Chapter 12 | Fiscal Policy, Deficits, National Debt

Question 1

Demand Policies for Stabilization

Answer 1

Fiscal policies – changes in government spending, taxes, and transfers – act as aggregate demand shocks, have multiplied impact on aggregate demand, and can counter output gaps

Question 2

Fiscal policy

Answer 2

changes in government purchases, taxes, transfers to achieve macroeconomic outcomes of steady growth, full employment, and stable prices

Question 3

Circular flow transmits the effects of fiscal policy

Answer 3

Circular flow transmits the effects of fiscal policy

Question 4

Injection

Answer 4

spending in the circular flow not starting with consumers: G (government spending), I (business investment spending), X (exports)

Question 5

Leakage

Answer 5

spending leaking out of the circular flow through taxes, saving, imports

Question 6

Multiplier effect

Answer 6

spending injection has multiplied effect on aggregate demand

Question 7

Multiplied increase in aggregate demand from

Answer 7

Increased government spending
Tax cuts
Increased transfers

Question 8

Multiplied decrease in aggregate demand from

Answer 8

Decreased government spending
Tax increases
Decreased transfers

Question 9

Demand-Side Fiscal Policy

Answer 9

Size of multiplier effects depends on leakages out of circular flow

Question 10

Size of Multiplier Effect Formula

Answer 10

Size of Multiplier Effect = 1 / % of leakages from additional income

More leakages = smaller multiplier

Fewer leakages = larger multiplier

Question 11

Changes in injections

Answer 11

G, I, X – is aggregate demand shock, shifting AD rightward (↑ injections) or leftward (↓ injections) by multiplied effect of initial rejection

Question 12

Expansionary fiscal policy

Answer 12

increases aggregate demand by increasing government spending, decreasing taxes, or increasing transfers

• Shifts the aggregate demand curve rightward – positive aggregate demand shock
• Counters a recessionary gap

Question 13

Contractionary fiscal policy

Answer 13

decreases aggregate demand by decreasing government spending, increasing taxes, or decreasing transfers

• Shifts the aggregate demand curve leftward – negative aggregate demand shock
• Counters an inflationary gap

Question 14

Injections multiplier effects on equilibrium real GDP depend on how close economy is to potential GDP

Answer 14

When economy below potential GDP, more of increase in aggregate demand increases real GDP

When economy at or above potential GDP, more of increase in aggregate demand drives up prices

Question 15

Disagreements About Demand-Side Fiscal Policy

Answer 15

Hands-off camp favours tax cuts to accelerate economy; spending reductions to slow economy

Hands-on camp favours government spending to accelerate economy; tax increases to slow economy

Question 16

Supply-Side Fiscal Policy

Answer 16

Fiscal policies targeting aggregate supply – tax incentives, support for R&D, education, training – promote economic growth, but hands-off and hands-on camp differ in emphasizing long-run or short-run effects.

Question 17

Government policies to promote economic growth include spending and tax incentives

Answer 17

To stimulate saving and increase quantity of capital

For research and development

For education and training increasing human capital

Question 18

Fiscal spending and tax policies can increase quantity and quality of inputs, increasing (long-run and short-run) aggregate supply and potential GDP per person

Answer 18

Fiscal spending and tax policies can increase quantity and quality of inputs, increasing (long-run and short-run) aggregate supply and potential GDP per person

Question 19

Supply-side effects

Answer 19

incentive effects of taxes on aggregate supply

Question 20

Supply-siders believe

Answer 20

tax cuts have powerful incentive effects and will increase, not decrease, government tax revenues

Question 21

Laffer Curve

Answer 21

graph showing that as tax rate increases, tax revenues increase, reach a maximum, then decrease

Evidence shows that tax cuts reduce revenue

Question 22

Supply-sider arguments appeal to politicians

Answer 22

promise tax cuts – which voters like – without reducing government services or going into debt

Question 23

Fiscal policies that encourage saving can decrease aggregate demand in the present

Answer 23

Hands-off camp believes long-run benefits of increased aggregate supply outweigh short-run mismatches between reduced aggregate demand and aggregate supply

Hands-on camp worries that short-run costs of decreased aggregate demand and recession outweigh long-run benefits of economic growth

Question 24

Deficits and Surpluses

Answer 24

Automatic stabilizers create cyclical budget deficits and surpluses while keeping the economy close to potential GDP. Structural deficits and surpluses at potential GDP are more problematic

Question 25

Government budget scenarios

Answer 25

Balanced budget – revenues = spending

Budget deficit revenues – < spending

Budget surplus revenues – > spending

Question 26

Automatic stabilizers

Answer 26

tax and transfer adjustments counteracting changes to real GDP, without explicit government decisions

Question 27

During contractions

Answer 27

tax revenues fall, transfer payments increase, supporting spending and aggregate demand, but causing automatic budget deficit

Question 28

During expansions

Answer 28

tax revenues rise, transfer payments decrease reducing spending and aggregate demand, but causing automatic budget surplus

Question 29

Automatic stabilizers work like a thermostat, keeping economy close to potential GDP

Answer 29

Since automatic stabilizers introduced after Great Depression, business cycles are less frequent, contractions less severe

Question 30

Cyclical deficits and surpluses

Answer 30

created only as a result of automatic stabilizers counteracting business cycles

Question 31

With automatic stabilizers, government attempts to balance the budget during

Answer 31

Recessions – decrease aggregate demand, make recessions worse

Expansions – increase aggregate demand, increase risk of inflation

Question 32

With a balanced budget over the business cycle, cyclical surpluses during expansions offset cyclical deficits during contractions

Answer 32

With a balanced budget over the business cycle, cyclical surpluses during expansions offset cyclical deficits during contractions

Question 33

Economists are concerned with

Answer 33

structural deficits and surpluses

Question 34

structural deficits and surpluses

Answer 34

budget deficits and surpluses at potential GDP

Question 35

National Debt

Answer 35

Deficits are a flow while debit is a stock. Of five common arguments about national debt, some are myths, some are potential problems.

Question 36

Deficits and debt have different time dimensions

Answer 36

Deficits and surpluses are flows
Debt is a stock

Question 37

National debt (public debt)

Answer 37

total amount owed by government = (sum of past deficits) - (sum of past surpluses)

Question 38

Five arguments about national debt

Answer 38

1. Will Canada go bankrupt?
2. Burden for future generations?
3. Debt is always bad
4. Interest payments create self-perpetuating debt
5. Crowding out and crowding in

Question 39

1. Will Canada go bankrupt?

Answer 39

a) Largely a myth

b)Government of Canada never has to pay back national debt – can simply refinance it

c) Governments that do not pay debts find it difficult/expensive to borrow on bond market

Question 40

2. Burden for future generations?

Answer 40

a) Depends on who receives interest payments on national debt – Canadians or non-Canadians

Question 41

3. Debt is always bad

Answer 41

a) Myth – consumers and businesses make smart choices to go into debt

b) Government debt can be smart choice if positive impact on economy of spending financed by debt is greater interest cost

c) Government debt can be not-smart choice if spending financed by debt for consumption only

d) Yes – Hands-Off camp opposes, No – Hands On camp supports, debt financed government spending to prevent recession

Question 42

4. Interest payments create self-perpetuating debt

Answer 42

a) Potential problem of the national debt

b) Canada’s yearly deficits between mid-1970s and mid-1990’s increased national debt and interest payments -> increasing yearly deficits

c) Vicious cycle broke in 1996

Question 43

5. Crowding out and crowding in

Answer 43

a) Potential problem and benefit of the national debt

b) Crowding out - when government debt-financed fiscal policy decreases private investment by raising interest rates

c) Crowding in - when government debt-financed fiscal policy increases private investment by improving expectations

Question 44

Politics & Economics

Answer 44

Sort out economic arguments from political arguments so that you can make informed choices as a citizen about hands-off and hands-on roles for government fiscal policy and your own future

Question 45

Political philosophies differ among countries

Answer 45

United States – created through a revolution against British government’s interference – has hands-off origins

Canada – created by an act of government – has hands-on origins

Question 46

Words about proper role for government often reveal speaker’s point of view

Answer 46

Hands-off words used with government: intervene, interfere, mistake

Hands-on words used with government: act, participate, responsibility

Question 47

Arguments about fiscal policy, deficits, and debt often mix up politics and economics

Answer 47

• Policies that make economic sense (balance budget over business cycle) might not make political sense; when recession over, hard to stop spending, to raise taxes
• Political hands-off arguments against government are often disguised as arguments against national debt
• Sort out economic from political arguments to make informed choices about hands-off and hands-on role for government