Fiscal policy

Question 1

what is discretionary fiscal policy

Answer 1

When the government is taking actions to change spending or taxes to achieve its economic objectives (fiscal policy)

Question 2

automatic stabilisers

Answer 2

Transfer payments and taxes that automatically increase or decrease along with the business cycle.

Question 3

draw the diagram of an expansionary fiscal policy

Answer 3

Question 4

describe this diagram

Answer 4

Economy begins at equilibrium at $1200 real GDP and price level of 100

Year 2: LRAS1 shifts to LRAS2, AD1 shifts to AD2(w/o policy) which is below potential GDP (recession, workers sacked, profits fall) SRAS1 shifts to SRAS2. economy will be at short-run equilibrium

increasing gov expenditure and/or reduce taxes will shift AD1 to AD2(w policy). Equilibrium at C, which is at potential GDP

Question 5

draw diagram of the effect a contractionary fiscal policy would have on the economy

Answer 5

Question 6

explain the diagram

Answer 6

The economy begins in equilibrium at point A, at potential GDP of $1200 billion and a price level of 100.

LRAS increases to $1400 billion in the second year.

The shift in aggregate demand from AD1 to AD2(without policy) results in a short-run macroeconomic equilibrium beyond potential GDP of $1450 billion (point B).

The economy will experience a rising inflation rate, with the price level rising from 100 to 104.

Decreasing government purchases or increasing taxes will shift AD1 to AD2(with policy) and keep real GDP from moving beyond its potential level. The inflation rate is 3 per cent rather than 4 per cent, and real GDP is at its potential level of $1400 billion

Question 7

Multiplier effect

Answer 7

process by which an increase in autonomous expenditure leads to a larger increase in real GDP.

spending and real GDP increase over a number of periods

Question 8

draw a diagram to show the multiplier effect from an increase in gov purchase

Answer 8

Question 9

The shift to the right from AD1 to AD2 shows

Answer 9

the initial increase in government purchases raises incomes and leads to further increases in consumption spending, the aggregate demand curve will ultimately shift further to the right, to AD3.

Question 10

The multiplier effect will continue over a number of periods, with

Answer 10

the additional consumption spending in each period being half of the income increase from the previous period. Eventually, the process will be complete,

Question 11

what is the government purchases multiplier:

Answer 11

ratio of the change in equilibrium real GDP to the initial change in government purchases

Question 12

describe how tax cuts have a multiplier effect

Answer 12

an inital tax cut increases disposable income –> increases consumption –> set off further increases in real GDP and income

Question 13

tax multiplier equation

Answer 13

tax multiplier = change in equilibrium GDP/ change in taxes

Question 14

is tax multiplier a negative no?

Answer 14

yes

Question 15

if the tax multiplier is –1.6, a $10 billion cut in taxes

how much will it increase real GDP

Answer 15

will increase real GDP by –1.6 × –10 billion = $16 billion.

Question 16

why may there be a smaller increase in aggregate demand when there is an increase in government purchases

Answer 16

a portion will be saved or a portion might be spent on imports

Question 17

what effect does a change in tax rates have on equilibrium real GDP?

Answer 17

The higher the tax rate –> the smaller the amount of any increase in income that households have available to spend –> reduces the size of the multiplier effect

Question 18

a cut in tax rates affects equilibrium real GDP through two channels

Answer 18

(1) a cut in tax rates increases the disposable income of households, which leads them to increase their consumption spending, and
(2) a cut in tax rates increases the size of the multiplier effect.

Question 19

multiplier effect and aggregate supply

draw diagram

Answer 19

Question 20

describe this diagram

Answer 20

The economy is initially at point A.

An increase in government purchases causes the aggregate demand curve to shift to the right, from AD1 to AD2.

The multiplier effect results in the aggregate demand curve shifting further to the right, to AD3 (point B).

Because of the upward-sloping supply curve the shift in aggregate demand results in a higher price level.

new equilibrium at point C, both real GDP and the price level have increased. The increase in real GDP is less than indicated by the multiplier effect with a constant price level

Question 21

describe the multiplier effect of decreases in gov purchases and increases in taxes

Answer 21

an increase in taxes –> reduce household disposable income –> reduce consumption spending –> reduced sales –> firms cut back on production –> lay off workers –> fall income –> reduced consumption

Question 22

Real GDP is currently $1200 billion, and potential GDP is $1250 billion. If the government increased government purchases by $50 billion or cut taxes by $50 billion, the economy could be brought to equilibrium at potential GDP.’

true or false?f

Answer 22

false, multiplier effect not considered.

Because of the multiplier effect, an increase in government purchases or a decrease in taxes of less than $50 billion is necessary to increase equilibrium real GDP by $50 billion. For instance, assume that the government purchases multiplier is 2 and the tax multiplier is –1.6

Gov purchases multiplier = change in equilibrium real GDP/ change in gov purchases

2= 50/ change in gov purchases

change in gov purchaes = 25

Tax multiplier = change in equilibrium real GDP/ change in taxes

-1.6 = 50/change in taxes

change in taxes= -31.25

Question 23

Getting the timing right can be more difficult with fiscal policy than with monetary policy for two main reasons.

Answer 23

1. reserve bank can change monetary policy monthly at montly meetings or any time by calling a special meeting
2. change in fiscal policy made through budget in May annually. Must pass through Lower and Upper House which can take many months

Question 24

describe why it may take a while to implement fiscal policy

Answer 24

e.g. $10b to construct railway lines –> months for detailed construction plans –> state gov asks for bids from private construction companies –> winnings bidders selected –> several months before project begins

Question 25

it takes time for policy-makers to collect statistics and identify changes in the economy. It can also take a substantial amount of time for the government to

Answer 25

formulate policy and get it passed through parliament.

Question 26

the size of the multiplier effect may be limited if

Answer 26

if gov expenditure causes crowding out

Question 27

what is crowding out

Answer 27

A decline in private expenditure as a result of an increase in government purchases.

Question 28

explain the crowding out effect (financial crowding out specifically)

Answer 28

gov spends w/o increasing taxation --\> most likely operating with budget deficit --\> borrows money by issuing cth bonds and securities --\> borrow from domsetic market, demand for loanable funds increase and real interest rate increases --\> reduced consumption and investment and net exports

Question 29

if government borrowing occurs on global financial markets, ( by selling securities and bonds) what effect does it have on domestic interest rates

Answer 29

no effect

Question 30

what is another way gov borrowing can cause interest rates to rise? give an example

Answer 30

if government borrowing for spending programs increases aggregate demand by an amount that puts upward pressure on inflation Australian government was borrowing around $1 million each day to fund stimulus infrastructure programs that were continuing even though the rate of economic growth was returning to a healthier level. inflationary pressures that led the RBA to increase interest rates 4 times during 2010.

Question 31

when might crowding out not be a problem

Answer 31

In a deep recession when many firms are very pessimistic about the future where investment spending falls to very low levels and is unlikely to fall much further even if interest rates rise.

Question 32

If the economy is close to potential GDP, will crowding out be a problem

Answer 32

an increase in interest rates may result in a significant decline in investment spending

Question 33

what is another way that gov expenditure can cause crowding out i.e. decline in private expenditure?

Answer 33

paying off government debt in the future will require higher taxes in the future, which can depress economic growth.

Question 34

describe when resource crowding out may occur what happens?

Answer 34

If increases in government spending occurred at a time when the economy was near or at full capacity, the government would be taking resources that would otherwise be used by the private sector. due to limited resources, the price for resources will rise

Question 35

What is the long-run effect of a permanent increase in government spending? distinguish with crowding out effect in the short-run

Answer 35

most economists agree that the result is complete crowding out. private expenditure falls by the same amount gov expenditure has increased e.g. before 20% G and 80% private . After 30% G and 70% private * Gov expenditure comes at the expense of private expenditure cf partial crowding out in short-run

Question 36

An expansionary fiscal policy does not have to cause complete crowding out in the short run. how come?

Answer 36

If the economy is below potential GDP it is possible for both government purchases and private expenditure to increase.

Question 37

what is net debt

Answer 37

he difference between the amount of funds the government borrows and the amount it lends

Question 38

Describe trend of government debt

Answer 38

The Coalition government consistently reduced the net debt of the Commonwealth government throughout the period after 1995/96 and by 2005/06 the government had no net debt, and had become a net saver . Australia moved into a position of significant debt from 2008/09 onwards, as government borrowing was required to fund the budget deficit

Question 39

why do budget deficits occur during contractions or recessions?

Answer 39

due to automatic stabilisers

Question 40

cyclically adjusted budget deficit or surplus measures?

Answer 40

The cyclically adjusted budget deficit or surplus measures what the deficit or surplus would be if the economy were at potential GDP

Question 41

how does the GDP level affect the cyclically adjusted budget deficit?

Answer 41

if real GDP is above potential GDP, budget will be in surplus (increase in taxes, reduction in transfer payments) if real GDP is below potential GDP, budget will be in deficit (fall in taxes, rise in revenue) if real GDP = potential GDP, budget will be balanced

Question 42

The federal government’s budget in Australia was in deficit by over $15 billion in 1993 and moved into a surplus of over $12 billion in 2000. Someone commented, ‘The government must have acted to raise taxes or cut spending or both’.

Answer 42

false could also be that household incomes and firms profits rose --\> increase in tax and unemployment fell --\> fall in transfer

Question 43

Should the federal budget always be balanced?

Answer 43

To balance the budget every year the government might have to take actions that would destabilise the economy. e. g. balance budget during contraction (GDP below potential level) where budget automatically moves into a deficit --\> increase in taxes etc. --\> reduces aggregate demand and further slows down growth e. g. balanced budget during expansion (GDP above potential leve) where budget automatically moves into a surplus --\> to balance, cut taxes and increase spending --\> inflationary pressures

Question 44

how does the gov pay its interest on the debt? what is the problem if the gov has a very high debt level?

Answer 44

raise funds through taxes to pay debts higher the debt --\> more tax needs to be raised or cut back on spending

Question 45

crowding out effectively reduces private investment spending less investment means? how can this be somewhat offset?

Answer 45

Lower investment spending means lower capital stock in the long run and a reduced capacity of the economy to produce goods and services. somewhat offset if some of the government debt is incurred to finance improvements in infrastructure, education or R&D --\> add to productive capacity

Question 46

distinguish between the effect of short-run and long-run fiscal policy actions

Answer 46

short-run: stabilise economy long run: increase productivity --\> long-term growth concerned with supply side policies --\> shifts LRAS supply curve to the right

Question 47

Most fiscal policy actions that attempt to increase aggregate supply do so by

Answer 47

changing taxes to increase the incentives to work, save, invest and start a business.

Question 48

The long-run effects of tax policy what is a tax-wedge

Answer 48

The difference between the pre-tax and post-tax return to an economic activity.

Question 49

reducing the tax wedge by cutting the marginal tax rate on income would

Answer 49

would result in a larger quantity of labour supplied because the after-tax wage would be higher

Question 50

In general, economists believe that the smaller the tax wedge for any economic activity

Answer 50

the more of that economic activity that will occur.

Question 51

effects on aggregate supply reducing the marginal tax rates on personal income

Answer 51

reduces the tax wedge faced by workers --\> increases quantity of labour supplied. sole proprietorships, whose profits are taxed at the personal income tax rates. --\> encourages entrepreneurship, encouraging the opening of new businesses. households are also taxed on their returns from saving at the personal income tax rates --\> Reducing marginal income tax rates therefore also increases the return to saving.

Question 52

effects on aggregate supply ## Footnote Company income tax.

Answer 52

Cutting the company income tax rate would encourage investment spending by increasing the return corporations receive from new investments in equipment, factories and office buildings. innovations are often embodied in new investment goods --\> increase the pace of technological change.

Question 53

effects on aggregate supply ## Footnote Taxes on capital gains

Answer 53

earnings are, in effect, taxed twice: once when corporations pay the company income tax on their profits, and again when the profits are received by individual investors in the form of capital gains. Lowering the tax rates on capital gains increases the supply of ***loanable funds from households to firms***, increasing saving and investment and lowering the equilibrium real interest rate.

Question 54

draw the supply side effects of a tax change

Answer 54

Question 55

explain this diagram

Answer 55

equilibrium is at point A No tax change, shifts from LRAS1 to LRAS2 new equilibrium at B With tax reductions and simplifications the long-run aggregate supply curve shifts further to the right to LRAS3 and equilibrium moves to point C (further increasing real GDP and lowering price)

Question 56

Economists who are sceptical of the magnitude of supply-side effects believe that

Answer 56

believe that tax cuts have their greatest impact on aggregate demand, rather than on aggregate supply

Question 57

Most economists would agree that there are supply-side effects to

Answer 57

reducing taxes: decreasing marginal income tax rates will increase the quantity of labour supplied, cutting the company income tax will increase investment spending and so on. The magnitude of the effects is the subject of considerable debate,

Question 58

why is the magnitude of supply side effects of tax changes debatable?

Answer 58

economists believe that tax changes have only a small effect on saving and investment. in their view, saving and investment are affected much more by changes in income or changes in expectations of the future profitability of new investment due to technological change or improving macroeconomic conditions than they are by **tax changes.**

Question 59

draw the phillip's curve what does it show

Answer 59

short-run relationship between unemployment rate and inflation

Question 60

If aggregate demand does not increase by as much as LRAS, short-run macroeconomic equilibrium will occur at what if it shifts by the same amount?

Answer 60

a level of real GDP **below the potential level.** But if it shifts at the same amount, the the economy can remain in macroeconomic equilibrium at potential GDP. he unemployment rate will rise, but the price level will rise by less than it would have, meaning that the inflation rate will fall.

Question 61

describe the following diagram if aggregate demand was strong and draw the corresponding phillip's curve

Answer 61

In year 2, if the AD curve shifts to the right by the same amount as the LRAS curve, then macroeconomic equilibrium **occurs at real GDP of $1450 billion,** which is the new higher level of potential GDP (point B). The price level rises from 100 to 104, so the inflation rate remains a**t 4 per cent**. Point B on the Phillips curve is the same as point A because the inflation and unemployment rates haven’t changed.

Question 62

describe the following diagram if aggregate demand was weak and draw the corresponding phillip's curve

Answer 62

Year 2: macroeconomic equilibrium occurs below potential GDP. Inflation falls to 2% and unemployment rises to 6%

Question 63

the AD–AS model indicates that slow growth in aggregate demand leads what does this explain

Answer 63

both higher unemployment and lower inflation. This relationship explains why there is a short- run trade-off between unemployment and inflation

Question 64

Is the Phillips curve a policy menu? During the 1960s some economists argued that the Phillips curve represented a

Answer 64

structural relationship in the economy: a structural relationship depends on the basic behaviour of consumers and firms and remains unchanged over long periods

Question 65

Is the Phillips curve a policy menu? Structural relationships are useful in formulating economic policy because

Answer 65

policy-makers can anticipate that these relationships are constant—that is, the relationships will not change as a result of changes in policy.

Question 66

Is the Phillips curve a policy menu? potentially, if the phillips curve were a structural relationship,

Answer 66

Potentially, policy-makers could use expansionary/contractionary monetary and fiscal policies to choose a point on the curve that had lower unemployment and higher inflation.

Question 67

Is the Phillips curve a policy menu? Because many economists and policy-makers in the 1960s viewed the Phillips curve as a structural relationship

Answer 67

they believed it represented a permanent trade-off between unemployment and inflation.

Question 68

Is the Phillips curve a policy menu? describe the permanent trade-off between unemployment and inflation

Answer 68

As long as policy-makers were willing to accept a permanently higher inflation rate, they would be able to keep the unemployment rate permanently lower Similarly, a permanently lower inflation rate could be attained at the cost of a permanently higher unemployment rate.

Question 69

what features of the 1960s held that there was a stable trade-off between inflation and unemployment?

Answer 69

early 1960s the inflation rate in many industrialised countries was low, while the unemployment rate was high. late 1960s the unemployment rate had declined, while the inflation rate had increased.

Question 70

Who argued that the phillip's curve did not present a permanent trade off? who supported this?

Answer 70

US economist Milton Friedman in 1968 argued that the Phillips curve did not represent a permanent trade-off between unemployment and inflation US economist Edmund Phelps published an academic paper making a similar argument

Question 71

why did friedman and phelps argue there was no trade off in the long-run between unemployment and inflation?

Answer 71

b/c LRAS curve is vertical so the phillip curve could not be downward sloping in the long run

Question 72

the level of real GDP in long run is also referred to as

Answer 72

potential GDP

Question 73

what will happen to real GDP and unemployment in the short-run and long-run?

Answer 73

it the short-run they will fluctuate in the long-run they will return to potential GDP or the natural rate of unemployment (unemployment when economy is operating at potential GDP) * inflation has no effect on real GDP(always=potential GDP) and unemployment (always= natural rate)

Question 74

draw the long-run phillip's curve and LRAS curve according to Friedman and Phelps

Answer 74

Question 75

what implication can be drawn If the long-run Phillips curve is a vertical line

Answer 75

no trade-off exists between unemployment and inflation in the long run

Question 76

If the long-run Phillips curve is a vertical line, then no trade-off exists between unemployment and inflation in the long run, how can you experience the trade-off in the 1950s and 60s? How did Friedman justify?

Answer 76

Friedman argued that the statistics from those years actually showed only a short-run trade-off between inflation and unemployment. The short-run trade-off existed differences between the expected inflation rate and the actual inflation rate (by workers and firms) could lead the unemployment rate to rise above or dip below the natural rate

Question 77

calculate real wage ## Footnote company’s managers and the unions agree on a wage of $31.50 per hour to be paid during 2015. Both the company and the unions expect that the price level will increase from 100 in 2014 to 105 in 2015, so the inflation rate will be 5 per cent.

Answer 77

Real wage= 􏰂 nominal wage/price level x 􏰃 100= $31.50/105 x 􏰃 100= 􏰂 $30

Question 78

impact of unexpected price level changes on the real wage ## Footnote company’s managers and the unions agree on a wage of $31.50 per hour to be paid during 2015. Both the company and the unions expect that the price level will increase from 100 in 2014 to 105 in 2015, so the inflation rate will be 5 per cent. If inflation rate was 2% during 2015? if the inflation rate was 8% during 2015?

Answer 78

Question 79

If actual inflation is higher than expected inflation then

Answer 79

actual real wages in the economy will be lower than expected real wages and many firms will hire more workers than they had planned. Therefore, the unemployment rate will fall.

Question 80

If actual inflation is lower than expected inflation,

Answer 80

actual real wages will be higher than expected and many firms will hire fewer workers than they had planned, and the unemployment rate will rise.

Question 81

Friedman and Phelps concluded that

Answer 81

an increase in the inflation rate increases employment (and decreases unemployment) only if the increase in the inflation rate is **unexpected.**

Question 82

If workers fail to understand that rising inflation leads over time to comparable increases in wages, then, when inflation increases, in the short run

Answer 82

firms can increase wages by less than inflation without needing to worry about workers quitting or their morale falling. Once again, we have a higher inflation rate leading in the short run to lower real wages and lower unemployment.