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Chapter 21 Fiscal Policy• Key Concepts• Summary• Practice Quiz• Internet Exercises

©2002 South-Western College Publishing

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What is a discretionary fiscal policy?

The deliberate use of changes in government spending or taxes to alter aggregate demand and stabilize the economy

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What are examples of expansionary fiscal policy?• Increase government spending

• Decrease taxes• increase government spending and taxes equally

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What are examples of contractionary

fiscal policy?• Decrease government spending

• Increase taxes• Decrease government spending and taxes equally

5$6 $6.1 $6.2

AS

0

150

155

AD1

AD2

Real GDP

E2

XE1

155

Government Spending to Combat a Recession

Pri

ce L

evel

full employment

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Increase in government

spending

Increase in the aggregate

demand curve

Increase in the price

level and the real GDP

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With an MPC of 0.75, what is the spending

multiplier?

1/MPS = 1/1/4 = 4

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How much will real GDP increase by with

an increase in government spending

of $50 bil?4 x $50 bil = $200 bil

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What is thetax multiplier?

The change in aggregate demand (total spending) resulting from an initial change in taxes

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What happens when government cuts taxes by $50 bil?

The multiplier process is less because initial spending increases only by $38 bil instead of $50 bil

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What is the formula for the tax multiplier?

1 – spending multiplier

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How much does real GDP increase by with a cut in taxes of $50 bil?

3 x $50 bil = $150 bil

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Can we assume that the MPC will remain fixed?No, it can change from one time period to another

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Can fiscal policy be used to combat

inflation?Yes, this would happen when the economy is operating in the Classical or Intermediate range of the aggregate supply curve

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What will happen to AD with a cut in G spending of 25 bil?

-$25 bil x 4 = -$100 bil

16$6 $6.1

AS

0

155

160

Real GDP

E2

E1

Using Fiscal Policy to Combat Inflation

E´

Pri

ce L

evel

full employment

AD1

AD2

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Decrease in government

spending

Decrease in the aggregate

demand curve

Decrease in the price level

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What will happen to AD with a cut in taxes of 33.3 bil?

$33.3 x -3 = -$100 bil

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What is the balanced budget multiplier?

An equal change in government spending and taxes, which changes aggregate demand by the amount of the change in government spending

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What is anautomatic stabilizer?

Federal expenditures and tax revenues that automatically change levels in order to stabilize an economic expansion or contraction

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What are examples of automatic stabilizers?

• Transfer payments• Unemployment compensation• Welfare

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What is abudget surplus?

A budget in which government revenues exceed government expenditures in a given time period

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What is abudget deficit?

A budget in which government expenditures exceed government revenues in a given time period

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$1,000

$750

$500

$250

$4 $6 $8

G

$2,500T

Real GDP

Bu

dg

et

def

icit

Bu

dg

et su

rplu

s

Automatic Stabilizers

Go

vern

men

t S

pen

din

g a

nd

Tax

es

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Increase in real GDP

Tax collections fall and government

transfer payments rise

Budget offsets inflation

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Decrease in real GDP

Tax collections fall and government

transfer payments rise

Budget offsets

recession

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What is supply-side fiscal policy?

A fiscal policy that emphasizes government policies that increase aggregate supply

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What is the purpose of supply-side fiscal

policies?To achieve long-run growth in real output, full employment, and a lower price level

292 4 6 8 10 12

AS

0

100

200

250

Demand-Side Fiscal Policy

Real GDPAD1

AD2

E1

E2

Pri

ce L

evel

150

full employment

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Increase in government spending; decrease in net taxes

Increase in the aggregate demand curve

312 4 6 8 10 120

100

200

250

Supply-Side Fiscal Policy

Real GDPAD

E1

Pri

ce L

evel

150

AS1

AS2

full employmentE2

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Decrease in resource prices; technological advances; subsidies;

decrease in regulations

Increase in the aggregate supply curve

33L1 L2

0

W2

W1

Labor DemandQ of Labor

Wag

e ra

te

E2

E1

Supply-Side Policies Affect Labor Markets

Before tax-cut labor supply

After tax-cut labor supply

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Will an increase in taxes lead to higher

government revenues?That depends on where the economy is on the Laffer Curve

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What is theLaffer Curve?

Puts forth the idea that increasing taxes from zero will increase tax revenues up to a certain point

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What happens beyond a certain point?

Tax revenues begin to decline as the economic pie begins to shrink

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Why does the economic pie begin to shrink?Workers have less incentive to work and investors have less of an incentive to invest

38Tmax

T0

R

Federal Tax Rate

Fed

eral

Tax

Rev

enu

e

A

The Laffer Curve

100%

B

C

D

Rmax

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Key Concepts

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Key Concepts• What is a discretionary fiscal policy?• What are examples of expansionary fiscal policy?• What are examples of contractionary fiscal policy?• With an MPC of 0.75, what is the multiplier?• How much will real GDP increase by with an increa

se in government spending of $50 bil?

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Key Concepts cont.• What is the tax multiplier?• What is the formula for the tax multiplier?• Can fiscal policy be used to combat inflation?• What will happen to ad with a cut in g spendin

g of 25 bil?• What is the balanced budget multiplier?

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Key Concepts cont.

• What is an automatic stabilizer?• What is a budget surplus?• What is a budget deficit?• What is supply side fiscal policy?• What is the Laffer Curve?

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Summary

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Fiscal policy is the use of government spending, taxes, and transfer payments for the purpose of stabilizing the economy.

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Discretionary fiscal policy follows the Keynesian argument that the federal government should manipulate aggregate demand in order to influence the output, employment, and price levels in the economy.

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Discretionary fiscal policy requires either new legislation to change government spending or taxes in order to stabilize the economy.

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Expansionary fiscal policy is a deliberate increase in government spending, a deliberate decrease in taxes, or some combination of these two options.

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Contractionary fiscal policy is a deliberate decrease in government spending, a deliberate increase in taxes, or some combination of these two options.

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Using either expansionary or contractionary fiscal policy, the government can shift the aggregate demand curve in order to combat recession, cool inflation, or achieve other macroeconomic goals.

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• Increase government spending• Decrease taxes• Increase government spending and taxes equally

Expansionary Contractionary

Discretionary Fiscal Policies

• Decrease government spending• Increase taxes• Decrease government spending and taxes equally

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The tax multiplier is the multiplier by which an initial change in taxes changes aggregate demand (total spending) after an infinite number of spending cycles.

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Expressed as a formula, the tax multiplier = 1 - spending multiplier.

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A balanced budget multiplier is not neutral. A dollar of government spending increases real GDP more than a dollar cut in taxes. Thus, even though the government does not spend more than it collects in taxes, it is still stimulating the economy.

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Combating recession and inflation can be accomplished by changing government spending or taxes.

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The total change in aggregate demand from a change in government spending is equal to the change in government spending times the spending multiplier. The total change in aggregate demand from a change in taxes is equal to the change in taxes times the tax multiplier.

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Increase in government

spending

Increase in the aggregate

demand curve

Increase in the price

level and the real GDP

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Decrease in government

spending

Decrease in the aggregate

demand curve

Decrease in the price level

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A budget surplus occurs when government revenues exceed government expenditures.

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A budget deficit occurs when government expenditures exceed government revenues.

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Automatic stabilizers are changes in taxes and government spending that occur automatically in response to changes in the level of real GDP.

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The business cycle creates braking power. A budget surplus slows down an expanding economy. A budget deficit reverses a downturn in the economy.

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$1,000

$750

$500

$250

$4 $6 $8

G

$2,500T

Real GDP

Bu

dg

et

def

icit

Bu

dg

et su

rplu

s

Automatic Stabilizers

Go

vern

men

t S

pen

din

g a

nd

Tax

es

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According to supply-side fiscal policy, lower taxes encourage work, saving, and investment, which shift the aggregate supply curve rightward. As a result, output and employment increase without inflation.

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The Laffer curve represents the relationship between the income tax rate and the amount of income tax revenue collected by the government.

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Chapter 21 Quiz

©2002 South-Western College Publishing

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1. Contractionary fiscal policy is deliberate government action to influence aggregate demand and the level of real GDP through a. expanding and contracting the money

supply.b. encouraging business to expand or

contract investment.c. regulation of net exports.d. decreasing government spending or

increasing taxes.

D. The money supply is under control of the Federal Reserve and not Congress.

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2. The spending multiplier is defined as a. 1 / (1 - marginal propensity to

consume).b. 1 / (marginal propensity to

consume)c. 1 / (1 - marginal propensity to save). d. 1 / (marginal propensity to consume

+ marginal propensity to save.

A. The spending multiplier is also defined as 1/MPS.

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3. If the marginal propensity to consume is 0.60, the value of the spending multiplier is a. 0.4b. 0.6c. 1.5d. 2.5.

D. Spending multiplier = 1 / (1 - MPC) = 1 / (1 - 0.60) = 1 / 40/100 = 5 / 2 = 2.5

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4. Assume the economy is in recession and real GDP is below full employment. The marginal propensity to consume is 0.80, and the government increases spending by $500 billion. As a result, aggregate demand will rise by a. zero.b. $2,500 billion.c. more than $2,500 billion.d. less than $2,500 billion.

B. Change in aggregate demand (Y) = initial change in government spending (G) x spending multiplier.

Spending multiplier = 1 / 1 - MPC) = 1 / (1 - 0.80) = 1 / 20/100 = 5

Y = $500 billion x 5Y = $2,500 billion

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5. Mathematically, the value of the tax multiplier in terms of the marginal propensity to consume (MPC) is given by the formula a. MPC 1.b. (MPC 1) MPCc. 1 / MPCd. 1 [1 / 1 MPC)].

D. The tax multiplier is also stated as Tax multiplier = 1 - spending multiplier.

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6. Assume the marginal propensity to consume (MPC) is 0.75 and the government increases taxes by $250 billion. The aggregate demand curve will shift to the a. left by $1,000 billion.b. right by $1,000 billion.c. left by $750 billion d. right by $750 billion.

A. The tax multiplier is -3 (1 - spending multiplier) and -3 times $250 equals a $750 billion decrease. The movement is left because consumers have less money to spend.

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7. If no fiscal policy changes are made, suppose the current aggregate demand curve will increase horizontally by $1,000 billion and cause inflation. If the marginal propensity to consume is 0.80, federal policy-makers could follow Keynesian economics and restrain inflation bya. decreasing government spending by $200

billion.b. decreasing taxes by $100.c. decreasing taxes by $1,000 billion.

A. Change in government spending (G) x spending multiplier = change in aggregate demand, rewritten:

G = change in aggregate demand / spending multiplier

Spending multiplier = 1 / (1-MPC) = 1 / (1-0.80) = 1 / 20/100 = 5

G = -$1,000/5, G = -$200 billion.

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8. If no fiscal policy changes are implemented, suppose the future aggregate demand curve will exceed the current aggregate demand curve by $500 billion at any level of prices. Assuming the marginal propensity to consume is 0.80, this increase in aggregate demand could be prevented by a. increasing government spending by $500

billion.b. increasing government spending by $140

billion.c. decreasing taxes by $40 billion.d. increasing taxes by $125 billion.

D. Change in taxes (T) x tax multiplier = change in aggregate demand, rewritten:

Tax multiplier = 1 - spending multiplierSpending multiplier = 1 / (1-MPC) = 1 / 1-0.80) = 1 / 20/100 =

5Tax multiplier = 1 - 5 = -4, T = $600 billion/5, T = -$200

billion

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9. Suppose inflation is a threat because the current aggregate demand curve will increase by $600 billion at any price level. If the marginal propensity to consume is 0.75, federal policy-makers could follow Keynesian economics and restrain inflation bya. decreasing taxes by $600 billion.b. decreasing transfer payments by $200

billion. c. increasing taxes by $200 billion.d. increasing government spending by

$150 billion.C. 3 x $200 billion = $600 billion.

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10. If no fiscal policy changes are implemented, suppose the aggregate demand curve will exceed the current aggregate demand curve by $900 billion at any level of prices. Assuming the marginal propensity to consume is 0.90, this increase in aggregate demand could be prevented by a. increasing government spending by $500

billion.b. increasing government spending by $140

billion.c. decreasing taxes by $40 billion. d. increasing taxes by $100 billion.

D. The multiplier here is 10 (1 divided by 1/10 = 10). If taxes are increased by $100 billion spending will go down by $90 billion. Ten times $90 equals $900.

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11. Which of the following is not an automatic stabilizer? a. Defense spending.b. Unemployment compensation benefits.c. Personal income taxes.d. Welfare payments.

A. Defense spending does not automatically change levels as real GDP changes.

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12. Supply-side economics is most closely associated with a. Karl Marx.b. John Maynard Keynes.c. Milton Friedman.d. Ronald Reagan.

D. The most familiar supply-side economic policy of the Reagan administration was the tax cuts implemented in 1981.

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13. Which of the following statements is true? a. A reduction in tax rates along the

downward-sloping portion of the Laffer curve would increase tax revenues.

b. According to supply-side fiscal policy, lower tax rates would shift the aggregate demand curve to the right, expanding the economy and creating some inflation.

c. The presence of the automatic stabilizers tends to destabilize the economy.

d. To combat inflation, Keynesians recommend lower taxes and greater government. A.

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T0

R

Rmax

Federal Tax Rate

Fed

eral

Tax

Rev

enu

e

A

The Laffer Curve

100%

B

C

D

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END