Chapter 10 1. An example of an autonomous consumption policy is a policy that A) lowers tax rates to stimulate additional consumer spending. B) makes credit more widely available to consumers in order to stimulate greater borrowing. C) increases unemployment compensation to prevent consumption from falling when unemployment rises. D) increases the multiplier and in this way increases consumption spending. 2. Consider the case where prices are flexible in the short run and the government wants to eliminate a recessionary gap of $200 by increasing government spending. If the mpc is.8, then the government should increase spending by A) $20. B) $40. C) greater than $40. D) $220. 3. Assume the price level is flexible. Suppose the government wants to eliminate an inflationary gap of $1,000 and the mpc is.8. The government should increase taxes by A) $200. B) $250. C) more than $250. D) none of the above; the government should decrease taxes instead. 4. Suppose government spending increases by 50. If equilibrium output rises by 100 and interest rates increase as well, then A) it can be inferred that the mpc is 1/2. B) it can be inferred that the mpc is less than 1/2. C) it can be inferred that the mpc is greater than 1/2. D) no inference can be made about the value of the mpc. 5. Crowding out A) increases the multiplier effect, so an increase in taxes reduces income by more. B) increases the multiplier effect, so an increase in taxes reduces income by less. C) decreases the multiplier effect, so an increase in taxes reduces income by more. D) decreases the multiplier effect, so an increase in taxes reduces income by less. Page 1
6. If the mpc is 0.9 and the government reduces its expenditures by $100, then equilibrium income will A) decrease by $900. B) decrease by $1,000. C) increase by $900. D) increase by $1,000. 7. Suppose equilibrium income is $100 billion lower than potential income. If the mpc is 0.8, potential income can be attained by government spending by billion. A) increasing; $100 B) increasing; $20 C) decreasing; $100 D) decreasing; $20 8. All of the following policies are alternatives to fiscal policy EXCEPT A) policies that affect autonomous consumption. B) policies that affect autonomous investment. C) policies that affect income tax rates. D) policies that affect autonomous net exports. 9. Keynesian economists argue that the crowding out effect is A) insignificant, so fiscal policy is ineffective. B) negative, implying that increased government budget deficits lead to higher private spending levels. C) relatively small, so expansionary fiscal policy is still effective. D) relatively large, so expansionary fiscal policy is ineffective. 10. Reducing the budget deficit by cutting government spending could conceivably A) increase income if interest rates fall enough and government spending is less productive than private investment. B) increase income if interest rates rise enough and government spending is more productive than private investment. C) decrease income if interest rates fall too much and government spending is less productive than private investment. D) decrease income if interest rates rise enough and government spending is less productive than private investment. Page 2
11. Expansionary aggregate demand policy includes all of the following EXCEPT A) increasing government spending. B) increasing autonomous expenditures. C) increasing imports. D) decreasing taxes. 12. Fine tuning an economy A) is possible, according to both Keynesians and Classicals. B) is possible, according to Keynesians but not Classicals. C) is possible, according to Classicals but not Keynesians. D) is impossible, according to both Keynesians and Classicals. 13. An inflationary gap occurs when A) equilibrium income is below potential income. B) equilibrium income is above potential income. C) equilibrium income equals potential income. D) equilibrium income is below autonomous expenditure. 14. When an economy grows so fast that it exceeds potential income, automatic stabilizers A) cause the price level to increase more rapidly than otherwise. B) cause the price level to increase less rapidly than otherwise. C) have no effect on the price level. D) have an uncertain effect on the price level. Use the following to answer question 15: AP Real expenditures E1 E0 AE0 AE1 1050 1200 Real income Page 3
15. Refer to the graph above. If the mpc is 0.8, the shift from AE0 to AE1 could be explained by a A) $30 increase in government spending. B) $30 decrease in government spending. C) $120 decrease in government spending. D) $150 decrease in government spending. Use the following to answer question 16: 16. Refer to the graph above. If wage and price controls had not been introduced during the Second World War, the massive increase in military spending would have eventually A) shifted the SAS curve to the right. B) shifted the AD curve to the left. C) shifted the SAS curve to the left. D) had no effect on AD and SAS. 17. The income tax A) is an automatic stabilizer because income tax revenues rise as income increases, slowing an economic expansion. B) is an automatic stabilizer because income tax revenues rise as income increases, accelerating an economic expansion. C) is an automatic stabilizer because income tax revenues fall as income increases, accelerating an economic expansion. D) is not an automatic stabilizer. 18. In general, a $10 billion increase in taxes causes A) an increase in income that exceeds $10 billion. B) an increase in income that equals $10 billion. C) a decrease in income that exceeds $10 billion. D) a decrease in income that equals $10 billion. Page 4
19. Property taxes are A) not an automatic stabilizer because they don't vary with income. B) not an automatic stabilizer because they vary with income. C) an automatic stabilizer because they don't vary with income. D) an automatic stabilizer because they vary with income. Use the following to answer question 20: Real output A B C D potential output time 20. Refer to the graph above. A recessionary gap occurs at point A) A B) B C) C D) D 21. When potential output is known to be within a particular range of values A) a more expansionary fiscal policy is appropriate. B) a more contractionary fiscal policy is appropriate. C) no change in fiscal policy is appropriate until potential output can be determined more precisely. D) the choice of fiscal policy will depend on the level of equilibrium output. 22. During an economic expansion, automatic stabilizers A) reduce both budget surpluses and deficits. B) reduce a budget surplus but increase a deficit. C) reduce a budget deficit but increase a surplus. D) increase both budget surpluses and deficits. Page 5
23. As the economy expands, tax revenues and transfer payments, causing the economy to expand by than it would in the absence of automatic stabilizers. A) fall, rise, less B) rise, rise, more C) fall, fall, more D) rise, fall, less 24. If the government knew the precise values of the multiplier and potential income A) fine tuning the economy would be possible. B) fine tuning the economy would be much easier but mistakes would still occur occassionally. C) fine tuning the economy would still be very difficult. D) fine tuning the economy would be more difficult. 25. Consider the case where prices are flexible in the short run and the government wishes to eliminate a recessionary gap of $200 by increasing government spending. If the mpc is.75, then the government should increase spending by A) $200. B) $50. C) greater than $50. D) less than $50. 26. As the economy contracts, tax revenues and transfer payments, causing the economy to contract by than it would in the absence of automatic stabilizers. A) fall, rise, less B) rise, rise, more C) fall, fall, more D) rise, fall, less 27. If wage and price controls had not been introduced during the Second World War, and the economy still experienced a recessionary gap, the massive increase in military spending would have ultimately A) increased both output and the price level. B) increased only output. C) increased only the price level. D) had no effect on output or the price level. Page 6
28. During an economic contraction, automatic stabilizers A) reduce both budget surpluses and deficits. B) reduce a budget surplus but increase a deficit. C) reduce a budget deficit but increase a surplus. D) increase both budget surpluses and deficits. 29. If there were no multiplier effect, the need for demand management policies would A) be reduced because spending would no longer be a public good. B) be increased because spending would no longer be a public good. C) be the same because spending would still be a public good. D) be increased because the incentive to spend would be reduced even further. 30. When the price level is flexible, the multiplier is A) smaller than in the case where prices are constant. B) larger than in the case where prices are constant. C) the same as in the case where prices are constant. D) larger in the case of expansionary fiscal policy and smaller in the case of contractionary fiscal policy. 31. All of the following policies are designed to affect investment expectations EXCEPT A) honest and accurate policy announcements. B) interest rate policies. C) central bank policies that bail out financial institutions. D) regulatory policies that reduce the likelihood of bank failures. 32. Suppose that the price level is constant, that the mpc is 3 4, and that government spending increases by 50. Now suppose the AD curve shifts out by 150 in response to the change in government spending. From this information, we can conclude that the increase in spending A) did not raise interest rates or crowd out investment. B) raised interest rates and reduced investment by less than 50. C) raised interest rates and reduced investment by 50. D) raised interest rates and reduced investment by more than 50. Page 7
33. Using fiscal policy to stabilize the economy is difficult for all of the following reasons EXCEPT that A) potential income is uncertain. B) the effects of policy changes cannot be known with certainty. C) there are time lags involved in the use of fiscal policy. D) the size of the government debt doesn't matter. 34. According to the aggregate expenditure model, the best way to reduce inflation is to A) increase aggregate demand by cutting government spending or raising taxes. B) increase aggregate demand by raising government spending or cutting taxes. C) decrease aggregate demand by cutting government spending or raising taxes. D) decrease aggregate demand by raising government spending or cutting taxes. 35. Crowding out occurs when A) workers lose jobs as a result of anti-inflationary fiscal policies. B) the federal government engages in bond sales to finance its budget deficit. C) the government enacts budget cuts to balance the budget. D) tax receipts rise more slowly than anticipated, resulting in the need to cut government spending. 36. Assume the price level is flexible. Suppose the government wants to eliminate a recessionary gap of $1,000 and the mpc is.8. The government should decrease taxes by A) $200. B) $250. C) more than $250. D) none of the above; the government should increase taxes instead. 37. Budget surpluses A) can occur only when fiscal policy is contractionary. B) can occur only when the economy is expanding rapidly. C) can occur if fiscal policy is contractionary, or if the economy is expanding rapidly. D) cannot occur if fiscal policy is contractionary, or if the economy is expanding rapidly. 38. Normally, a contractionary fiscal policy that produced a budget surplus would be expected to do all of the following except A) check inflationary pressures. B) reduce equilibrium output. C) reduce potential output. D) raise tax revenues. Page 8
39. During the Second World War, the Canadian government pursued A) an expansionary fiscal policy that created large budget surpluses. B) a contractionary fiscal policy that created large budget surpluses. C) an expansionary fiscal policy that created large budget deficits. D) a contractionary fiscal policy that created large budget deficits. 40. When the government runs a deficit, the interest rate tends to A) rise. B) fall. C) remain unchanged. D) rise or fall, depending on how the deficit is financed. 41. Crowding out is associated with A) a reduction in business investment resulting from an increase in government borrowing and higher interest rates. B) an increase in business investment resulting from an increase in government borrowing and higher interest rates. C) an increase in private savings caused by higher future tax liabilities when government increases borrowing. D) a decrease in government spending caused by a shortage of available credit. 42. If an economy is in a recession, one fiscal policy that might help it recover is A) a cut in social security payments. B) a cut in the income tax rate. C) a cut in education spending. D) an increase in property taxes. 43. When the government runs a deficit, it must A) buy bonds to finance the deficit. B) sell bonds to finance the deficit. C) increase the money supply to finance the deficit. D) raise taxes immediately. Page 9
44. Assume the price level is fixed. Suppose the government wants to eliminate a recessionary gap of $1,000 and the mpc is.8. The government should A) decrease spending by $200. B) decrease taxes by $250. C) increase taxes by $200. D) increase taxes by $250. 45. Suppose government spending increases by 50. If equilibrium real output rises by 500 and prices rise as well, then A) it can be inferred that the mpc is.9. B) it can be inferred that the mpc is less than.9. C) it can be inferred that the mpc is greater than.9. D) no inference can be made about the value of the mpc. Use the following to answer question 46: 46. Refer to the graph above. The massive increase in defence spending that occurred during the Second World War caused A) the AD curve to shift from AD 0 to AD. B) the AD curve to shift from AD to AD 0. C) the SAS curve to shift to the right. D) the SAS curve to shift to the left. 47. Automatic stabilizers cause A) deeper recessions and more rapid expansions. B) deeper recessions and slower expansions. C) shallower recessions and slower expansions. D) shallower recessions and more rapid expansions. Page 10
48. Automatic stabilizers tend to create A) budget deficits throughout the business cycle. B) budget surpluses throughout the business cycle. C) budget deficits during the recovery phase of the business cycle and budget surpluses during the recession phase. D) budget deficits during the recession phase of the business cycle and budget surpluses during the recovery phase. 49. The economy has a fixed price level, an mpc of.5 and a recessionary gap of 240. Using the aggregate expenditure model, an economist would advise government to increase government expenditures by A) 120. B) 240. C) 480. D) 620. 50. Government spending policies designed to offset changes in aggregate demand are called A) aggregate supply policies. B) Classical fiscal policies. C) countercyclical fiscal policies. D) laissez-faire policies. Page 11
Answer Key 1. B See the description of autonomous consumption policies in the text. 2. C In the case where prices are flexible, the multiplier is smaller than in the fixed-price case and larger increases in government spending are required to close a recessionary gap. 3. C See the Applying the Tools box. 4. C Since interest rates rose as a result of the increase in government spending, crowding out occurred. This crowding out reduced the multiplier below what it would have been in the absence of crowding out (i.e. 1/(1-mpc)). Since the observed multiplier was 2, the multiplier in the absence of crowding out must be greater than 2, so the mpc must be greater than 1/2. 5. D Crowding out produces lower interest rates that reduce the contractionary effect of a tax increase, so it reduces the multiplier. 6. B Since the multiplier is 1/(1-mpc) or 10 when the mpc = 0.9, the cut in government spending will be magnified into a decline in equilibrium output that is ten times as great. 7. B The multiplier is 1/(1-mpc) or five if the mpc equals 0.8, so raising spending by $20 billion will raise equilibrium income by $100 billion. 8. C Changes in income tax rates are one type of fiscal policy. 9. C Keynesians assume that deficit financing has no or little effect on interest rates, so there is little offsetting effect on business investment. 10. A Lowering the budget deficit reduces both government borrowing and government bond sales. The result is a drop in interest rates and an increase in private investment. If private investment is more productive than government spending, income could grow if the increase in private investment is significant enough. 11. C Increasing imports is contractionary. 12. D Page 12
Both Keynesians and Classicals recognize that fine tuning is very difficult because the dynamic adjustment process that governs the macroeconomy is extremely complicated and poorly understood. 13. B When equilibrium income is above potential income, an inflationary gap arises because pressure for wage and price increases develops. 14. B As income and employment increase, automatic stabilizers increase tax revenues and reduce transfer payments, both of which reduce the increase in aggregate demand and help to stem inflationary pressures. 15. B The shift in the AE curve causes equilibrium income to fall by $150. Since the mpc is 0.8, the government spending multiplier is 5 (=1/[1-mpc]), so that government spending has to change by only one-fifth of the change in income. 16. C The huge increase in defence spending would have eliminated the recessionary gap produced by the Depression and created an inflationary gap instead, leading to an upward shift of the AS curve. 17. A Higher income generates higher income tax revenues, which cause aggregate demand to increase less rapidly than it otherwise would. 18. C Increasing taxes reduces aggregate demand, causing a decrease in income that exceeds $10 billion because of the multiplier effect. 19. A Property taxes are based on the value of a piece of property and do not vary with income, so they cannot be an automatic stabilizer. 20. C A recessionary gap occurs when income falls below potential GDP. 21. D If equilibrium output is below the range, a more expansionary fiscal policy is called for. If equilibrium output is above the range, a more contractionary fiscal policy is called for. If equilibrium output is inside the range, no change in fiscal policy is probably best. 22. C Automatic stabilizers are countercyclical fiscal policies so as income rises, taxes increase and spending decreases. Both changes reduce a deficit or increase a surplus. 23. D Higher income and lower unemployment raise tax revenues and reduce transfer payments. These changes moderate any increase in consumption and slow the rate of expansion. Page 13
24. C Problems such as lags, crowding out, policy conflicts, and political resistance would still make fine tuning difficult. 25. C In the case where prices are flexible, the multiplier is smaller than in the fixed-price case and larger increases in government spending are required to close a recessionary gap. 26. A Lower income and higher unemployment reduce tax revenues and increase transfer payments, helping to maintain consumption and reduce the size of the recession. 27. A The huge increase in defence spending would have eliminated the recessionary gap produced by the Depression and created an inflationary gap instead, leading to both a higher level of output and a higher price level. 28. B Automatic stabilizers are countercyclical fiscal policies so as income falls, taxes fall and spending increases. Both changes increase a budget deficit or reduce a surplus. 29. A Without the multiplier, spending would no longer be a public good because increases in spending would benefit only the people involved in a particular transaction. Thus a one dollar increase in spending would generate only a one dollar increase in income. 30. A The multiplier is smaller than in the fixed-price case. This occurs for both expansionary and contractionary fiscal policy. 31. B Interest rate policies alter the cost of borrowing to finance investment spending rather than investment expectations. 32. C Since the multiplier is 4 in this case if there are no offsetting effects, the AD curve should have shifted out by 200 if there were no crowding out. Since the AD curve shifted out by only 150, investment must have been reduced by 50. 33. D The size of the government debt may adversely affect the economy, and this may limit the usefulness of fiscal policy. 34. C Reducing aggregate demand by cutting spending or raising taxes lowers equilibrium income which reduces upward pressure on wages and prices. 35. B Page 14
Crowding out occurs when government bond sales drive up interest rates and reduce business investment. 36. C See the Applying the Tools box. 37. C Contractionary fiscal policy either reduces spending or raises taxes, both of which tend to create a budget surplus. A budget surplus can also result from an economic boom that raises tax revenue and reduces spending. 38. C Potential output is determined by supply side factors that are largely unaffected by the budget surplus or deficit. 39. C The huge increase in defence spending created an economic boom but was financed in large part by borrowing. 40. A When the government runs a deficit, it does so through selling bonds. To get people to buy these bonds, they must offer higher interest rates on them. 41. A Crowding out arises when government bond sales drive up interest rates and depress business investment. 42. B Cutting income taxes will increase the incomes of consumers, leading to an increase in aggregate demand and income. 43. B Bond sales provide the funds the government needs to cover the budget deficit. 44. B See the Applying the Tools box. 45. C The higher prices will cause the AE curve to shift downward. Thus a tenfold increase of real output will require a multiplier greater than 10 and an mpc greater than.9. 46. A The huge increase in defence spending increased aggregate expenditure at each income level, causing the AE curve to shift up and the AD curve to shift out. 47. C Automatic stabilizers reduce economic fluctuations by causing countercyclical changes in taxes and transfer payments. 48. D Page 15
The presence of automatic stabilizers reduces tax revenues and increases transfer payments during an economic contraction and therefore increase the budget deficit. The reverse is true during an economic recovery or expansion. 49. A Divide the recessionary gap of 240 by the multiplier of 2. 50. C Countercyclical fiscal policy is designed to mitigate the effects of any changes in aggregate demand that might create a business cycle. Page 16