CHAPTER 13 Fiscal Policy, Deficits, and Debt

Question 1

What is fiscal policy?

Answer 1

Fiscal policy refers to changes in government spending and tax collections designed to achieve full employment, price stability, and economic growth.

Question 2

What is the difference between discretionary and nondiscretionary fiscal policy?

Answer 2

Discretionary fiscal policy refers to government spending and tax changes that require current congressional action. Nondiscretionary fiscal policy occurs automatically without the need for new congressional action.

Question 3

What is the role of the President’s Council of Economic Advisers (CEA)?

Answer 3

The CEA provides expertise and assistance on economic matters and advises on fiscal policy, but congressional committees have the final say on fiscal bills.

Question 4

What is expansionary fiscal policy?

Answer 4

Expansionary fiscal policy aims to increase aggregate demand to raise real GDP, typically by increasing government spending or reducing taxes, especially during a recession

Question 5

How does the multiplier effect relate to expansionary fiscal policy?

Answer 5

The multiplier effect amplifies the impact of an initial change in government spending or taxes, shifting aggregate demand more than the original change.

Question 6

What is the fiscal policy response to a recession?

Answer 6

The government can increase spending, reduce taxes, or both to increase aggregate demand and restore full-employment output.

Question 7

What happens when the government increases spending by $5 billion with an MPC of 0.75?

Answer 7

The multiplier effect (with an MPC of 0.75) shifts aggregate demand by $20 billion, raising real GDP by $20 billion, from $490 billion to $510 billion.

Question 8

Why must a tax cut be larger than government spending increases to have the same effect?

Answer 8

A portion of the tax cut is saved rather than spent, so a larger tax cut is needed to achieve the same initial increase in consumption.

Question 9

What is contractionary fiscal policy?

Answer 9

Contractionary fiscal policy reduces aggregate demand by decreasing government spending, increasing taxes, or both, and is used to control inflation, especially demand-pull inflation.

Question 10

What is the goal of contractionary fiscal policy?

Answer 10

To reduce aggregate demand and slow or stop demand-pull inflation by shifting the aggregate demand curve leftward.

Question 11

How does the government use decreased government spending to control inflation?

Answer 11

The government can reduce spending, causing a leftward shift in aggregate demand, but it must account for the inflexible price level to avoid creating a recession.

Question 12

How does a tax increase affect aggregate demand during inflationary periods?

Answer 12

A tax increase reduces disposable income, lowering consumption spending and shifting aggregate demand leftward, which helps reduce inflationary GDP gaps.

Question 13

What is the effect of combining government spending decreases with tax increases?

Answer 13

Combining both policies helps control inflation by reducing aggregate demand and shifting the aggregate demand curve leftward.

Question 14

What is the multiplier effect in fiscal policy?

Answer 14

The multiplier effect refers to the process by which an initial change in spending or taxes results in a larger overall change in real GDP due to successive rounds of increased consumption.

Question 15

Why must the government adjust fiscal policy to account for a fixed price level during contractionary fiscal policy?

Answer 15

If the price level is fixed, a reduction in spending may not result in the expected decrease in output, potentially causing a recession if the adjustment is too large.

Question 16

What is meant by “built-in stability” in fiscal policy?

Answer 16

Built-in stability refers to the automatic adjustments in government revenues and expenditures that stabilize the economy without requiring active policy decisions. This includes changes in tax revenues and transfer payments based on the business cycle.

Question 17

How does the U.S. tax system contribute to built-in stability?

Answer 17

The U.S. tax system causes net tax revenues (taxes minus transfers) to rise when GDP increases and fall when GDP decreases, automatically stabilizing the economy.

Question 18

What happens to tax revenues during an economic expansion?

Answer 18

During an expansion, tax revenues automatically increase due to higher personal income taxes, corporate taxes, and payroll taxes, which helps moderate the economic growth and prevents inflation.

Question 19

How do transfer payments work as automatic stabilizers?

Answer 19

Transfer payments, such as unemployment compensation and welfare, increase during recessions and decrease during expansions, helping to cushion economic downturns.

Question 20

What is the role of government expenditures (G) in built-in stability?

Answer 20

Government expenditures (G) are fixed and do not change with GDP, while tax revenues (T) vary directly with GDP, creating automatic budget deficits or surpluses based on economic conditions.

Question 21

How do tax systems affect built-in stability?

Answer 21

A progressive tax system increases the average tax rate with GDP, creating greater built-in stability. A proportional tax system keeps the average tax rate constant, offering moderate stability, while a regressive tax system decreases the average tax rate as GDP rises, providing lower stability.

Question 22

How much did the U.S. tax system reduce the severity of business fluctuations in 2009?

Answer 22

The U.S. tax system helped reduce the severity of business fluctuations by about 8-10% of the change in GDP, as seen in the 2009 recession when individual income tax revenues fell by 22%.

Question 23

Can built-in stabilizers fully counteract large swings in GDP?

Answer 23

No, built-in stabilizers can only dampen the effects of business cycle fluctuations. Discretionary fiscal policies (e.g., tax rate changes) or monetary policies (e.g., interest rate adjustments) are needed to fully counteract severe recessions or inflation.

Question 24

What does the cyclically adjusted budget measure?

Answer 24

It adjusts the federal budget deficit or surplus to account for automatic changes in tax revenues due to GDP changes, showing the fiscal policy stance if the economy were at full-employment GDP.

Question 25

Why can’t we simply examine actual budget deficits or surpluses to determine fiscal policy?

Answer 25

Actual deficits or surpluses include automatic changes in tax revenues from GDP fluctuations, so they don’t reflect discretionary fiscal policy actions.

Question 26

What is the purpose of adjusting for automatic tax changes?

Answer 26

To isolate the effects of discretionary fiscal policy and determine whether the policy is expansionary, contractionary, or neutral.

Question 27

What indicates neutral fiscal policy in the cyclically adjusted budget?

Answer 27

If actual government expenditures equal the tax revenues that would occur at full-employment GDP, resulting in a zero cyclically adjusted budget deficit.

Question 28

How do cyclical deficits arise?

Answer 28

They occur due to automatic declines in tax revenues during a recession, which are not the result of discretionary fiscal policy changes.

Question 29

What does an increase in the cyclically adjusted budget deficit signify?

Answer 29

It indicates expansionary fiscal policy, usually due to tax cuts or increased government spending.

Question 30

What does a cyclically adjusted budget surplus indicate?

Answer 30

It signals contractionary fiscal policy, typically from increased taxes or reduced government spending.

Question 31

How does the cyclically adjusted budget clarify fiscal policy?

Answer 31

It removes the effects of automatic tax changes due to economic fluctuations, showing whether fiscal policy is expansionary, contractionary, or neutral.

Question 32

What is the impact of expansionary fiscal policy on the cyclically adjusted budget?

Answer 32

Expansionary fiscal policy increases the cyclically adjusted deficit as a percentage of potential GDP.

Question 33

How can we identify contractionary fiscal policy using the cyclically adjusted budget?

Answer 33

A shift from a cyclically adjusted deficit to a cyclically adjusted surplus indicates contractionary fiscal policy.

Question 34

What role do cyclical deficits play in understanding fiscal policy?

Answer 34

They help distinguish between deficits caused by economic downturns (cyclical) and those caused by discretionary fiscal policy (expansionary or contractionary).

Question 35

What key adjustment does the cyclically adjusted budget make?

Answer 35

It adjusts actual deficits and surpluses to eliminate cyclical effects on tax revenues and compares government spending to the potential tax revenues at full-employment GDP.

Question 36

What is the difference between actual and cyclically adjusted deficits in U.S. fiscal policy?

Answer 36

Cyclically adjusted deficits are smaller than actual deficits because they exclude cyclical factors like recession-related drops in tax revenues. Cyclically adjusted deficits show the true stance of fiscal policy.

Question 37

What information is needed to determine whether fiscal policy is expansionary, contractionary, or neutral?

Answer 37

Only cyclically adjusted surpluses and deficits as percentages of potential GDP provide this information.

Question 38

What was the federal budget deficit in 2008, and why did it increase?

Answer 38

The actual federal deficit in 2008 was -3.1% of GDP. It increased due to a recession and fiscal stimulus checks sent to taxpayers, which reduced tax revenues and increased government spending.

Question 39

How did the U.S. government respond to the Great Recession of 2007-2009?

Answer 39

The government passed a $152 billion economic stimulus package in 2008, which included checks to individuals. In 2009, the American Recovery and Reinvestment Act (ARRA) provided $787 billion in tax rebates and increased government spending on infrastructure and healthcare.

Question 40

What was the result of the fiscal stimulus in 2009 on the U.S. economy?

Answer 40

Despite the stimulus, the economy did not recover quickly. Unemployment remained high, and tax collections stayed low, keeping the budget deficits significant.

Question 41

What happened to the cyclically adjusted deficit in the late 2010s (2017-2019)?

Answer 41

The cyclically adjusted deficit rose to -5.0% of GDP in 2019 due to tax cuts and increased government spending, even as the economy was at full employment.

Question 42

What was the primary economic response during the COVID-19 pandemic in 2020?

Answer 42

The government passed the CARES Act, a $2.2 trillion stimulus package, to support individuals and businesses during the pandemic, leading to the highest federal budget deficit in peacetime history (-14.9% of GDP).

Question 43

How did the U.S. economy recover after the 2020 pandemic recession?

Answer 43

The economy recovered faster than expected, with the GDP gap narrowing from -10.7% in March 2020 to -2.8% by early 2021, aided by the fiscal stimulus.

Question 44

What was the inflation rate by March 2022, and how did it affect fiscal policy debates?

Answer 44

The inflation rate reached 8.5% in March 2022. This sparked debates on whether the ongoing fiscal stimulus was excessive and contributing to inflation, especially as the economy neared full employment.

Question 45

What were the key issues raised by economists about fiscal policy in the late 2010s and early 2020s?

Answer 45

Economists debated whether the continued fiscal stimulus during full employment periods was necessary, with some fearing it would lead to inflation, while others argued it was still needed to support the financial system.

Question 46

What role did the cyclically adjusted deficit play in assessing fiscal policy during the pandemic?

Answer 46

The cyclically adjusted deficit for 2020 was only slightly smaller than the actual deficit, indicating that despite the crisis, the economy was operating close to full employment, suggesting successful fiscal stimulus.

Question 47

What is the “recognition lag” in fiscal policy?

Answer 47

The time between the start of a recession or inflation and when it is recognized. It typically takes 4-6 months to confirm a downturn or inflation because the economy fluctuates unpredictably.

Question 48

What is the “administrative lag” in fiscal policy?

Answer 48

The delay between recognizing the need for fiscal action and the actual implementation of that action. Government processes, such as passing laws, can take months.

Question 49

What is the “operational lag” in fiscal policy?

Answer 49

The delay between when fiscal action is ordered and when it begins to impact the economy. Tax cuts have short operational lags, while government spending on infrastructure has long planning and construction periods.

Question 50

How do political considerations impact fiscal policy?

Answer 50

Politicians may push for policies, like tax cuts or increased spending, not for economic reasons but to gain voter support, particularly around elections, which can lead to economic instability (political business cycles).

Question 51

What is a “political business cycle”?

Answer 51

Swings in economic activity driven by election-motivated fiscal policies, rather than by efforts to stabilize the economy.

Question 52

How do expectations of future policy reversals affect fiscal policy?

Answer 52

If people believe fiscal measures (like tax cuts) are temporary, they may save rather than spend the extra money, reducing the intended economic boost. Similarly, temporary tax increases may not reduce consumption as expected.

Question 53

What is the issue with state and local governments’ fiscal policies?

Answer 53

State and local governments often worsen recessions by cutting spending or raising taxes during downturns, as they are required to balance their budgets. This can offset federal stimulus efforts.

Question 54

How did the CARES Act of 2020 help state and local governments?

Answer 54

The CARES Act provided $340 billion to state and local governments, helping prevent them from cutting spending or raising taxes, thus reducing the negative impact on the economy.

Question 55

What is the “crowding-out effect” in fiscal policy?

Answer 55

When the government borrows money for deficit spending, it raises interest rates, which can reduce private investment, weakening the intended stimulus of fiscal policy.

Question 56

When is the crowding-out effect less of a concern?

Answer 56

During a recession, the crowding-out effect is minimal because investment demand is low as businesses have excess capacity and little incentive to invest.

Question 57

When does the crowding-out effect become more problematic?

Answer 57

When the economy is at full capacity, the demand for investment is high, and higher interest rates may significantly reduce private investment, weakening the impact of fiscal policy.

Question 58

What was the size of the U.S. government’s budget deficit in 2020?

Answer 58

The U.S. government ran the largest peacetime budget deficit in history—14.9% of GDP—due to the massive fiscal stimulus to counter the COVID-19 recession.

Question 59

What are the main complications of fiscal policy?

Answer 59

Timing issues (recognition, administrative, and operational lags), political considerations, future policy reversals, state and local government finance problems, and the crowding-out effect.

Question 60

What is the U.S. national debt?

Answer 60

The U.S. national debt, or public debt, is the accumulation of all past federal deficits and surpluses, primarily resulting from war financing, recessions, and fiscal policy.

Question 61

How much was the U.S. public debt in January 2022?

Answer 61

As of January 2022, the U.S. public debt totaled $29.7 trillion, with $23.2 trillion held by the public and $6.5 trillion held by federal agencies and the Federal Reserve.

Question 62

How did the U.S. public debt change after the 2007–2009 recession?

Answer 62

The public debt more than doubled from $8.5 trillion in 2006 to $18.2 trillion in 2015 due to large budget deficits aimed at fighting the Great Recession and supporting recover

Question 63

What are U.S. government securities, and what types exist?

Answer 63

U.S. government securities are financial instruments issued by the federal government to borrow money. The four types are Treasury bills (short-term), Treasury notes (medium-term), Treasury bonds (long-term), and U.S. savings bonds (long-term, nonmarketable).

Question 64

What was the percentage of U.S. public debt held by foreigners in 2021?

Answer 64

In 2021, foreign citizens, businesses, and governments held about 26% of the total U.S. public debt.

Question 65

What is the debt-to-GDP ratio, and how did it change in 2020?

Answer 65

The debt-to-GDP ratio is the public debt held by the public as a percentage of GDP. In 2020, it spiked due to increased debt from pandemic relief efforts and a decrease in GDP caused by the pandemic.

Question 66

What is the primary burden of the public debt?

Answer 66

The primary burden is the annual interest charge on the debt, which was $352 billion in 2021, or 1.5% of GDP.

Question 67

Why is there no immediate risk of bankruptcy for the U.S. government due to its public debt?

Answer 67

The U.S. government can refinance its debt by selling new bonds to pay off maturing bonds and has the ability to raise taxes to finance its debt.

Question 68

How does the U.S. public debt affect future generations?

Answer 68

The public debt does not impose a significant burden on future generations since most of it is owed to U.S. citizens, who also hold Treasury securities as assets.

Question 69

What are some concerns related to the U.S. public debt?

Answer 69

Concerns include income inequality, reduced incentives due to higher taxes, and the crowding-out effect, where government borrowing may reduce private investment.

Question 70

What is the “crowding-out effect”?

Answer 70

The crowding-out effect refers to the reduction in private investment due to the government borrowing large amounts of money, which can drive up interest rates.

Question 71

How can public investments offset the crowding-out effect?

Answer 71

Public investments, like infrastructure and education, can increase future production capacity and stimulate private investment, partially offsetting the negative effects of crowding out

Question 72

What is the U.S. public debt’s impact on income distribution?

Answer 72

The ownership of government securities is concentrated among wealthier individuals, meaning that interest payments on the public debt mildly increase income inequality.

Question 73

What is the U.S. public debt’s foreign ownership, and how does it affect Americans?

Answer 73

26% of the U.S. public debt is held by foreign entities. Interest and principal payments on this debt transfer goods and services from the U.S. to foreigners, reducing U.S. purchasing power.

Question 74

What is the relationship between the U.S. public debt and the global economy?

Answer 74

While the U.S. has the world’s largest public debt in absolute size, other nations, such as Japan and Italy, have higher public debt relative to GDP.

Question 75

How does the U.S. debt-to-GDP ratio compare internationally?

Answer 75

As of 2021, the U.S. debt-to-GDP ratio was around 133%, which is high but lower than Japan, Italy, and Greece.

Question 76

What are the current challenges facing Social Security and Medicare funding?

Answer 76

Social Security and Medicare face funding shortfalls due to an aging population, with the Social Security Trust Fund expected to be exhausted by 2034 and the Medicare Trust Fund by 2026.

Question 77

What are the projected consequences of the U.S. aging population for Social Security and Medicare?

Answer 77

With fewer workers paying taxes into Social Security and Medicare, the systems will face funding shortfalls, requiring either higher taxes or reduced benefits to maintain current levels of service.