Chapter 13: Fiscal Policy

Question 1

At the Canadian federal level, which taxes generate the greatest revenue?

Answer 1

Income taxes (both personal income and corporate profits) and social insurance taxes

Question 2

What is social insurance?

Answer 2

Government programs intended to protect families against economic hardship (mainly pension plans and social assistance benefits).

Question 3

What is fiscal policy?

Answer 3

Changes in government spending, taxes, and transfers designed to affect overall spending.

Question 4

How do you calculate disposable income?

Answer 4

Disposable income = Income - Taxes + Transfers

Question 5

What does the government use fiscal policy for?

Answer 5

To shift the aggregate demand curve, and close a recessionary or inflationary gap.

Question 6

What is expansionary fiscal policy?

Answer 6

Fiscal policy that increases aggregate demand by increasing government purchases, decreasing taxes, or increasing transfers.

Question 7

What are the three forms of expansionary fiscal policy?

Answer 7

An increase in government purchases of goods and services, a cut in taxes, and an increase in government transfers.

Question 8

What is contractionary fiscal policy?

Answer 8

Fiscal policy that reduces aggregate demand by decreasing government purchases, increasing taxes, or decreasing transfers.

Question 9

What are the three forms of contractionary fiscal policy?

Answer 9

A reduction in government purchases of goods and services, an increase in taxes, and a reduction in government transfers.

Question 10

What are the three main arguments against expansionary fiscal policy?

Answer 10

Government spending always crowds out private spending; Government borrowing always crowds out private investment, and; Government budget deficits lead to reduced private spending.

Question 11

What is the counter-argument against the claim that government spending always crowds out private spending?

Answer 11

The claim assumes that resources in the economy are always fully employed, which they’re not. Expansionary fiscal policy during recessionary gaps puts unemployed resources to work and generates higher spending and higher income. Government spending only crowds out private spending when the economy is operating at full employment.

Question 12

What is the counter-argument against the claim that government borrowing always crowds out private investment?

Answer 12

Crowding out depends on whether the economy is depressed or not. Government borrowing crowds out private investment spending only when the economy is operating at full employment (which is why most economists do not recommend a fiscal expansion at such times).

Question 13

What is the counter-argument against the claim that government budget deficits lead to reduced private spending?

Answer 13

The claim is based on the assumption that expansionary fiscal policy will have no effect on the economy because far-sighted consumers will undo any attempts at expansion by the government (Ricardian equivalence). In reality, most consumers, when provided with extra cash (generated by fiscal expansion), will spend at least some of it. So even fiscal policy that takes the form of temporary tax cuts or transfers of cash to consumers probably does have an expansionary effect.

Even with Ricardian equivalence, a temporary rise in government spending that involves direct purchases of goods and services (i.e., road construction), will still lead to a boost in total spending in the near term.

Question 14

What is a key reason for caution in the case of fiscal policy?

Answer 14

Time lags between when the policy is decided upon and when it is implemented. Because of these lags, an attempt to increase spending to fight a recessionary gap may take so long to get going that the economy has already recovered on its own. In fact, the recessionary gap may have turned into an inflationary gap by the time expansionary fiscal policy takes effect. In that case, expansionary fiscal policy will make things worse, not better.

Question 15

What causes time lags in fiscal policy?

Answer 15

The government has to realize a recessionary or expansionary gap exists; The government has to develop a spending plan, and; It takes time to spend money.

Question 16

Consider whether this situation is expansionary or contractionary fiscal policy: several military bases around the country, which together employ tens of thousands of people, are closed.

Answer 16

Contractionary fiscal policy (decrease in government spending).

Question 17

Consider whether this situation is expansionary or contractionary fiscal policy: the number of weeks an unemployed person is eligible for unemployment benefits is increased.

Answer 17

Expansionary fiscal policy (increase in government transfers).

Question 18

Consider whether this situation is expansionary or contractionary fiscal policy: the federal tax on gasoline is increased.

Answer 18

Contractionary fiscal policy (increase in government taxes).

Question 19

Explain why federal disaster relief, which quickly disburses funds to victims of natural disasters such as hurricanes, floods, and large-scale crop failures, will stabilize the economy more effectively after a disaster than relief that must be legislated.

Answer 19

Because federal disaster relief is not impacted by time lags. It takes time for policy to be decided upon, legislated, and implemented. By the time relief that must be legislated has been distributed, the economy may be in a worse-off position, and it may take more time and resources to restore it to a stabilized form than quick disaster relief.

Question 20

Is the following statement true or false? Explain. “When the government expands, the private sector shrinks; when the government shrinks, the private sector expands.”

Answer 20

This statement implies that expansionary fiscal policy will result in crowding out of the private sector, and that the opposite, contractionary fiscal policy, will lead the private sector to grow. Whether this statement is true or not depends upon whether the economy is at full employment; it is only then that we should expect expansionary fiscal policy to lead to crowding out. If, instead, the economy has a recessionary gap, then we should expect instead that the private sector grows along with the fiscal expansion, and contracts along with a fiscal contraction.

Question 21

Why do changes in government taxes or transfers shift the AD curve by less than an equal-sized change in government purchases?

Answer 21

Because government spending directly contribute X amount to real GDP. Through taxes and transfers, households will only spend some amount of X (recall the MPC), and the rest will “leak” out into savings.

Question 22

How do you calculate total effects of the multiplier on government purchases?

Answer 22

ΔY = ΔG * (1/(1-MPC))

Question 23

How do you calculate the total effects of the multiplier on government transfers?

Answer 23

ΔY = ΔTR * MPC * (1/(1-MPC))

Question 24

When expansionary fiscal policy takes the form of a rise in transfer payments, real GDP may rise…

Answer 24

By either more or less than the initial government outlay. That is, the multiplier may either be more or less than 1 depending on the size of the MPC.

Question 25

What are lump-sum taxes?

Answer 25

A tax that is the same for everyone, regardless of any actions people take. When lump-sum taxes are in effect, taxes will not reduce the size of the multiplier.

Question 26

In practice, what determines the size of the multiplier?

Answer 26

Who among the population should get tax cuts or increases in government transfers.

Question 27

What are automatic stabilizers?

Answer 27

Government spending and taxation rules that cause fiscal policy to be automatically expansionary when the economy contracts and automatically contractionary when the economy expands without requiring any deliberate actions by policy makers. Taxes that depend on disposable income are the most important example of automatic stabilizers.

Question 28

What is the importance of automatic stabilizers?

Answer 28

To reduce the impacts of positive and negative demand shocks on the economy (and reduce the size of the multiplier). They blunt the extremes of the business cycle.

Question 29

What is discretionary fiscal policy?

Answer 29

Fiscal policy that is the direct result of deliberate actions by policy makers rather than automatic adjustments or rules. For example, during a recession, the government may pass legislation that cuts taxes and increases government spending in order to stimulate the economy.

Question 30

What is austerity?

Answer 30

A form of contractionary fiscal policy that takes the form of sharp cuts in spending plus tax increases.

Question 31

What determines the amount by which changes in government purchases raise real GDP?

Answer 31

The size of the multiplier.

Question 32

Explain why a $500 million increase in government purchases of goods and services will generate a larger rise in real GDP than a $500 million increase in government transfers.

Answer 32

A $500 million increase in gov purchases of g&s directly contributes $500 million to aggregate spending, which sets the multiplier in motion. So the contribution will equal $500 million * 1/(1-MPC). Transfers to households will only raise aggregate spending if it leads to an increase in consumer spending. Consumer spending rises by MPC * 1 for every $1 increase in disposable income, where MPC is less than 1. So a $500 million increase in government transfers will cause real GDP to rise only MPC times as much as a $500 million increase in government purchases of goods and services. It will increase real GDP by $500 million * MPC * 1/(1-MPC).

Question 33

Explain why a $500 million reduction in government purchases of goods and services will generate a larger fall in real GDP than a $500 million reduction in government transfers.

Answer 33

If government purchases of goods and services fall by $500 million, the initial fall in aggregate spending is $500 million. If there is a $500 million reduction in government transfers, the initial fall in aggregate spending is MPC * $500 million, which is less than $500 million.

Question 34

The country of Boldovia has no unemployment insurance benefits and a tax system using only lump-sum taxes. The neighbouring country of Moldovia has generous unemployment benefits and a tax system in which residents must pay a percentage of their income. Which country will experience greater variation in real GDP in response to positive and negative demand shocks? Explain.

Answer 34

Boldovia will experience greater variation in its real GDP than Moldovia because Moldovia has automatic stabilizers while Boldovia does not. In Moldovia, the effects of slumps will be lessened by unemployment insurance benefits that will support residents’ incomes, while the effects of booms will be diminished because tax revenues will go up. In contrast, incomes will not be supported in Boldovia during slumps because there is no unemployment insurance. In addition, because Boldovia has lump-sum taxes, its booms will not be diminished by increases in tax revenue.

Question 35

How do you calculate the total increase in real GDP resulting from an autonomous increase in aggregate spending, when taxes are included in the mix?

Answer 35

Total increase in real GDP = [1 + (MPC * (1-t)) + (MPC * (1-t))^2 + (MPC * (1-t))^3 + … * initial autonomous increase in aggregate spending

OR

Total increase in real GDP = (1/1-(MPC * (1-t))) * initial autonomous increase in aggregate spending

Question 36

How do you calculate the multiplier when taxes are included in the mix?

Answer 36

Multiplier = 1/1 - (MPC * (1-t))

Question 37

What is an example of how government can influence investment through fiscal policy?

Answer 37

The federal government’s decision to move the economy towards reduced emissions of greenhouse gases; this involves investment incentives for electric cars, sweetened deals for companies in the fossil fuel sector for investment in carbon capture technologies, etc.

Question 38

How do you calculate the government purchases multiplier?

Answer 38

Δ Equilibrium real GDP/Δ Government Purchases = ΔY/ΔG > 1

Question 39

Why is the ultimate increase in real GDP less than the shift in AD triggered by an initial increase in government purchases?

Answer 39

As the SRAS curve is upward sloping, the real GDP and price level are both higher in the equilibrium. Since we’ve dropped the assumption that the price level is fixed, firms will adjust their prices based on an increase in demand, which will in turn reduce demand and establish a new equilibrium that is less than the original shift in AD.

Question 40

What is aggregate demand management?

Answer 40

Trying to shift the aggregate demand, either through expansionary or contractionary fiscal policy.

Question 41

How do you calculate disposable income with proportional tax?

Answer 41

YD = (1-t)*Y

Question 42

How do you calculate changes in disposable income with proportional tax?

Answer 42

ΔYD = (1-t)*ΔY