Even if I have to dig a hole

Even if I have to dig a hole and cover it back up, I do have a job. FISCAL POLICY [“G” and “T”] John Maynard Keynes “Father of Fiscal Policy”

Introduction • This chapter confronts the following questions: 1. Can government spending and tax policies help ensure full employment? 2. What policy actions will help fight inflation? inflation 3. What are the roles of government intervention? intervention

Taxes (“T”) and “G”Spending • Up until 1915, the federal government 1915 collected few taxes and spent little. • In 1902, it employed fewer than 1902 350, 000 people and spent $650 million. • Today, it employs nearly 4. 3 million people and spends more than $3. 4 trillion.

Government Revenue • Government expansion started with the 16 th Amendment to the U. S. Constitution (1913) Amendment 1913 which extended the taxing power to incomes. • Today, the federal government collects over $2. 7 trillion a year in tax revenues. trillion

Let’s say the German government decides to connect East Germany to West Germany by constructing a water bridge over the Elbe River. They did this, spending 500 million euros. The next picture is a kilometer-long “concrete bathtub” water bridge near the town of Magdeburg.

Loanable Funds Market Real Interest Rate, (percent) [*Use this graph if there is a chg in savings by consumers or chg in fiscal policy] [*Use the Money Market graph when there is a change in MS] D 1 D 2 S Lenders Borrowers IR=10% E 2 I R= 8% E 1 Use the “real interest rate” with LFM, because it is long-term. LFM long-term Use “nominal interest rate” with money market, as it is short-term. market short-term Starting from a balanced budget, if the budget G incr spending or decr T to get out of spending T a recession, they would now be running recession a deficit and have to borrow, pushing deficit up demand in the LFM and increasing LFM the interest rate $2 T F 1 F 2 Quantity of Loanable Funds G $2 T T Balanced Budget [G&T=$2 Tr. ]

Demand for Loanable Funds Market (b) (a) Business firms demand for Demand for Loanable Funds at 3% [a lot of investment] [no G borrowing] DI Real Interest Rate S D 1[no G] 3% A LFM 3% A 1. 5 QID Trillions of Dollars Low interest rates, so - a lot of investment

Demand for Loanable Funds Market (b) (a) With “G” borrowing, the demand for LF at 5% Government Demand for Funds Real D 2(G) Interest Rate 5% S D 1[no G] 3% B A LFM Business firms demand for Loanable Funds at 5% [not as much investment] Business Demand for Funds DI 5% B 3% A 1. 0 1. 5 QID 2 QID 1 Trillions of Dollars Higher interest rates, so not as much investment

Balanced Budget [$2 Tril. “G” = $2 Tril. “T”] Recession $2 Trillion Incr G to $2. 2 $2 Trillion Deficit so higher I. R. or Decr T to $1. 8 So expansionary fiscal policy leads to higher interest rates. G T Inflation Decr G to $1. 8 or Incr T to $2. 2 So, contractionary fiscal policy leads to lower interest rates. Gonna have to borrow Budget Deficit Surplus so Lower I. R. Wow! A surplus

[Incr G; Decr T] PL Start from a Balanced Budget G & T = $2 Trillion $2 T G $2 T T PL 2 PL 1 SRAS AD 2 LRAS AD 1 “I can’t get a job. ” E 1 E 2 YR YF G T AD DI Y/Empl. /PL; C “Now, this is better. ” AD Real GDP G Y/Emp/PL; T LFM I. R. IR

[Decr G; Incr T to close a contractionary gap] PL SRAS Start from a Balanced Budget G & T = $2 Trillion AD 2 LRAS PL 1 $2 T G E 1 $2 T PL 2 T E 2 AD 1 YF YI G T AD DI Real GDP G LFM Y/Empl. /PL; C AD Y/Emp/PL; T [like we have “money trees”] LFM I. R. IR

Everyone Wants To Go To Heaven But No One Wants To Die. Everyone Wants Government Spending But No One Wants To Pay Taxes.

Recessionary Gap AD 1 SRAS AD 2 LRAS YR Y* Expansionary Fiscal Policy Keynes and Lydia Lopokova G T

Inflationary Gap SRAS LRAS AD 2 AD 1 Y* YI Expansionary Contractionary Fiscal Policy G T

The automatic stabilizers may be called the automatic pilot of our economy, not very well suited for takeoffs and landings, economy but fine for the smooth part of the flight. But when the going gets rough, the economy must use manual controls. [discretionary G&T] rough controls G&T Nondiscretionary Fiscal Policy (Automatic stabilizers) 1. Transfer Payments A. Welfare checks B. Unemployment checks C. Food Stamps D. Social Security E. Corporate dividends F. Veteran’s benefits 2. Progressive Income Taxes Automatic stabilizers take 33 -50% out. Stabilizers are like a thermostat maintaining temperature. They are shock absorbers. 33%-50% AD 2 AS AD 2 AD 3 YR Y* YR ; T ; AD 2 YI ; T YI ; AD 3 A pilot may take a stroll thru & let the co-pilot cruise. If there is thru cruise turbulence, the pilot will rush back to the cockpit turbulence pilot will rush back to the cockpit [President & Congress] and use manual controls to correct economic turbulence. Discretionary turbulence fiscal policy is our manual control system

More vertical [more progressive], the more stability for the economy. Taxes Government Expenditures, G, and Tax Revenues, T 12 -31 -65 Taxes Transfers More Transfers Deficit Less Tax Money More tax money Surplus G ov. Fewer purchases Transfers by Fed, state and local governments GDP 1 GDP 2 GDP 3 YR YI Y* Real Domestic Output, GDP

Keynesian Model Recess. Gap Inflat. Gap

Discretionary Fiscal Policy Deliberate use of government spending and/or taxing. “G” and “T” Discretion of Congress Nondiscretionary Fiscal Policy Unempl. check Automatic Stabilizers 1. Welfare & food stamps 2. Unemploy. insurance 3. Social security 4. Corporate Dividends 5. Progressive Tax System

Fiscal Policy Automatic stabilizers. Suppose the economy is in recession: Real GDP AD 1 AS AD 2 PL YR Y* “Recession” Tax collections Transfer payments G>T The deficit grows

Fiscal Policy Automatic stabilizers. If the economy has an inflationary gap: Real GDP PL AS AD 2 AD 1 Tax collections Transfer payments G

Discretionary Fiscal Policy Discretionary Contractionary Fiscal Policy 1. Decrease “G” 2. Increase “T” Expansionary Fis. Policy 1. Increase “G” 2. Decrease “T”

The Kennedy/Johnson $10 Billion Tax Cuts of 1964 The “Golden Age of Fiscal Policy”

When Kennedy came into office: 1. The top marginal tax rate was 91% & drops to 52% [35% today] 2. The unemployment rate was 6. 7% & drops below 5%. 3. A recession becomes a very good low unemployment - low inflation (2%) economy. 4. The expansion continued to 1969. Kennedy had been hesitant about a $10 billion tax cut but finally saw the Keynesian Light. 12/31 -65

Keynesian Policy: “Balance the Economy, not the Budget. ” “Even if the jobs are digging holes and filling them up. ” Deficits Surpluses

FINANCING OF DEFICITS [Is borrowing or printing the money more expansionary? ] 1. Government borrows from the public [results in higher interest rates which crowds out investment] Higher I. R. MS 1 MS 2 2. Just print the money [Money creation – lower interest rates so this would be more expansionary] But the LR increase in MS results in an increase in inflation PL 2 7% 4% Lower I. R. AD 2 AS AD 1 PL 1 Y* Y

How To Dispose of Surpluses [Should we hold the surplus or give it back] 1. Debt Retirement [Give the surplus back during recessions to get lower interest rates and expand the economy] 2. Impound The Surplus [Keep the surplus during inflations and give it back during recessions] AD 2 AS AD 1 PL Y* YI

“CROWDING OUT” EFFECT [Incr G AS AD 2 AD 1 4% 2% G 14 IG Y* 12 Friedman Just follow the “monetary rule. ” Decr Ig] G can finance a deficit by: 1. Borrowing - this raises interest rates in the LFM and “crowds out” investment. 2. Money Creation - no “crowding out” so is more expansionary than borrowing. 10 Real interest rate (%) YR 16 incr I. R. 8 6 4 2 Crowding Out Effect DI 0 5 10 15 20 25 30 35 Investment (billions of dollars) 40

Negative Net Export Effect of Fiscal Policy “Negative Xn” Expansionary Fiscal Policy Due to higher interest rates, dollar appreciates LRAS SRAS AD +G +C +Ig AD -Xn YR Y*

Negative Net Export Effect of Fiscal Policy “Negative Xn” of Expansionary Fiscal Policy Contractionary Fiscal Policy Due to higher interest rates, dollar appreciates Due to lower interest rates, dollar depreciates LRAS SRAS AD AD -Ig -C -G +Xn +G +C +Ig -Xn YR Y* Y* YI

Liberal (“G”) or Conservative (“G”) G G Liberals Recession: Increase “G”; Inflation: Increase “T” Conservatives Recession: Decrease “T”; Inflation: Decrease “G”

Fiscal Policy Lags “The shower starts out too cold, because the pipes have not yet warmed up. So the fool turns up the hot water. nothing happens, so he turns up the hot water further. The hot water comes on and scalds him. He turns up the cold water. Nothing happens right away, so he turns up the cold further. When the cold finally starts to come up, he finds the shower too cold, and so it goes. ” Fiscal Policy lags 1. 2. 3. 4. Data (recognition) lag “Wait-and-see” lag – short run Legislative lag (political) Effect lag [takes months]

E 4 LRAS AD 1 AD 2 SRAS 1 SRAS 2 E 1 E 2 E 4 E 3 YR YF YI E 2

Traditional Fiscal Policy [“G” & “T”] will not work with Stagflation AD 2 LRAS SRAS 2 AD 1 15% 10% 4% AD 3 15% 10% 5% YR YR YF Stagflation

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

Tax rate (percent) 100 l 0 Tax revenue (dollars)

Tax rate (%) 100 m l 0 Tax revenue (dollars)

100 Tax rate (percent) n m l 0 Tax revenue (dollars)

100 Tax rate (%) n m m Maximum Tax Revenue l 0 Tax revenue (dollars)

Ben Stein’s part in this movie as a boring econ prof was voted one of the 50 most famous scenes in American film. Ben Stein [from “Ferris Bueler’s Day Off”] graduated from Columbia University in 1966 with a degree in economics and from Yale Law School in 1970 as valedictorian. He was a speech writer for Nixon. He has written 16 books, including his latest humor book, “How To Ruin Your Life”.

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 hitting the 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 Laffer cuve. I couldn’t shoot my way out” Tax revenue (dollars) m 0 Maximum Tax Revenue n l Reagan The “Gipper” m Tax rate (percent) 100 Bonzo For rich people, there would be a disincentive to quit working when people they hit the top marginal tax rate. For most workers, this was not the case. most workers not the case

Emphasis on Expansionary Tax Cuts [which shifts AD to the right, increasing Y & PL] Impact upon. . . • Saving and Investment [Lower taxes increase DI & S; less business taxes will increase investment. Our “national factory” will increase. ] We will have Economic [Keeping more of our money makes us work harder and longer] Heaven. • Work Incentives • Risk Taking [Lower tax rates promise a larger potential after-tax reward] So, the AS Curve will shift right bringing prices down.

SUPPLY-SIDE FISCAL POLICY Can sustain a much greater increase in AD if the AS curve is also shifting to the right. Price level AD 1 AD 2 AS 1 AS 2 PL 2 10% PL 1 PL PL 3 0 Q 1 Q 2 10% Q 3 Real GDP

MULTIPLIER WITH PRICE-LEVEL CHANGES Inflation and the Multiplier [4] AS Price Level Full Multiplier Effect AD 1 AD 2 AD 3 +20 Reduced Multiplier Effect Due to Inflation P 2 P 1 + 80 bil. M(4)=chg. Y/chg. E [80] [20] GDP 1 + 40 bil. GDP 2 GDP 3 M(2)=chg. Y/chg. E [40] [20]

EXPANSIONARY FISCAL POLICY [MPS=. 25] the multiplier at work. . . $5 billion initial direct increase in spending AS Price level AD 1 AD 2 Full $20 billion increase in AD +5 P 1 $485 $505 Real GDP (billions)

CONTRACTIONARY FISCAL POLICY [MPS=. 25] the multiplier at work. . . AS AD 2 AD 1 Price level P 1 P 2 $5 billion initial direct decrease in spending Full $20 billion decrease in AD $515 Real GDP (billions)

LEGISLATIVE MANDATES Employment Act of 1946 Council of Economic Advisors(CEA) Joint Economic Committee (JEC)

Legislative Mandates for Remedial Fiscal Measures 1. Employment Act of 1946 – a law promoting economic stability 1946 (by promoting “maximum employment, production, and purchasing power”) through monetary and fiscal policies This act was a government commitment to ensure prosperity commitment after WWII. [not only “could” but “would” – no more laissez faire] “could” “would” This act gave the Keynesians economists theoretical and economists legal justification to use fiscal policy to stabilize the economy. justification policy 2. Council of Economic Advisers (CEA) [for the President] – 3 distinguished economists (on leave from President economists universities) who assist and advise the President on economic President matters. Their staff is made up of 11 senior and 6 junior economists. They forecast and project the deficit, inflation, GDP growth, foreign exchange rates, immigration, & antitrust legislation The President must submit annual economic report describing the current economic state with recommendations. “The President’s intelligence arm in the war against the business cycle. ”

Greg Mankiw of Harvard has ridiculed supply-side tax cuts as “fad economics” conceived by “charlatans and cranks, ” in his textbook. Head of the CEA Edward Lazear PHD in Econ, Harvard Matt Slaughter of Dartmouth Ben Bernanke, Former Board Governor, succeeded Maniew. [scored 1590 on SAT] [Now Chairman of Fed] Katherine Baicker U. C. L. A.

Joint Economic Committee of Congress and Humphrey-Hawkins Act of 1978 If you look at my “C” average college grades, the CEA can help me.

AE & Fiscal Policy Questions on 2000 AP Exam If MPS incr from. 10 to. 20, the ME would decrease from 10 to 5. 1. (81%) The value of the spending multiplier (ME) decreases when multiplier a. tax rates are reduced d. government spending increases b. exports decline c. imports decline e. the marginal propensity to save increases 2. (75%) Which of the following policies would a Keynesian recommend during recommend a period of high unemployment and low inflation? 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 AS 3. (47%) Which of the following best explains why equilibrium income will increase by more than $100 in response to a $100 increase in G? in The Multiplier ensures more C a. Incomes will rise, resulting in a tax decrease. b. Incomes will rise, resulting in higher consumption. with each round. 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 inventories usually precede inventories a. increases in inflation b. increases in imports c. stagflation d. decreases in production e. decreases in unemployment

S Full. Employ. AE 5. (63%) The economy on the right is is currently experiencing C+Ig E a. inflation b. recession c. expansion $500 C A d. stagflation e. rapid growth $400 6. (77%) Correct monetary policy to policy reach FE GDP is to increase GDP a. the MS b. the RR c. discount rate d. taxes e. exports 0 $800 $1, 000 $2, 000 7. (36%) The minimum increase in government spending to reach full employment is spending employment Determine what the “M” is going a. $2, 000 b. $1, 000 c. $500 from A to E; then M X ? = $1, 000 d. $200 e. $100 8. (58%) In the simple Keynesian AE model [not AD/AS] of an economy, model AD/AS] changes in Ig or G will lead to a change in which of the following? which a. the price level b. the level of output and employment c. interest rates d. the AS curve 9. (83%) In a closed-private in which the APC is. 75, which of following is true? closed-private. 75 true 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 c. If income is $200, then saving is $50 e. If income is $500, then saving is $100

10. (63%) Suppose that DI is $1, 000, consumption is $700, and the MPC is. 6. $1, 000. 6 If DI then increases by $100, consumption and savings will equal which of $100 the following? If $700 of $1, 000 DI is consumed, then Consumption Savings saving is $300. MPC of. 6 means if DI a. $420 $280 increases by $100, then $60 more will be b. $600 $400 consumed & $40(. 4) more will be saved(40%). c. $660 $320 The $60 added to the $700 already consumed d. $660 $440 = $760 consumed and the additional $40 e. $760 $340 saved = $340 saved. Fiscal Policy Questions from 2000 Exam 11. (73%) An inflationary gap can be eliminated by all of the following EXCEPT gap a. an increase in personal income taxes d. a decrease in G b. an increase in the MS e. a decrease in Xn Which answer does not slow the economy? c. an increase in the interest rate 12. (56%) A major advantage 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

13. (70%) In the short run, a contractionary fiscal policy will cause AD, policy AD output, and the price level to change in which of the following ways? output level AD Output Price level a. decrease b. decrease increase c. increase decrease d. increase 14. (52%) Crowding out due to government borrowing occurs when out 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 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 billion 16. (42%) Compared to expansionary monetary policies adopted to policies counteract a recession, expansionary fiscal policies tend to result in policies a. less public spending c. a high rate of economic growth b. higher interest rates d. lower prices

1995 AP Exam 17. (71%) An increase in which will increase the value of the ME? in 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 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 & 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 money 20. (85%) Which of the following will result in the greatest increase in AD? 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 taxes 21. (65%) Which of the following will result from a decrease in government spending? 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

Expenditures Questions 22 -23 refer to the diagram(rt), which depicts an economy’s “C” function. 22. (56%) If the MPC increases, the equilibrium increases S C+Ig C C 2 levels of income and consumption will 0 Ig 0 change in which of the following ways? change C 1 + $1 Equil. Level $700 of Income of Consumption a. No change b. No change Increase 0 $1, 500 $2, 000 Real Income c. Increase No change A larger MPC means a smaller MPS, and a larger M. d. Increase this will increase income and result in more “C” at e. Decrease the new level of equilibrium income (GDP). 23. (48%) If private investment of $100 is added to the economy, the equilibrium levels added of income and consumption will change in which of the following ways? change Equil. Level of Income of Consumption a. Increase Decrease b. Increase c. Increase No change d. No change Increase e. No change

AE F 22. (61%) The graph indicates equilibrium at E for a closed economy without G. If the economy addition of G results in equilibrium at F, at 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. C+Ig+G C+Ig E $300 $200 0 $1, 000 $1, 500 GDP $1, 500 23. (84%) According to Keynesian theory, decreasing taxes and increasing G will theory G most likely change consumption and unemployment in which of the following ways? consumption unemployment Consumption Unemployment a. Decrease No change b. Decrease No change c. Increase Decrease d. Increase e. No change Decrease 24. (79%) In an economy at full employment, a presidential candidate proposes cutting employment the government debt in half in 4 years by increase T and reducing G. According to G Keynesian theory, implementation of these policies is most likely to increase theory a. unemployment d. aggregate supply b. consumer prices c. aggregate demand e. the rate of economic growth

25. (79%) If the economy is in a severe recession, which of the following is the recession fiscal policy most effective in stimulating production and employment? policy in 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 decrease expenditures and tax revenues by the same amount. This action will affect revenues amount affect output and interest rates in which of the following ways? output rates Output Interest Rates a. Increase b. Increase c. No change d. Decrease e. Decrease Increase Decrease An equal decrease in G & T [Let’s say by $10 billion] would decrease GDP by $10 billion. The decrease in GDP would billion decrease PL which would cause a decrease in interest rates 27. (28%) If crowding out only partially offsets the effects of a tax cut, which of the out cut following changes in interest rates and GDP are most likely to occur. changes rates GDP Interest Rates GDP a. Increase Partially means GDP increases. Starting from a increases b. Increase Remain unchanged budget, the tax cut would put the G in deficit balanced c. Increase Decrease and the G borrowing would increase demand for money d. Remain unchanged Increase in the LFM and push up interest rates e. Decrease

28. (62%) According to the Keynesian saving schedule, when schedule aggregate income increases by a given amount, savings will increases a. remain the same b. decrease by the amount of the change in income c. increase by the amount of the change in income d. increase by less than the amount of the change in income e. increase by more than the amount of the change in income

President Bush’s College Transcript And – What did President Bush have to say about “power pants”?

1. With the Employment Act of 1946, the federal government committed 1946 itself to accept (total/some) degree of responsibility for employment/prices. 2. Fiscal policy is carried out primarily by the (local/state/federal) government. 3. Discretionary fiscal policy [G & T] (does/does not) require congressional action. 4. In a mixed [private & public) closed economy, taxes & (savings/government spending) economy are leakages, while Ig and (savings/government spending) are injections. leakages injections 5. In a mixed economy, the equilibrium GDP exists where (C+Ig/C+Ig+G+Xn)=GDP. economy 6. The balanced budget multiplier indicates that equal increases in G&T tend to (decrease/increase/not change) the equilibrium GDP. [M BB is “ 1”] 7. Assume in a private economy that equilibrium GDP is $400 billion & the MPC is. 80. Suppose the G collects new taxes of $50 bil. & spends the entire amount on our infrastructure. As a result equilibrium GDP will be ($400/$450/$500) bil. 8. Suppose a constitutional amendment requires that the G always balance its budget. If it desired to increase GDP by $40 billion, G should budget billion (increase/decrease) government spending & taxes by ($30/$40/$50) billion.

9. In a severe recession, Keynesians would favor a(n) (increase/decrease) in taxes. PL AE 2 AE 1 YR Y* 800 ? 10. If the government tries to eliminate a budget deficit during a depression, depression these efforts will (help/hurt) the depression. 11. A conservative economist who advocates an active fiscal policy would recommend tax (increases/decreases) during a recession and (increases/decreases) in government spending during inflation. S AE PL C YR A I 12. If the F. E. GDP is OC, then it would be appropriate fiscal policy for O government to (increase/decrease) “G” and (increase/decrease) “T”. “G” “T” 13. If the F. E. GDP is OA, then it would be appropriate fiscal policy for government to (increase/decrease) “G” and (increase/decrease) “T”. “G” “T”

14. If G increases its spending during 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 expansionary. 15. The following fiscal actions, (incurring a budget surplus and 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 inflation. greatest anti-inflationary impact of a budget surplus will occur when the G (impounds/uses) the surplus 16. The funds & lets them (stand idle/pay off the debt). Should I give it back? 17. In describing the built-in stabilizers, we can say that personal & corporate income tax collections automatically (incr/decr) as GDP increases & transfers & subsidies (incr/decr) as GDP increases.

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

FISCAL POLICY – Pure and Simple There are 3 things that could “diminish AD. ” Price level AD 1 AD 2 AS Fiscal Policy: No Complications P 1 $490 YR $510 Real GDP (billions) Y*

Three things that could “diminish AD. ” 1. Crowding-out Effect 2. Net Export Effect AD 1 AD’ 2 AD 2 AS Net Export Effect Expansionary fiscal policy leads to more government borrowing, increasing the interest rate, & decreasing Ig PL 1 Crowding-out Effect Higher interest rates decrease investment] and the. . . $490 $503 $510 Real GDP (billions)

3. Inflation would be a third factor That could reduce aggregate demand AD 2 Price level AD 1 AS P 1 $495 $505 $515 Real GDP (billions)

NS 18 -21 T 2 1 Answer the next 3 questions(18 -21) based on the diagram. 18. Deficits 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 D, the F. E. budget will entail a (deficit/surplus). 20. If the tax line had a greater slope [more progressive tax system], stability would be (less/greater). 21. If government adhered strictly to an annually balanced budget then the government’s budget would tend to the economy. (destabilize/stabilize)

For Questions 22 -24 [graph] 22. (T 1/T 4) tax system is characterized by the least built-in stability 23. (T 1/T 4) tax system is characterized by the most built-in stability 24. (T 1/T 4) tax system will generate the largest cyclical deficits 25. Nondiscretionary Fiscal Policy NS 22 -30 (does/does not) require congressional action. 26. If the MPC is. 5, a $10 B increase in “G” will increase “C” [not income] by ($20/$10/$5) billion. income [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). year 28. When politicians use fiscal policy to cause an improvement in the economy just prior to an election, this is called a election (presidential/Congressional/political) business cycle. 29. When G incurs a deficit which is financed by borrowing, borrowing causing interest rates to increase which decreases Ig, this is Ig called the (crowding-in/crowding out) effect. 30. Supply-siders argue that the primary effect of tax cuts is to shift the AS curve (leftward/rightward).

NS 31 -34 31. If the MPC is. 8, a $2 billion increase in “G” will increase “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. 9, a $1 billion increase in “G” will increase “consumption” by ($10/$9/$8) billion. “consumption” AE 33. In a private-closed economy, the MPS is. 2, consumption equals income at $200 billion, and the level of investment is $10 billion. The equilibrium level of income at the new level is ($200/$250) billion. 34. If the MPS is. 2 and the economy has a recessionary spending gap of $5 billion, we may conclude that the equilibrium billion level of GDP is ($5/$20/$25) below the FE GDP. 200 “C” Ig $10 + 200 ? AE S AE 2 AE 1 +$5 YR S C+Ig ?

NS 35 - 38 35. If the MPS is. 5 and the economy has an inflationary spending gap of $6 billion, we may conclude that the equilibrium level of GDP is ($6/$12/$18) billion above the GDP FE GDP. S AE 1 AE 2 AE -$6 Y* YI 36. If the government decreases G&T by $10 billion, then a MPS of. 10, the equilibrium GDP would (increase/decrease) by GDP ($5/$100) billion. 37. With a MPC of. 75, Government increases G&T by $8 billion. The equilibrium GDP (increases/decreases) by ($75/$32/$8) billion. 38. If the government runs a budget surplus and desires to curb inflation, it should (give the surplus back/keep it in storage).

1. Expansionary fiscal policy will be most effective AS curve is (vertical/horizontal) & (incr/decr) “C” and (incr/decr) unemployment. [increase GDP] when the 2. The paradox of thrift indicates that an increase in saving (matched/ unmatched) by an increase in investment will lower equilibrium GDP. [On #3, start from a balanced budget] G $2 Tr. T $2 Tr. [G ; LFM ; In. Rates ] 3. A contractionary fiscal policy [decr G, incr T] would cause a[an] T (incr/decr) in output[GDP] and a[an] (incr/decr) in interest rates. An expansionary fiscal policy [incr G, decr T] would cause a[an] T (incr/decr) in output[GDP] and a[an] (incr/decr) in interest rates. [G ; LFM ; In. Rates ] 4. In the AE model, if AE[AD]doesn’t buy up FE output(GDP), then the output(GDP) equilibrium output is (less than/more then) full employment output. “Recessionary Gap” “Inflationary Gap”

5. To decrease AD the greatest amount, the government should: amount (decrease “G” only/increase “T” only/both decr G & incr T) 6. To increase AD the greatest amount, the “G” should: (increase “G” only/decrease “T” only/both incr G and decr T) 7. In a recessionary gap (AE model) at the equilibrium point[actual GDP] planned investment is (greater than/equal to/less than) saving, but at the FE GDP level, planned investment[backup] is (greater than/equal to/less than) saving. level saving 8. In an inflationary gap(AE model), at the equilibrium point [actual GDP] gap model 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 inventories, AE is inventories (less than/greater than) FE output & spending will (increase/decrease). 10. If businesses are experiencing an unplanned decrease in inventores [disinvestment] disinvestment AE is (less than/greater than) FE output & spending will (increase/decrease).

500 11. If “C” equals income at $500 billion, & MPC is. 9, then an billion. 9 increase in Ig of $10 billion will change equilibrium GDP to ($400/$490/$510/$600) billion. 12. A conservative economist would want tax (incr/decr) during a recession & (incr/decr) in “G” during inflationary times 13. A liberal economist would want tax (incr/decr) during an inflation & (incr/decr) in “G” during recessionary periods 14. An inflationary gap indicates AE[actual GDP] (exceeds/falls short of) FE GDP. 15. A recessionary gap indicates AE[actual GDP] (exceeds/falls short of) FE GDP. 16. To increase GDP[but reduce military spending], we would combine two spending] (domestic/overseas) bases into one (domestic/overseas) base. 17. A tax cut to expand the economy would (incr/decr) Y & (incr/decr) in. rates. 18. A tax increase to contract the economy would (incr/decr) Y & (incr/decr) IR.

19. To 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 $500 billion & MPS is. 4. Now “G” collects taxes of of $22 billion and spends the entire amount. As a result, equilibrium GDP amount will change to: ($445/$478/$522/$555). 21. With a MPC of. 5, a $12 billion increase. 5 in “G” will increase “C” by ($12/$24/$36) bil. 22. With a MPC of. 5 and the economy in a recessionary spending gap of $12 billion, we may conclude that the equilibrium is ($12/$24/$36) billion short of FE GDP

23. An increase in Ig of $25 billion results in an increase billion in equilibrium income(GDP) of $50 B, so the MPS is? . 5 24. A contractionary fiscal policy results in a(n) (incr/decr) in output, and a(n) (incr/decr) in interest rates. [Incr T or Decr G] 25. Increasing T or decreasing G will (increase/decrease) consumption, and (increase/decrease) unemployment. 26. With a MPC of. 5, and the economy with an inflationary GDP. 5 inflationary Gap of $50 B, G could eliminate this inflationary GDP Gap by Gap inflationary Gap reducing government spending by? $25 bil. spending 27. With a MPC of. 5 and current output at $500 bil. but FE . 5 FE output is $700 bil. , correct fiscal policy would be to bil policy (increase G/decrease T) by $100 billion.

28. An increase in Ig in an economy (increase)/decrease) GDP & (increase/decrease) C. 29. In a recessionary economy, at economy FE GDP, saving is (less than/more than) Ig. FE GDP saving Ig 30. In a recessionary economy, economy (actual Y/potential Y) exceeds (actual Y/potential Y). 31. In a mixed-closed economy (no Xn), the leakages are? economy Xn leakages [S & T] and the injections are? [G & Ig] injections 32. If the economy has an inflationary Gap, at Gap FE GDP, saving (exceeds/is less than) Ig. GDP saving 33. If there is an equal increase in G&T of $25 bil. , bil then output will (increase/decrease) & interest rates output [based on PL] will (increase/decrease). PL]

E-con The End

“Econ, econ” Review for AE & Fiscal Policy