Week 21 - Spending and Output Pt3

Question 1

What are automatic stabilisers in fiscal policy?

Answer 1

Policies that automatically increase government spending or decrease taxes when real output declines, without the need for new legislation.

Question 2

What are examples of automatic stabilisers?

Answer 2

Unemployment compensation and the progressive income tax system.

Question 3

How do automatic stabilisers work during a recession?

Answer 3

They help sustain household income and consumption by increasing government transfers and reducing tax burdens automatically.

Question 4

Why don’t automatic stabilisers require new decisions or legislation?

Answer 4

Because they are built into existing laws and respond automatically to changes in economic conditions.

Question 5

When is fiscal policy especially useful?

Answer 5

During prolonged periods of recession when automatic stabilisers and monetary policy may not be enough.

Question 6

What type of policy is more commonly used for short-run economic stabilisation?

Answer 6

Monetary policy is more often used due to its flexibility and quicker implementation.

Question 7

What are automatic stabilisers?

Answer 7

Automatic stabilisers are automatic changes in the government budget deficit that help dampen fluctuations in economic activity.

Question 8

How do automatic stabilisers function during a recession?

Answer 8

They increase the budget deficit by reducing taxes and/or increasing transfer payments automatically, helping to support aggregate demand.

Question 9

How do automatic stabilisers respond during an expansion?

Answer 9

They reduce the budget deficit by increasing tax revenues and reducing transfer payments, helping to cool down the economy.

Question 10

What is discretionary fiscal policy?

Answer 10

It refers to deliberate government decisions to increase or decrease government purchases, transfer payments, and taxation to influence the economy.

Question 11

What is the formula for the government deficit?

Answer 11

Government Deficit = G – T, where T is net taxes (tax revenue minus transfer payments).

Question 12

How do net taxes (T) behave over the business cycle?

Answer 12

Net taxes tend to rise during expansions (as incomes and tax revenues increase) and fall during recessions (due to lower income and higher transfer payments).

Question 13

What happens to incomes, consumption, and profits during a recession?

Answer 13

They decline, which leads to lower tax revenues and higher transfer payments.

Question 14

How do automatic stabilisers operate during a recession?

Answer 14

Tax revenues fall, transfer payments (like unemployment benefits) rise, and net taxes decrease—automatically increasing the government deficit (G – T).

Question 15

What causes net taxes to fall during recessions?

Answer 15

A decline in income, consumption, and profits reduces tax revenues, while more people claim unemployment and other benefits.

Question 16

What happens during economic expansions to income, consumption, and profits?

Answer 16

They increase, leading to higher tax revenues and lower transfer payments.

Question 17

How do automatic stabilisers function during an expansion?

Answer 17

Net taxes automatically increase as tax revenues rise and transfer payments fall, reducing the government deficit.

Question 18

What is the automatic effect of the business cycle on the government deficit (G – T)?

Answer 18

The deficit increases during recessions and decreases during expansions without new policy decisions.

Question 19

What was the purpose of the American Recovery and Reinvestment Act of 2009?

Answer 19

To stimulate the economy during the Great Recession through tax cuts and increased government spending.

Question 20

How much was allocated to tax cuts and government spending in the 2009 stimulus?

Answer 20

$200 billion in tax cuts and $600 billion in increased government spending.

Question 21

What was the effect of the 2009 stimulus package?

Answer 21

It raised consumption spending and real GDP was higher than it would have been otherwise.

Question 22

What was the CARES Act of 2020?

Answer 22

A $2.2 trillion economic stimulus package in response to the economic impact of COVID-19.

Question 23

What were some key components of the CARES Act?

Answer 23

$300 billion in one-time payments to individuals

$260 billion in enhanced unemployment benefits

$669 billion in small business funding (e.g., Paycheck Protection Program)

$500 billion in aid for large corporations

$339.8 billion to support state and local governments

Question 24

Why was urgent fiscal intervention needed in March 2020?

Answer 24

It was predicted that most airlines could go bankrupt without immediate support, highlighting the severe economic fallout.

Question 25

What were the goals of the COVID-19 stimulus package?

Answer 25

To restore planned aggregate expenditure (PAE), offset losses in investment (physical and human capital), and maintain valuable employment relationships.

Question 26

What is the key assumption in the basic Keynesian model?

Answer 26

Producers meet demand at preset (fixed) prices in the short run.

Question 27

What defines short-run equilibrium in the Keynesian model?

Answer 27

Short-run equilibrium occurs when output Y= planned aggregate expenditure (PAE).

Question 28

What does short-run equilibrium output represent?

Answer 28

It is the level of output that prevails when prices are predetermined and firms simply meet the level of demand.

Question 29

Why are prices considered fixed in the short run in the Keynesian model?

Answer 29

Because firms cannot immediately adjust prices in response to changes in demand due to contracts, menu costs, and market frictions.

Question 30

What happens if PAE is less than output in the Keynesian model?

Answer 30

Firms accumulate unintended inventories, leading them to reduce production.

Question 31

What happens if PAE is greater than output?

Answer 31

Firms draw down inventories and increase production to meet demand.

Question 32

What is the formula for planned aggregate expenditure (PAE) in the Keynesian model?

Answer 32

PAE = C + I + G + NX

Question 33

In the Keynesian model, what do the components of PAE stand for?

Answer 33

C = Consumption I = Investment G = Government spending NX = Net exports (exports – imports)

Question 34

How is consumption (C) expressed in terms of income and taxes in the Keynesian model?

Answer 34

C = C̅ + c(Y – T) Where: C̅ = Autonomous consumption c = Marginal propensity to consume (mpc) Y = Income T = Net taxes

Question 35

How do we incorporate the consumption function into the PAE equation?

Answer 35

PAE = [C̅ + c(Y – T)] + I + G + NX

Question 36

What is the role of the marginal propensity to consume (mpc or c)?

Answer 36

It determines how much consumption changes in response to a change in disposable income (Y – T).

Question 37

Why do we assume I, G, and NX are fixed in the short-run Keynesian model?

Answer 37

To simplify analysis and focus on how changes in income affect consumption and overall output.

Question 38

What is the expression for PAE in terms of the marginal propensity to consume (c)?

Answer 38

PAE = (C + cT + I + G + NX) + cY

Question 39

What is the short-run equilibrium condition in the Keynesian model?

Answer 39

Y = PAE

Question 40

How do you express short-run equilibrium output using the PAE formula?

Answer 40

Y = (C + cT + I + G + NX) + cY

Question 41

How do you solve for Y in the Keynesian model?

Answer 41

Y - cY = C + cT + I + G + NX Y(1-c) = C + cT + I + G + NX Y = (C + cT + I + G + NX)/ (1-c)

Question 42

What does the denominator 1−c represent in the Keynesian equation for output?

Answer 42

It reflects the income-expenditure multiplier. The larger the mpc (c), the larger the multiplier.

Question 43

Why is this model useful for fiscal policy analysis?

Answer 43

It shows how changes in autonomous spending (C, I, G, NX, T) affect total output via the multiplier effect.

Question 44

What is the income-expenditure multiplier?

Answer 44

It measures the effect of a 1-unit change in autonomous expenditure on short-run equilibrium output.

Question 45

What does a multiplier of 5 mean?

Answer 45

A 1-unit increase in autonomous spending increases output by 5 units; a 10-unit decrease reduces output by 50 units.

Question 46

What determines the size of the multiplier in the Keynesian model?

Answer 46

The marginal propensity to consume (mpc)

Question 47

What is the formula for the multiplier?

Answer 47

Multiplier = 1/ (1-c) Where c is the marginal propensity to consume.

Question 48

How does a higher mpc affect the multiplier?

Answer 48

A higher mpc leads to a larger multiplier, meaning changes in spending have a stronger impact on output.

Question 49

Is the multiplier effect immediate?

Answer 49

No, it occurs over time as increased spending leads to income, which leads to more spending, and so on.

Question 50

How is the multiplier used to calculate the change in output?

Answer 50

Change in output (ΔY) = Multiplier × Change in autonomous expenditure (ΔA)

Question 51

In the example: PAE = 960 + 0.8Y → Y = 4,800; then PAE = 950 + 0.8Y → Y = 4,750. What is the multiplier?

Answer 51

Change in A = –10 Change in Y = –50 Multiplier = ΔY / ΔA = 50 / 10 = 5

Question 52

If MPC (c) = 0.8, what is the multiplier?

Answer 52

Multiplier = 1/ 1-0.8 = 5

Question 53

If MPC (c) = 0.6, what is the multiplier?

Answer 53

Multiplier = 1/ 1-0.6 = 2.5

Question 54

What happens to the multiplier when MPC increases?

Answer 54

The multiplier increases, making the economy more responsive to changes in autonomous spending.

Question 55

What does the multiplier imply for fiscal policy?

Answer 55

Small changes in government spending or taxes can lead to larger changes in output due to the multiplier effect.

Question 56

What is the tax multiplier?

Answer 56

It measures the effect of a change in net taxes on short-run equilibrium output.

Question 57

What is the formula for the tax multiplier?

Answer 57

Tax Multiplier = -c/(1-c) Where c is the marginal propensity to consume (MPC).

Question 58

Why is the tax multiplier negative?

Answer 58

Because an increase in taxes reduces disposable income, which reduces consumption and output.

Question 59

If c = 0.8, what is the tax multiplier?

Answer 59

Tax multiplier = -0.8/ 1-0.8 = -0.8/0.2 = -4

Question 60

How does the tax multiplier compare to the spending multiplier?

Answer 60

The tax multiplier is smaller in absolute value because only a portion (c) of the tax change affects spending.

Question 61

How does a tax cut affect output?

Answer 61

A tax cut increases disposable income → increases consumption → increases output.

Question 62

What is the effect of a $10 tax cut if c = 0.75?

Answer 62

Tax multiplier = -0.75/ 1-0.75 = -3 Change in Y = –3 × (–10) = +30 increase in output.

Question 63

What happens when taxes are a function of income (T = tY)?

Answer 63

Taxes increase with income, reducing the marginal impact of changes in income on consumption. This stabilises the economy.