         $40 billion
     d.                                                    3/4?                                     $80 billion         $60 billion
     e.                                                    4/5?                                    $100 billion         $80 billion


     PTS: 1

6.   Why does it take a larger reduction in taxes to create the same increase in   AD as a given increase in government purchases?
     ANS:
     It is the initial effect in the goods and services market that triggers the multiplier process. When government increases its purchases, the dollar amount of the purchases is the magnitude of the initial effect. However, with a change in taxes, the initial effect is the change in consumption caused by the change in taxes, and that change in consumption is smaller than the change in taxes.




     PTS: 1

7.   Use the accompanying diagram (from page 790) to answer questions a and b.




     a.                                                       Starting from the initial equilibrium in the diagram, illustrate the case of a supply-side
                                                              fiscal policy that left the price level unchanged in both the short run and long run.
     b.                                                       Compared to your answer in a, when would a supply-side fiscal policy result in an
                                                              increase in the price level?


     ANS:
     a.




        This is what happens when the supply-side policy shifts aggregate demand and
        aggregate supply by the same amount.




     b.                                                       This is what happens when the supply-side policy shifts aggregate demand more than
                                                              aggregate supply.
     PTS: 1

8.   Why can a decrease in tax rates increase   AS as well as AD, whereas an increase in government purchases will increase AD but not AS?

     ANS:
     An increase in government purchases increase AD but it does not improve producers’ (supply side) incentives to produce and so does not change AS. A cut in tax rates similarly increases AD but to the extent that it improves producers’ incentives to produce, it also increases AS.




     PTS: 1

9.   Illustrate diagrammatically the short-run and long-run effects of a government budget deficit. Describe the mechanism that makes these effects different.




     ANS:
     In the short run, deficit reduction is contradictory fiscal policy; either tax increases and/or a reduction in government purchases will shift the aggregate demand curve to the left, and a lower price level and lower RGDP will result.
      In the long run, however, the story is different. Lowering the budget deficit, or running a larger budget surplus, leads to a lower real interest rate, which increases private investment and stimulates higher growth in capital formation and economic growth, shifting the SRAS and LRAS curves rightward. The final effect was a higher RGDP and a lower price level than would have otherwise prevailed.




     PTS: 1

				
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