Test #3 (chapter 13)

Question 1

What is a government transfer?

What are social insurance programs?
examples?

Answer 1

Government payments to households for which no good or service is provided in return

Social insurance programs = government programs intended to protect families against economic hardship
- most government transfers are towards social insurance

• public pension (CPP/GPP)
• old age security (OAS)
• guaranteed income supplement (GIS)

Question 2

Funds flow INTO the government in the form of what?

Funds flow OUT in the form of what?

Answer 2

INTO: taxes and government borrowing

OUT: government purchases of goods and services and government transfers to households

Question 3

What are the two areas of taxes that contain the biggest proportion of tax revenue?

Answer 3

Biggest = taxes on income, profits, and capital gains

second biggest = taxes on goods and services

Question 4

What are the biggest proportioned areas of government spending?

Answer 4

biggest = compensation of employees

second biggest = social benefits

third biggest = goods and services

Question 5

How does the government affect G, C, and I

Answer 5

Government directly controls G

C is affected indirectly by changes in T and TR
(ex. more taxes = fall in consumer disposable income = fall in consumer spending)

I is also affected indirectly by T and regulations

Question 6

The government can shift the __________ curve

Answer 6

AD

Question 7

What is fiscal policy?

Answer 7

The use of T, TR, or G to shift the AD curve

Question 8

What is expansionary fiscal policy? What kind of gap can it close?

Answer 8

It is fiscal policy that increases AD
3 forms:
- increasing government purchases of goods and services
- cut in taxes
- increase in government transfers

*can close a recessionary gap

Question 9

What is contractionary fiscal policy? What kind of gap can it close?

Answer 9

It is fiscal policy that decreases AD
3 forms:
- reducing government purchases of goods and services
- increase in taxes
- reduction in government transfers

*can close an inflationary gap

Question 10

What are the 3 criticisms of fiscal policy

Answer 10

1. Government spending always crowds out private spending:
   - true only if economy is at full employment
   *expansionary fiscal policy during a recession puts unemployed resources to work –> generates higher income + spending
2. Government borrowing always crowds out private investment spending:
   - true only if economy is NOT depressed
   *in depression, a fiscal expansion will lead to higher incomes, which lead to increased savings
3. Government budget deficits reduce private spending: aka “Ricardian equivalence”
   - idea is that consumers will cut spending today to save for increase in future T to pay off debt
   *consumers don’t have this much foresight
   *even if they do, they will decrease C over time and G will act much quicker

Question 11

Why is there a lag in fiscal policy?

Answer 11

There are significant time lags between policy and implementation

It takes time to:
- realize the output gap by collecting + analyzing data
- develop a plan
- implement the action plan

Question 12

Will a $50 billion increase in TR have the same effect as a $50 billion increase in government purchases?
explain.

Answer 12

NO

• impact of change in G is direct
• impact of change in T and TR is indirect
• changes in G have a more powerful effect on the economy - and it has a bigger multiplier

Question 13

Fiscal policy can shift the AD curve, but how do we find out how much it will shift the curve?

Answer 13

We have to use the multiplier

Question 14

What is the TR multiplier and the G multiplier?

Answer 14

TR multiplier = MPC / (1-MPC)
side note:
- with a 0.5 MPC, the multiplier is exactly 1
- if the MPC is less than 0.5, the multiplier is less than 1
- if the MPC is more than 0.5, the multiplier is more than 1

G multiplier = 1 / (1-MPC)

**In general, a change in government transfers or taxes shifts the aggregate demand curve by less than an equal-sized change in government purchases, resulting in a smaller effect on real GDP

Question 15

How do we decide WHO among the population should get tax cuts or increase in TR

Answer 15

• depends on the multiplier of a specific group

Ex. give unemployment benefits or cut in give more dividend income?
People who are unemployed receiving benefits will typically have a higher MPC than those who will receive dividend income which means the unemployment benefits will increase aggregate demand more

Question 16

How do taxes change the multiplier?

Answer 16

Lump-sum taxes (tax that is the same for everyone regardless of income) –> no change in the multiplier
1/(1-MPC)

Non-lump-sum taxes (most common) –> some income leaks as taxes –> new multiplier
1/1-(MPC x (1-t))

Question 17

Tax revenue automatically _________ during recessions due to ____________
What does this act like?

Answer 17

decreases

non-lump sum taxes

Acts like an automatic expansionary policy

Question 18

Define automatic stabilizers

Answer 18

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

(most important example = Taxes that depend on disposable income)

Question 19

transfer payments tend to _______ when the economy is contracting and ________ when the economy is expanding

Answer 19

rise

fall

Question 20

What is discretionary fiscal policy?

Answer 20

The direct result of deliberate actions by policy makers rather than automatic adjustments or rules → typically only used in the severe recession or sustained economic weakness

–> legislation of tax cuts, increases in G or TR to stimulate economy

Question 21

What is austerity?
Can we measure the value of the “fiscal multiplier”?

Answer 21

Sharp cuts in spending plus tax increases –> form of contractionary fiscal policy

• hard to measure since other things are not usually constant
• new evidence from Europe after 2009
• several nations implemented austerity because of debt concerns
• we can compare GDPs with + without austerity to estimate the multiplier

Question 22

How do expansionary and contractionary fiscal policies affect the budget balance?

Answer 22

Other things equal, expansionary fiscal policies reduce the budget balance for that year (budget deficit goes up)

Contractionary fiscal policies increase the budget balance for that year (budget deficit goes down or a surplus happens)

**however, if you see a budget deficit you can’t say that it’s due to expansionary policy
–Two different changes in fiscal policy that have equal-sized effects on the budget balance may have quite unequal effects on the economy
–Often, changes in the budget balance are themselves the result, not the cause, of fluctuations in the economy

Question 23

What is the relationship between the budget balance and the business cycle?

Answer 23

• budget deficit during recession
• surplus or less deficit during expansion

(even clearer is rise in unemployment with rise in budget deficit)
*Mostly reflects automatic stabilizers at work

Question 24

What is the cyclically adjusted budget balance?

Answer 24

An estimate of what the budget balance would be if real GDP were exactly equal to potential output
- used to separate the effects of the business cycle from the effects of discretionary fiscal policy

*Cyclically adjusted budget deficit doesn’t fluctuate as much as the actual budget deficit → large actual deficits are usually caused in part by a depressed economy

Question 25

What would a balanced budget every year do?

Answer 25

It would undermine the role of automatic stabilizers

ex. recession –> T decreases, TR increases –> budget deficit

*a balanced budget rule would deepen a recession

**budget should be balanced on average

Question 26

What is a deficit and what is debt? How are these used to measure fiscal health?

Answer 26

Deficit = the difference between what the government spends and its tax revenue over a given period (deficit = more spending than revenue)

Debt = the sum of money that a government owes at a particular time

*they are linked but not the same

A widely used measure of fiscal health is the debt-GDP ratio

Question 27

What is a fiscal year?

Answer 27

the time period used for much of government accounting, running from April 1 to March 31 in Canada → fiscal years are labelled by the calendar year in which they end

Question 28

Persistent budget deficits have long-run consequences because they lead to an increase in __________

Answer 28

public debt

Question 29

What is public debt?

Answer 29

government debt held by individuals and institutions outside the government

Question 30

What are the problems posed by rising government debt?

Answer 30

Crowding out:
- If budget deficit while at full employment → national savings fall → interest rates rise → leftward shift in the supply of loanable funds curve → decrease in investment spending = reduce economy’s long-run rate of growth

Financial pressure and default:
- may have to raise T, spend less, or borrow more (borrow = push deeper into debt)
- may enter a debt spiral (interest on govt. debt drives debt even higher)
- govt. may have to default because no one will want to loan to them anymore
- can they just print more money? no, then you have serious inflation issue

Question 31

What is the debt-GDP ratio?

Answer 31

government debt as a percentage of GDP, frequently used as a measure of a government’s ability to pay its debt

• debt-GDP ratio can fall, even when debt is rising, as long as GDP grows faster than debt

Question 32

What are implicit liabilities?

Answer 32

They are debts that the government must pay at a future date
- current deficit doesn’t include them

Canada’s largest implicit liabilities → transfer programs like Canada Health Transfer, the Canada Social Transfer, and benefits for retired and elderly people such as OAS and GIS (31.4% of total federal spending in Canada)

Question 33

What is the old-age dependency ratio?

Answer 33

the number of individuals aged 65 and over as a percentage of the population between ages 15 to 64 → this is rising

Question 34

What is the key question we have to ask to determine if the debt spiral is actually that serious?

Answer 34

Key question → is the interest rate the government has to pay more or less than the rate of growth in nominal GDP