CHAPTER 11: Fiscal Policy

Transcription

1 CHAPTER 11: Fiscal Policy 1a. Unemployment is below its natural rate and inflation is an increasing problem, so that real output must be above its potential level, and the economy faces an inflationary gap. To diminish this gap, the government can reduce its purchases, raise taxes, or pursue both actions simultaneously. Any of these actions results in a leftward shift in the AD curve. b. With declining output and unemployment above its natural rate, real output falls short of its potential level and the economy is experiencing a recessionary gap. This gap can be lessened by increasing government purchases, cutting taxes, or combining these two actions. Each of these actions results in a rightward shift in the AD curve. c. Because unemployment is at or close to its natural rate, equilibrium real output approximates its potential level. Therefore, no fiscal policy is required. 2a. The MPC is 0.35 (= $ /$ ), the MPW is 0.65 (= ), and the spending multiplier is 1.54 (= 1/0.65). b. The MPC is 0.25 (= -$ /-$ ), the MPW is 0.75 (= ), and the spending multiplier is 1.33 (= 1/.75). c. The MPW is 0.60 (= -$ /-$ ), the MPC is 0.40 (= ), and the spending multiplier is 1.67 (= 1/.60). 3. With a regressive tax system, changes in income cause only a small change in tax revenues. This dampens decreases in net tax revenues during periods of falling incomes and also dampens increases in net tax revenues when incomes are rising. Therefore, automatic stabilizers become less effective and the statement is true. 4a. MPW = (.60) +.05(.60) = =.61 b. Because MPW is.61, MPC is.39 (= ). This means that 39 cents of each new dollar of income is spent on domestic consumption items. c. The spending multiplier is 1.64 (= 1/.61). Chapter

2 5. FIGURE 11A 1 The Effects of a Rise in Government Purchases With MPC equal to 1/3, MPW equals 2/3 (1 - (1/3)). In the first spending round, the full increase in government purchases is spent, giving a $810 rise in real output and no increase in withdrawals. In the second spending round, real output rises by a further $270 (= (1/3) x $810), as sellers of the goods and services that were exchanged in the first round spend one-third of their $810 in new income on domestic consumption items. The remaining $540 (= (2/3) x $810) is used for withdrawals. In the third spending round, real output jumps by a further $90 (= (1/3) x $270), as sellers of the goods and services that were exchanged in the second round spend one-third of their $270 in new income on domestic consumption items. The remaining $180 (= (2/3) x $270) is used for withdrawals. 6a. Given an MPW of 0.65, the spending multiplier is 1.54 (= 1/0.65), so that the AD curve finally shifts to the right by $3.08 billion (= 1.54 x $2 billion). b. With an MPC of 0.45, MPW is.55 (= ). The spending multiplier is therefore 1.82 (= 1/.55), so that the AD curve finally shifts to the left by $9.09 billion (= 1.82 x $5 billion). c. Given an MPW of 0.7, the MPC is 0.3 (= 1-0.7), and the spending multiplier is 1.43 (= 1/0.7). The AD curve finally shifts to the left by -$1.3 billion (= -(0.3 x $3 billion) x 1.43). Chapter

3 d. A $4 billion tax cut causes spending to rise initially by $1.5 billion, MPC is.375 ($1.5 billion/$4 billion), which means MPW is.625 (= ). The spending multiplier is therefore 1.6 (= 1/.625), so that the AD curve finally shifts to the right by $2.4 billion (= 1.6 x $1.5 billion). 7a. MPW is.55 (= $4.4 billion/$8 billion) and MPC is.45 (= ). The multiplier is therefore (= 1/.55). b. The AD curve shifts to the left by $14.5 billion (= x $8 billion). c. FIGURE 11-A2 Contractionary Fiscal Policy Price Level (GDP deflator, 2002 = 100) Because a contractionary policy is being applied, the economy s initial equilibrium real output must be above potential output. This means that the AS curve is steep, so that the decrease in the equilibrium price level (for example, from 130 to 120, as shown in the graph) is proportionally greater than the drop in equilibrium real output (for example, from $650 billion to $645 billion as shown in the graph). Because of price-level changes, the fall in equilibrium real output is less than the $14.5 billion leftward shift in the AD curve. 8a. Higher tax rates lead to a rise in tax revenues, causing a leftward shift Chapter

4 in the AD curve, and pushing down the equilibrium real output and price level. b. Higher tax rates cause a rise in the marginal propensity to withdraw. This means that more funds are withdrawn in every spending round, which reduces the size of the spending multiplier. c. Higher tax rates mean that changes in income lead to larger changes in net tax revenues. Because tax revenues decrease more during periods of falling incomes and increase more when incomes are rising, automatic stabilizers become more effective. 9. When viewing a provincial economy as a separate entity, items from outside the province are treated as imports (and therefore as withdrawals) in the same way as products from outside Canada. This means that the MPW within a provincial economy is greater than the MPW within the entire Canadian economy. The result is a lower spending multiplier for provincial fiscal policy. 10. FIGURE 11A 3 Effects of Annually Balanced Budgets Price Level (GDP deflator, 2002 = 100) Price Level (GDP deflator, 1997 = 100) When the economy faces a recessionary gap (graph a), net tax revenues are reduced because of low incomes and high unemployment. The requirement of an annually balanced budget means that either government purchases must be reduced or tax revenues raised. In either case, aggregate demand decreases from AD 0 to AD 1. The result is a higher recessionary gap and a more severe downturn in the economy. In contrast, an inflationary gap (as shown in graph b), leads to an expansion of tax revenues due to high incomes and low unemployment. Given the requirement of an annually balanced budget, either Chapter

5 government purchases must be raised or taxes reduced. Either action causes an increase in aggregate demand from AD 2 to AD 3, increasing the size of the inflationary gap and heightening inflationary pressures in the economy. 11. A series of federal budget surpluses causes the reverse of the deficitdebt spiral. As budget surpluses reduce the size of the outstanding public debt, debt charges decrease, raising budget surpluses even further. This cycle accelerates the decline in public debt. 12. FIGURE 11A 4 Effects of Differing Estimates of Potential Output Price Level (GDP deflator, 2002 = 100) Price Level (GDP deflator, 2002 = 100) When the economy faces a recessionary gap (graph a) the apparent gap is enlarged if the estimate of potential output rises from PO 1 to PO 2. In contrast, when the economy faces an inflationary gap (graph b) the apparent gap is reduced if the estimated potential output rises from PO 1 to PO 2. Therefore, changes in the estimated potential output have a direct effect on the apparent size of any recessionary gap and an inverse effect on the apparent size of any inflationary gap. Chapter

6 Internet Application Questions 1a. Answers are found in the link to 'Budget Info'. b. Answers are found in the same link as in part a. 2a. Answer found in links to 'Data', 'Gross Domestic Product', and '9014' (Canada Gross Domestic Product, Expenditure-Based). Click on 'Ann D24193 Gross Domestic Product at Market Prices' and then press down the control key and click on 'Ann D24166 Govt Current Expenditure on Goods and Services'. Then click on 'Go' and 'Go'. Under 'Output Format' click on '2D Line Graph', and under 'Display Option' click on '% of D Gross Domestic Product at Market Prices'. Then press 'Go'. You can print out the resulting graph. b. Fiscal policy was particularly expansionary between 1981 and 1983 and then again between 1990 and It was particularly contractionary between 1987 and 1989 and then again after a. - b. - ANSWERS TO QUESTIONS AT END OF 'ECONOMIST EXTRAORDINAIRE' 1a. According to neoclassical economists, a fall in wages does not lead to permanent underspending in the economy since, based on Say s Law, supply creates its demand -- regardless of whether the demand originates with workers or other resource-providers in the economy. As workers incomes are reduced, other incomes will rise, so that all of the economy s production can be purchased. In contrast, in the Keynesian view, a fall in spending by workers may not be counteracted by spending increases by other economic participants, which means that underspending and an economic downturn are possible. b. According to neoclassical economists, an increase in injections will cause interest rates to change until expenditures and withdrawals are made equal at a single equilibrium level of output. On the other hand, in the Keynesian view, a rise in injections causes an increase in equilibrium output, which is needed to eradicate the discrepancy between injections and withdrawals. 2a. According to neoclassical economists, periods of low output and high unemployment are self-correcting without government intervention. Given flexible labour markets, high unemployment is eliminated by changes in real wages. Also, a temporary lack of spending causes an adjustment in interest rates. This adjustment balances injections and withdrawals and therefore eradicates the initial underspending. b. Keynes disagreed for two reasons. First, in his view labour markets do not necessarily reach equilibrium through changes in real wages. Second, interest rates do not necessarily adjust to counteract a temporary lack of spending. It is only through government intervention, said Keynes, that the elimination of low output and high unemployment can be assured. ANSWERS TO QUESTIONS AT END OF 'THE AGGREGATE EXPENDITURES MODEL AND GOVERNMENT' (at the Online Learning Centre) 1a. In this case, with the government purchases and aggregate expenditures schedules rising by $50 billion, the equilibrium level of GDP using the Chapter

7 spending-output approach would increase to $1400 billion. Using the injections-withdrawals approach, the I+G+X schedule would rise by $50 billion, and the equilibrium level of GDP would increase by the same amount to $1400 billion. b. Yes, the government would be running a $50 billion deficit, given that government purchases exceed taxes by this amount. 2a. When saving increases, total withdrawals (the S+M line) shift upwards, causing the intersection with total injections (the I+X line) to occur at a lower real output than before. b. No. Though an increase in saving can have a short-run contractionary effect on real output, in the long run high savings promote economic growth, since saving is essential for investment in new capital goods to take place. ANSWERS TO QUESTIONS AT THE END OF 'MOUNTAIN OR MIRAGE' (at the Online Learning Centre) 1a. With a $500 billion public debt, the budget deficit is $10 billion [= $180 billion + (.06 x $500 billion) - $200 billion]. In contrast, a $600 billion public debt means the budget deficit is $16 billion [= $180 billion + (.06 x $600 billion) - $200 billion]. Therefore, budget deficits and the size of the public debt are directly related, since a higher public debt means greater public debt charges, which cause a higher budget deficit. b. With a $500 billion public debt, the budget deficit is $5 billion [= $180 billion + (.05 x $500 billion) - $200 billion], and with a $600 billion public debt, the budget deficit is $10 billion [= $180 billion + (.05 x $600 billion) - $200 billion]. Therefore budget deficits and interest rates are directly related, since higher interest rates mean greater public debt charges, which cause a higher budget deficit. 2. This statement refers to the reversal of the crowding out effect. A decline in public debt means that government borrowing is reduced, which decreases the demand for borrowed funds. As a result, interest rates fall, raising the amount of investment spending carried out by businesses. 3a. - b. - c. - ANSWERS TO QUESTIONS AT THE END OF 'RISE AND FALL' (at the Online Learning Centre) 1. According to Khaldun, a dynasty s rulers become increasingly accustomed to ostentatious spending, which means that tax rites must keep on rising to fund these outlays. 2. Those in favour of tax cuts based on supply-side principles argue that the peak of the Laffer curve in Figure A is to the left of the current US tax rate. Thus a reduction in tax rates will lead to an increase in total tax revenues. Those opposed to tax cuts argue that the peak of the Laffer curve, if it does exist, is to the right of the current tax rate. For these Chapter

8 commentators, tax cuts will reduce total tax revenues. Chapter