Econ 102 Discussion Section 11 (Chapter 16) Chapter 13: Fiscal Policy Fiscal Policy: Changes in federal taxes or government expenditures used to achieve macroeconomic policy objectives - Note: Fiscal policy refers to federal policy only: not state or local policy. - Note: Fiscal policy must be designed to achieve macroeconomic goals. For instance, the hybrid tax car tax credit is environmental policy, not fiscal policy Two Types of Fiscal Policy 1) Automatic Stabilizers: Government expenditures that automatically change with the business cycle: the changes occur without any action from the government (i.e: unemployment benefits) 2) Discretionary Fiscal Policy: Government taking direct actions to change expenditures or taxes Cyclically Adjusted Budget Deficit: an estimate of what the budget deficit would be if GDP were exactly equal to potential GDP Fiscal Policy and Real GDP Recalling the AD-AS model, when the economy is not in a long run equilibrium, the government can use fiscal policy to return the economy to a long run equilibrium by shifting the AD curve Expansionary Fiscal Policy: Increases in government expenditures or reductions in taxes that shift AD right. This leads to higher GDP and prices Contractionary Fiscal Policy: Decreases in government expenditures or increases in taxes that shift AD left. This leads to lower GDP and price Limitations of Fiscal Policy Policy Lags: It can take a significant amount of time to enact fiscal policy (data collection, bill writing/debate, enacting approved policy), which can reduce the immediate effectiveness of discretionary fiscal policy Crowding Out: If the government pursues expansionary fiscal policy when the economy is not depressed, this can lead to a reduction in private investment in the long run. This is because expansionary fiscal policy leads to an increase in real GDP, which in turn increases money demand and the equilibrium interest rate. However, the increase in the interest rate also lead to a decrease in private consumption and investment. Fiscal Policy and the Multiplier Increases in government expenditure lead to increases in GDP via the multiplier. However, increases in transfer payments do not directly increase GDP. Only changes in government purchases lead to direct changes in AD. Decreases in taxes increase GDP by increasing income for consumers. However, consumers will not spend all of their additional income. They will increase spending based on the MPC. As a result, the net result on GDP is higher with a change in government spending than with a change in taxes !! ! Government Spending Multiplier = !! = !!!"# ! Tax Rate Multiplier = !! !!! !"# !! Lump-sum Tax Multiplier = !! Practice Problems 1) Which of the following would be classified as fiscal policy? A) The federal government passes tax cuts to encourage firms to reduce air pollution. B) The Federal Reserve cuts interest rates to stimulate the economy. C) A state government cuts taxes to help the economy of the state. D) The federal government cuts taxes to stimulate the economy. 2) Suppose that there was a federal budget surplus of $100 billion and that the economic output was above potential. If the economy had been at potential, it is estimated that tax revenues would have been $80 billion lower and that government spending would have been $70 billion higher. Using these estimates, what is the cyclically adjusted budget deficit or surplus? A.)$100 billion surplus B) $30 billion surplus C) $20 billion surplus D) $50 billion deficit 3) If the economy is rising above potential real GDP, which of the following would be an appropriate fiscal policy to bring the economy back to long-run aggregate supply? An increase in A) money supply B) government spending on infrastructure C) taxes D) gold prices 4) Suppose the tax multiplier is -1.5. When the government cuts taxes by $60 billion, what is change in GDP? A) a decrease of $90 billion B) an increase of $90 billion C) a decrease of $40 billion D) an increase of $40 billion 5) If policy makers are concerned that the economy is in danger of rising inflation because aggregate demand is increasing faster than aggregate supply, the appropriate fiscal policy response is to: A) Use expansionary fiscal policy B) Decrease government spending C) Increase interest rates D) Decrease taxes 6) If crowding out occurs, and increase in government spending: A) Increases the interest rate and consumption and investment spending rise B) Decreases the interest rate and consumption and investment spending rise C) Increases the interest rate and consumption and investment spending decline D) Decreases the interest rate and consumption and investment spending decline 7) If the economy suffers a negative supply shock, and the government responds with expansionary fiscal policy, this will ________ inflation and __________ unemployment A) Decrease, decrease B) Decrease, increase C) Increase, increase D) Increase, decrease 8) A cut in tax rates effects equilibrium real GDP through two channels: ___________ disposable income and consumer spending, and _____________ the size of the multiplier effect. A) Increasing; increasing B) Decreasing; decreasing C) Decreasing; increasing D) Increasing; decreasing Figure 16-5 9) Refer to Figure 16-5. In the dynamic model of AD-AS in the figure above, if the economy is at point A in year 1 and is expected to go to point B in year 2, Congress and the president would most likely A) decrease government spending. B) increase government spending. C) increase oil prices. D) increase taxes. 10) Crowding out will be greater: A) The less sensitive consumption is to changes in the interest rate B) If the economy is in recession, rather than at full employment C) The more sensitive investment spending is to changes in the interest rate D) The further equilibrium GDP is below potential GDP 11) The cyclically adjusted budget deficit calculates budget surplus or deficit A) If the economy was producing below potential GDP B) If the economy were at potential GDP C) If the economy were in recession D) If the economy was producing above potential GDP 12) Expansionary fiscal policy ____ the price level and ______ equilibrium real GDP A) Decreases; increase B) Decreases; decrease C) Increase; decrease D) Increase; increase 13) Given a consumption function C = $5000 + 0.8(YD) and an income tax rate of t = 0.25, by how much would the government have to change spending in order to close an output gap of 10% given that potential GDP is $5 trillion (remember: the sign of the output gap matters)? A) $300 billion B) -$250 billion C) $250 billion D) -$200 billion Table 16-1 Year Potential Real GDP Real GDP Price Level 2013 $14.0 trillion $14.0 trillion 150 2014 14.5 trillion 14.2 trillion 152 14) Refer to Table 16-1. Consider the hypothetical information in the table above for potential real GDP, real GDP and the price level in 2013 and in 2014 if the Congress and the president do not use fiscal policy. If the Congress and the president want to keep real GDP at its potential level in 2014, they should A) decrease income taxes. B) decrease government purchases. C) decrease the money supply. D) increase the level of interest rates. 15) The increase in the amount that the government collects in taxes when the economy expands and the decrease in the amount that the government collects in taxes when the economy goes into a recession is an example of A) automatic stabilizers. B) discretionary fiscal policy. C) discretionary monetary policy. D) automatic monetary policy. 16) To combat a recession with discretionary fiscal policy, Congress and the president should A) decrease government spending to balance the budget. B) decrease taxes to increase consumer disposable income. C) lower interest rates and increase investment by increasing the money supply. D) raise taxes on interest and dividends, but not on personal income. Answers: 1. D) 2. D) 3. C) 4. B) 5. B) 9. B) 10. C) 11. B) 12. D) 13.D) 6. C) 7. D) 8. A) 14. A) 15. A) 16. B)