Module 16 - Fiscal Policy

Question 1

Which of the following does Figure 16.6 show?

A. a deflationary gap given by UV.
B. a deflationary gap given by YfYe.
C. an inflationary gap given by UV.
D. an inflationary gap given by YfYe.

Answer 1

The correct answer is C. An inflationary gap exists when the level of demand at full- employment income (Yf in Figure 16.6) is greater than the level of demand neces- sary to maintain full-employment income. The gap is the excess of demand over that necessary to maintain full-employment income. In the diagram, this is given by the vertical distance between the 45° line and D, i.e. UV.

Question 2

Aggregate demand = C + I + G + (X − Z)

Imports are deducted from ___ because part of con- sumption, investment and government expenditures takes the form of purchases of___, rather than home-produced goods, and these purchases of ___ create factor incomes in other ___ and not in the ___.

Answer 2

aggregate demand;

imports;

imports;

economies;

domestic economy

Question 3

Which of the following policies would be appropriate for dealing with an inflationary gap?

A. Decrease income taxes.
B. Increase tariffs and quotas on imports.
C. Decrease government expenditure.
D. Increase unemployment compensation.

Answer 3

The correct answer is C. Decreasing an inflationary gap requires a deflationary fiscal and/or monetary policy. Reducing income taxes, reducing imports, and raising unemployment compensation would all increase aggregate demand and increase the inflationary gap. A reduction in government expenditure would decrease aggregate demand and reduce the inflationary gap.

Question 3

Money income is simply income measured by the ___ currently ruling.

Real income is measured by ___ to allow for changes over time in the value of the ‘measuring rod’ of money.

Thus, changes in money income include changes in ___; changes in real income reflect changes only in ___.

Answer 3

price weights;

adjusting money income;

price and quantity weights;

quantity weights

Question 4

This insufficiency of aggregate demand compared with the level of aggregate demand necessary to obtain and sustain Yf is known as the ___.

Answer 4

deflationary gap

Question 5

Faced with a deflationary gap, the government is considering either increasing government expenditure by $5 million or decreasing taxes by an equal amount. Assuming sufficient unemployed resources, which of the following is correct?

A. The increase in government expenditure will decrease the deflationary gap more than the decrease in taxes.

B. The decrease in tax will decrease the deflationary gap more than the increase in government expenditure.

C. Both policies will produce the same result.

D. The decrease in tax will reduce unemployment more than the increase in government expenditure, but the effect on the deflationary gap is unknown.

Answer 5

The correct answer is A. An increase in government expenditure of $5 million will result in a matching increase in income, which in turn will lead to an increase in consumption, the size of the increase being dependent on leakages from the circular flow. This multiplier process will continue to lead to an increase in output that will be some multiple of the original increase in government expenditure and will decrease the deflationary gap. A decrease in tax by $5 million will not be matched by an increase in national income of $5 million because it is a transfer of income from the government to households. However, households will spend a proportion of the $5 million on consumption expenditures, which will start off the multiplier process similarly to that outlined above with the first round of expenditure and income creation missing.

Question 6

A given increase in government expenditure does not always lead to a greater increase in real national output because

I. there may not be a sufficient quantity of unemployed resources to produce such an increase in real national output.

II. increased incomes may be spent on imports. Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

Answer 6

The correct answer is C. If actual output is equal to potential output, an increase in government expenditure will cause prices to rise, but real national output will not rise because no idle resources will be available. If all of the additional income generated by the increased government expenditure were spent on imports, no multiplier process would result.

Question 7

Assuming no offsetting changes in other components of aggregate demand, a deflationary gap between actual and potential output would be narrowed by

I. increased investment expenditure.

II. increased imports.

III. balanced increase in government expenditure and tax revenue.

Which of the following is correct?

A. I only.
B. II only.
C. I and II only.
D. I and III only.

Answer 7

The correct answer is D. An increase in aggregate demand would decrease a given deflationary gap between potential and actual output. An increase in investment expenditure and a balanced increase in government expenditure and tax revenue would increase actual output, the latter policy operating by the balanced budget multiplier. An increase in imports would decrease aggregate demand because imports are a leakage from the circular flow of income.

Question 7

This proposed operation of fiscal policy is known as ___, meaning that there is no single automatic rule that should be followed regarding the relationship between government expenditure and government taxation. Instead, fiscal policy should be discretionary.

Answer 7

functional finance

Question 8

In certain periods during the past five years, money incomes have increased in the UK but the standard of living has decreased. Which of the following can account for this?
Increases in

A. prices have been less than increases in money incomes.

B. prices have been greater than increases in money incomes.

C. money incomes do not lead to increases in spending.

D. money incomes cause real GNP to decline.

Answer 8

The correct answer is B. Higher money incomes will be associated with higher real living standards only if rising money incomes can continuously buy more goods and services. This is possible only if the prices of goods and services are not rising as fast as money incomes. Increases in money incomes are normally associated with increases in spending. Real GNP declines when aggregate demand declines, not when money incomes increase.

Question 9

At points to the right of Yf in Figure 16.6, which of the following is correct?

A. Real national income is increasing because more factors of production are being utilised.

B. Real national income is falling because the economy is departing from full employment.

C. Money national income is rising because output is rising.

D. Money national income is rising because of rising prices.

Answer 9

The correct answer is D. Yf represents full employment income. While national income for short periods can exceed Yf, for example by working 50-hour weeks, such a level of demand creates inflationary pressures, causing money national income to increase without a matching increase in real output.

Question 9

If national income, measured in current prices, doubles because all quantity weights double, then there is an increased flow of goods and services available to satisfy material wants.

If, on the other hand, national income doubles because all price weights double, then there is no change in the flow of goods and services available to satisfy material wants.

In the former case, ___ have doubled; in the latter case, ___.

Answer 9

real and money incomes;

money income has doubled while real income has not changed

Question 10

The government can influence the circular flow of income through taxes (T), a withdrawal from the circular flow of income, or through government expenditure (G), an injection into the circular flow.

A budget deficit (T < G) would have an ___on the economy; a budget surplus (T > G) would have a ___ on the economy.

Answer 10

expansionary effect;

deflationary effect

Question 11

A treasury publication describing the performance of the UK economy over the past decade includes a graph in which, for two months, actual GNP exceeded full-
employment (potential) GNP.

Which of the following must be true?

The graph was

A. wrong because it is not possible for actual GNP to exceed potential GNP.

B. wrong because during periods of full employment actual GNP causes increases in potential GNP.

C. correct because potential GNP is not an upper limit to output in each and every period.

D. correct because during periods of full employment actual GNP is always greater than potential GNP.

Answer 11

The correct answer is C. Potential output is defined as the output achievable when all resources are fully employed. In practice, however, resources can be over-fully employed for short periods, e.g. 50 hours per week for some members of the labour force. Because over-full employment cannot be sustained in the long run, potential output is defined with reference to a given practical rate of capacity utilisation of capital. There is no necessary connection between the level of employment and potential GNP. Full employment is defined as actual GNP equal to, not greater than, potential GNP.

Question 12

The naive monetarist view is that the components of aggregate demand are interdependent, so that changes in the budget deficit (surplus) are offset by equivalent changes, of opposite sign, in other components of aggregate demand.

If this were so, the creation of a budget deficit by raising G relative to T would not ___ aggregate demand in that the higher government expenditure would be at the expense of lower private expenditure. This is known as the ___.

In short, the naive Keynesian view is that the crowding-out effect is ___, while the naive monetarist view is that it is ___.

Answer 12

raise;

crowding-out effect;

zero;

unity;

Question 13

Recently a government announced decreases in income tax and government expenditure. From these policy decisions it can be inferred that the government concern was

I. the deflationary gap.
II. the inflationary gap.
III. the current high unemployment rate.

Which of the following is correct?

A. I only.
B. II only.
C. I and III only.
D. Not I nor II nor III.

Answer 13

The correct answer is D. Decreases in income tax would stimulate the economy; decreases in government expenditure would depress the economy. Had the decrease in government expenditure equalled the tax revenue increase, the net impact would have been to decrease aggregate demand by the balanced budget multiplier. It could then be inferred that the concern of the government was the inflationary gap. However, without knowing the magnitudes of the changes, it is not possible to predict the net effect and thus not possible to deduce the government’s concern.

Question 13

So far we have demonstrated that the limit to national income in the short run is determined by the ___, which in turn is determined by the available supply of___ and ___.

Answer 13

production possibilities frontier;

factors of production;

technical knowledge

Question 14

Ye is equilibrium income because only at this level of income are planned withdrawals equal to planned investment so that ___ (formula).

Answer 14

S + T + Z = I + G + X

Question 16

Generally speaking, the greater the proportion of the budget deficit created by expenditure increases, the lower the deficit necessary to obtain full-employment income, and vice versa.

An increase in government expenditure of $1 million results in an increase of $1 million in ___, less the government’s ___ to import goods and services.

The effect of a tax reduction of $1 million on ___ will depend on the public’s ___ to save plus its to import.

If the sum of these two ___ is greater than the government’s ___ to import, which appears likely, a $1 million increase in government expenditure will ___ aggregate demand more than a $1 million ___ in taxation revenue.

Answer 16

aggregate demand;

propensity;

aggregate demand;

marginal propensity;

marginal propensity;

marginal propensities;

marginal propensity

raise;

decrease

Question 18

It follows from this that the balanced budget does not have a neutral effect on the circular flow of income, as $1 of government expenditure is more ‘high pow- ered’ than $1 of taxation.

Thus, listing fiscal policies in descending orders of expansionary effects, we obtain:

(a) ___
(b) ___
(c) ___

Answer 18

(a) a budget deficit created by raising G relative to T;
(b) a budget deficit created by reducing T relative to G;
(c) increasing both G and T by the same amount.

To obtain a given increase in aggregate demand will require a smaller budget deficit if the deficit is created by raising G, and a larger budget deficit if the deficit is created by lowering T.

Alternatively, the same increase in aggregate demand could be obtained by raising both G and T, but where a substantial stimulus to the economy is required, it would necessitate a very large increase in the size of the government sector to produce the same effect as a budget deficit created by (a) or (b) above.

Question 20

Which of the following accounts for the fact that there is a limit to the level of national output in the short run? In the short run

A. the price of factors of production increases when the demand for them increases.

B. aggregate demand is relatively fixed.

C. it is not possible to substitute between the factors of production.

D. factors of production are limited in supply.

Answer 20

The correct answer is D. The upper limit to the level of national output in the short run is potential output, which is determined by the supply of factors of production. This fact is independent of the prices of factors of production. Aggregate demand can increase in the short run and variable factors of production can be substituted for each other in the short run.

Question 21

The naive Keynesian view is that the components of aggregate demand are independent of each other so that, for example, an increase in government expenditure (G) does not have any adverse effect on any other component of aggregate demand, namely C, I or X.

In this case, the creation of a budget deficit by raising G com pared with T will ___ aggregate demand by the full extent of the deficit thus created.

Conversely, the creation of a budget surplus by lowering G relative to T will ___ aggregate demand by the full amount of the surplus thus created.

Clearly, if this were so, changes in the budget deficit (surplus) will represent a ___ into (withdrawal from) the circular flow of income and would have a substantial impact on the level of aggregate demand, and therefore on national income and employment.

Answer 21

increase;

lower;

net injection;

Question 23

It is argued that government can always make national output higher by fiscal and/or monetary policy. This is not the case in practice because of which of the following?

A. The marginal propensity to consume is always less than one.

B. The labour force is not a fixed percentage of the population.

C. There is an upper limit to national output determined by the economy’s resources.

D. The ratio of capital to output increases as national output increases.

Answer 23

The correct answer is C. Whenever actual output is less than potential output, appropriate fiscal and monetary policies will lead to an increase in actual output. The size of the increase will depend upon the multiplier, which increases with the marginal propensity to consume, i.e. it does not have to equal one to prevent positive multiplier effects. Expansion requires unemployed resources (including labour), or technological change; it does not require labour to be a fixed percentage of the population. The ratio between capital and output, although affecting the rate of expansion, will not stop the expansion process. Expansionary aggregate demand policies will only be ineffectual when the economy has reached full employment, i.e. when productive capacity is fully utilised.

Question 24

A price index is a ___ of price changes, an attempt to measure the ___.

This is obtained by selecting a typical basket of goods and services, observing the price changes of these goods and services and weighting these ___ to allow for the differing economic importance of the different goods and services

Answer 24

representation;

average or representative price change;

price changes

Question 25

Aggregate demand in a closed economy is the sum of consumption, investment and government expenditures. The upper limit to national output is determined by

I. the stock of capital.
II. the quality and quantity of labour available.

Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

Answer 25

The correct answer is C. The upper limit to the level of national output is determined by the economy’s potential output. More labour added to a given capital stock will always increase an economy’s potential output, as will more capital added to a given labour force. Therefore, neither the capital stock on its own, nor the labour force on its own, will determine potential output.

Question 26

Over the past five years the rate of growth of actual GNP in an economy has been 5 per cent per annum, whereas the rate of growth of potential GNP has been only 4 per cent per annum. It can be concluded that

A. an inflationary gap exists.

B. a deflationary gap that existed five years ago is decreasing.

C. high unemployment currently exists.

D. aggregate demand currently exceeds potential GNP.

Answer 26

The correct answer is B. If the economy had been at full employment initially, it would be impossible for the growth of actual output to exceed the growth of potential output by 1 per cent per annum for five years. Hence, the observation that the growth of actual output has exceeded the growth of potential output over that period must imply that, initially, actual output was below potential output. Further, it must imply that the gap between actual output and potential output is falling – that is, the deflationary gap is decreasing. Currently the economy need not be at full employment, but it could now be.

Question 27

Generally speaking, the greater the proportion of the budget surplus created by expenditure reductions, the ___ necessary to obtain full employment income, and vice versa.

Answer 27

lower the budget surplus

Question 28

Which of the following statements must be true?

A. The columns for money and real GNP have been switched, because real GNP always increases.

B. The data are wrong because money and real GNP can never be equal.

C. Although prices increased over the three years, actual output decreased during one year.

D. Money GNP was the better measure of the performance of the economy over the period.

Answer 28

The correct answer is C. Money GNP rose in Year t + 1 while real GNP fell; hence prices increased in Year t + 1. The growth in money GNP was greater than the growth in real GNP in Year t + 2, indicating rising prices. Real GNP and money GNP are equal in the base year chosen and can subsequently be equal if increases in output are compensated by reductions in prices, and vice versa. Money GNP can be a misleading measure of economic performance because price changes and real output changes cannot be separated.

Question 29

Which of the following policies would be appropriate for dealing with a deflationary gap?

A. Increase income taxes.
B. Increase subsidies to exporting industries.
C. Decrease unemployment compensation.
D. Decrease government expenditure.

Answer 29

The correct answer is B. Decreasing a deflationary gap requires an expansionary fiscal and/or monetary policy. Increasing taxes, decreasing unemployment compen- sation, and decreasing government expenditure would all increase the deflationary gap. An increase in subsidies to exporting industries would stimulate exports, increase aggregate demand, and reduce the deflationary gap.

Question 30

The excess aggregate demand over and above the level of aggregate demand necessary to obtain and sustain Yf is known as the ___.

Answer 30

inflationary gap

Question 31

It is possible to obtain an index number that covers a wide or a narrow range of goods and services. The price index used to obtain real GNP is known as the ___.

Answer 31

GNP deflator

Question 32

Over time, national income measured in current prices can change for two reasons. Discuss.

Answer 32

A change in the output weights representing a change in the volume of goods and services produced; and/or a change in the price weights, which does not represent a change in the volume of goods and services but a change in the value of the measuring rod, money.

Clearly, if national income changes because of changes in the output weights, then the volume of goods and services available for consump tion and investment purposes has changed, i.e. ‘real’ national income has changed.

Alternatively, if national income has changed because the price weights have changed, with prices having risen or fallen, then the volume of goods and services has not changed: real national income has remained constant and the change in money national income is due to the change in the price weights