Fiscal Policy, Part 1Multiple Choice Questions1.Federal government outlays include:a.Transfer payments, grants to states, interest payments on the national debt and income taxrevenues.ernment purchases, transfer payments, grants to states and interest payments on thenational debt.c.Grants to states, interest payments on the national debt, income tax revenues and governmentpurchases.d.Interest payments on the national debt, income tax revenues, government purchases and transferpayments.2.The major component of federal government consumption is spending on:a.Foreign aid.b.National defense.c.Social Security, Medicare and Medicaid.d.Capital goods,e.g. highways and schools.3. A federal government surplus is said to exist when:a.Federal outlays are equal to federal revenues.b.Federal outlays are less than federal revenues.c.Federal outlays are greater than federal revenues.d.None of the above; federal government surpluses don’t exist.4.The government budget constraint says that:a.Increases in spending must be matched by increases in revenue.b.The difference between spending and revenues must equal the amount of new bond issues.c.State and local governments, in aggregate, cannot spend more than the federal government.d.Interest on government debt must be paid before tax revenues are spent on goods and services ordisbursed as transfer payments.Fiscal Policy, Part 15.Employing the government budget diagram shown above, assume that the economy is initially inequilibrium at point A. The movement A to D represents:a. A decrease in government spending and a decrease in taxes.b.An increase in government spending and an increase in taxes.c.An increase in government spending and/or a decrease in taxes.d. A decrease in government spending and/or an increase in taxes.6.In the diagram above, the impact of automatic stabilization is depicted by the movement from:a. A to B.b. A to D.c. A to F.d. C to F.7.In the diagram above, if the budget line is BB0 and the natural real GDP is $5300, the structural surplus ordeficit is:a.The vertical distance between F and C.b.The vertical distance between D and A.c.The horizontal distance between A and F.d.None of the above.Fiscal Policy, Part 18.In the diagram above, if the budget line BB 1, the natural real GDP is $5300, and actual real GDP is $5000,then the cyclical budget surplus or deficit is the:a.Vertical distance between A and C. b.Vertical distance between D and F. c.Horizontal distance between B and D. d.Horizontal distance between A and F.9.An increase in the tax rate, t:a.Will rotate the budget line upward. b.Will shift the budget line downward. c.Will increase the slope of the budget line. d.Both a. and c.10.The full employment surplus is:a.G + T. b.T + t*Y P- G. c.Y – T – t*Y P . d.Y P + G + T + t*Y P . 11.The actual government budget deficit ________ be used to determine the effectiveness of discretionaryfiscal policy actions because ________.a.can; it includes non-discretionary spending changes b.can; it excludes automatic stabilization expenditures c.cannot; it includes non-discretionary spending changes d.cannot; it excludes non-discretionary spending changesFiscal Policy, Part 1Discussion Questions1. Identify the four main categories of government spending and give an example of each.The four main components of government spending are expenditures to purchase goods and services,which can be subdivided into government investment spending on capital goods such as highwaysand schools and government consumption spending on such things as operating national parks andproviding police and fire protection; transfer payments such as Social Security and Medicare benefits;grants in aid through which the federal government assists state and local governments with, forexample, spending to provide homeland security; and net interest payments to holders of governmentbonds, net of interest paid to government.2.What are the government’s four main revenue sources?The four main revenue sources are personal taxes, contributions for social insurance (Social Securitytaxes), taxes on production (mainly sales taxes) and imports (tariffs), and corporate profits taxes.3.What is a budget deficit and what are the two main ways in which the government can finance deficitspending?A government budget deficit means that government spending over some time period is greater thanthe revenues government has collected over that period. According to government’s budget constraint, when revenues are insufficient to pay for spending, government must either borrow byissuing new bonds and going deeper into debt or print money, which increases the supply of high-powered money (currency in circulation and bank reserves) and increases the money supply.4.You have heard that the actual government deficit for the current year is going to be $30 billion greaterthan in the previous year. Based on this projection, what conclusions can you make regarding thegovernment’s fiscal policy?No definitive conclusion on the government’s fiscal policy can be made with the information given in the question because the actual deficit can change due to either a change in fiscal policy or a changein the level of output. To determine whether fiscal policy is expansionary or restrictive, the level ofthe natural employment deficit must be examined.Fiscal Policy, Part 15.Respond to the following statements about an economy where the government budget deficit has increasedduring a recession.a.The increase in the budget deficit indicates that policymakers have implemented expansionaryfiscal policies to bring the economy out of recession.b.The increase in the budget deficit indicates that fiscal policymakers have been irresponsible. Theyshould enact policies to reduce the deficit, either increase taxes and/or reduce governmentspending.Both statements indicate confusion between a cyclical deficit increase and a structural one. Theincrease in the budget deficit is a cyclical increase resulting from the recession. It indicates neitherthat policymakers have implemented expansionary fiscal policies nor that they have beenirresponsible. Enactment of discretionary restrictive fiscal policies could plunge the economy evendeeper into recession and result in an even larger budget deficit rather than a smaller one.Analytical QuestionsThese questions should be answered based on the standard models of analysis developed in class.The information in the various parts of the question is sequential and cumulative.Fiscal Policy, Part 11.The AD/AS Model with a Budget Balance Line. Country A’s economy, which is characterized by stickywages and prices, is initially (i.e., in Year 0) at the natural rate of unemployment with a substantial budget surplus.a.Based only on this information, use AD/AS Model and BB Line diagrams to clearly andaccurately show Country A’s initial (1) economic output, (2) inflation, and (3) governmentbudget balance. These diagrams should be drawn in BLACK.Fiscal Policy, Part 1b.Provide an economic explanation of what you have shown in your diagrams above.Because the unemployment rate was initially at the natural rate of unemployment, economic output was initially at its potential level, i.e., Y0 = Y P0 with inflation stable at π0.Because the government initially had a substantial budget surplus, the actual budget balance was in surplus, i.e., ABB0 > 0.Fiscal Policy, Part 1c.In Year 1, the government undertakes a $100 billion spending program to significantly increasethe number of school teachers. This additional spending is fully funded by an increase in tax rates.Incorporating only this additional information, clearly and accurately show on your diagramsabove what, if anything, happens to Country A’s (1) economic output, (2) inflation, and (3)RED.government budget balance. These changes should be drawn ind.Provide an economic explanation of what you have shown in your diagrams above. Discusswhat, if anything, happens to Country A’s (1) economic output, (2) inflation, and (3) government budget balance. Be sure to explain why these changes take place and what causes them.In Year 1, four events occur.First, the government increases spending by $100 billion. This increases plannedexpenditures and aggregate demand for any given inflation. This is represented by arightward shift of the aggregate demand curve from AD0 to AD1a. At every level ofinflation, economic output has increased.Second, the increase in government spending reduces the actual budget balance forany given level of economic output. This is represented by a downward shift of thebudget balance line from BB0 to BB1a.Third, the government fully funds the increase in government spending with anincrease in tax rates. This decreases disposable income, planned expenditures, andaggregate demand for any given inflation. This is represented by a leftward shift ofthe aggregate demand curve from AD1a to AD1.[The leftward shift of the aggregate demand curve from the tax rate increase issmaller than the rightward shift of the aggregate demand curve from thegovernment spending increase because the tax multiplier is smaller than theexpenditure multiplier.]Fourth, the increase in tax rates rotates the budget balance line upward from BB1ato BB1. The budget balance line BB1 intersects potential output, Y P0, at ABB0because the dollar amount of a tax rate change is always measured at potentialoutput.At the initial inflation of π0, aggregate demand is now greater than the long-run equilibriumaggregate supply that businesses want to produce (which is given by potential output, Y P0).This excess demand causes inflation to increase. The increase in inflation has two effects.First, the increase in inflation causes the central bank, acting according to theTaylor Principle, to increase the real policy interest rate, a movement along the MPcurve. The higher real policy interest rate increases the cost of borrowing, resultingin less borrowing and a decrease in planned expenditures and aggregate demand, amovement along the aggregate demand curve AD1.Fiscal Policy, Part 1Second, as inflation increases, actual inflation rises above expected inflation so thatbusinesses can raise their prices more quickly than they anticipated. This promptsbusinesses to increase their production, a movement along the short-run aggregatesupply curve SRAS1(πe = π0).This adjustment process continues until inflation increases to π1 when aggregate demand and short-run aggregate supply are once again equal with economic output at Y1. The increase in economic output from Y0 to Y1 also increases tax revenues, increasing the budget surplus from ABB0 to ABB1.When the Year 1 effects are complete, the economy is in a new short-run equilibrium where:(1)Economic output has increased from Y0 = Y P0 to Y1,(2)Inflation has increased from π0 to π1, and(3)The government budget surplus has increased from ABB0 to ABB1.Although the economy is in short-run equilibrium it is not in general equilibrium.Fiscal Policy, Part 1e.In Year 2, the central bank decides to target the real policy interest rate at its initial (i.e., Year 0)level. Incorporating only this additional information, clearly and accurately show on yourdiagrams above what, if anything, happens to Country A’s (1) economic output, (2) inflation, and(3) government budget balance. These changes should be drawn inBLUE.f.Provide an economic explanation of what you have shown in your diagrams above. Discusswhat, if anything, happens to Country A’s (1) economic output, (2) inflation, and (3) government budget balance. Be sure to explain why these changes take place and what causes them.In Year 2, two events happen.First, inflationary expectations are determined by a one-year adaptive process.Because actual inflation in Year 1, π1, is greater than expected inflation in Year 1,πe1 = π0, expected inflation in Year 2 adjusts upward to actual inflation in Year 1,i.e., πe2 =π1. This is represented by an upward shift of the short-run aggregatesupply curve from SRAS1(πe = π0) to SRAS2(πe = π1).Second, the central bank decides to target the real policy interest rate at its initial(i.e., Year 0) level. This is an discretionary expansionary monetary policy, reducingthe real policy interest rate for any given inflation. This is represented by adownward shift of the MP curve. A lower real policy interest rate reduces the cost ofborrowing, resulting in an increase in borrowing, planned expenditures, andaggregate demand for any given inflation. This is represented by a rightward shiftof the aggregate demand curve from AD1 to AD2.[The aggregate demand curve AD2 may be to the left of, equal to, or to the right ofthe aggregate demand curve AD1a.]At inflation of π1, aggregate demand is now greater than the long-run equilibrium aggregatesupply that businesses want to produce (which is given by potential output, Y P0). This excessdemand causes inflation to increase. The increase in inflation has two effects.First, the increase in inflation causes the central bank, acting according to theTaylor Principle, to increase the real policy interest rate, a movement along the MPcurve. The higher real policy interest rate increases the cost of borrowing, resultingin less borrowing and a decrease in planned expenditures and aggregate demand, amovement along the aggregate demand curve AD2.Second, as inflation increases, actual inflation rises above expected inflation so thatbusinesses can raise their prices more quickly than they anticipated. This promptsbusinesses to increase their production, a movement along the short-run aggregatesupply curve SRAS2(πe = π1).Econ 100B / UGBA 101B: Macroeconomic AnalysisPost Lecture #22 Exercise ANSWERSFiscal Policy, Part 1This adjustment process continues until inflation increases to π2 when aggregate demand and short-run aggregate supply are once again equal with economic output at Y2. The increase in economic output from Y1 to Y2 also increases tax revenues, increasing the budget surplus from ABB1 to ABB2 along the budget balance line BB1.When the Year 2 effects are complete, the economy is in a new short-run equilibrium where:(1)Economic output has increased from Y1 to Y2,(2)Inflation has increased from π1 to π2, and(3)The government budget surplus has increased from ABB1 to ABB2.Although the economy is in short-run equilibrium it is still not in general equilibrium.Fiscal Policy, Part 1b.In Year 1, the economy experiences a severe drought that leads to sharply higher food prices. Inaddition, household and business optimism about the economy declines substantially. The higherfood prices have a larger effect on economic output than the decline in optimism. Based only onthis additional information, clearly and accurately show in your diagrams above what, ifanything, happens to the economy’s (1) economic output, (2) inflation, (3) actual budget balance,RED.and (4) structural budget balance. These changes should be drawn inc.Provide an economic explanation of what you have shown in your diagrams above. Discusswhat, if anything, happens to the economy’s (1) economic output, (2) inflation, (3) actual budget balance, and (4) structural budget balance. Be sure to explain why these effects take place andwhat causes them.In Year 1, four separate events occur:First, inflation expectations are determined by a one-period (i.e., one-year) adaptiveprocess. Because the economy has a small positive output gap in Year 0 actualinflation in Year 0, π0, was greater than expected inflation in Year 0, πe0 = π-1, i.e., π0> πe0. As a result, inflation expectations in Year 1 adjust upward to actual inflationin Year 0, i.e., πe1 =π0. This is represented by a upward shift of the short-runaggregate supply curve from SRAS0(πe = π-1) to SRAS1a(πe = π0). Inflation is higherfor any given level of economic output.Second, a severe drought that leads to sharply higher food prices is a negative short-run aggregate supply shock, i.e., ρ1 > 0. This is represented by an upward shift ofthe short-run aggregate supply curve from SRAS1a(πe =π0) to SRAS1(πe =π0).Inflation is higher for any given level of economic output.Third, substantial declines in household and business optimism about the economyare a negative aggregate demand shock. This is represented by a leftward shift ofthe aggregate demand curve from AD0 to AD1. Economic output is lower for anygiven inflation.Because of the negative short-run aggregate supply shock, inflation increases. As inflationincreases, the central bank raises the real policy interest rate according to the TaylorPrincipal. A higher real policy interest rate increases the cost of borrowing that reduces theamount of borrowing and aggregate expenditures. In turn, this reduces economic output.Fourth, because there were no discretionary fiscal policy changes (neithergovernment purchases nor tax rates changed) the budget balance line, BB0, did notchange, i.e., BB1 = BB0. Consequently, there was no change in the structural budgetbalance, i.e., SBB1 = SBB0. However, the decline in economic output from Y0 to Y1caused tax receipts to decline endogenously. This increased the budget deficit(reduced the budget balance) along the budget balance line BB1 from ABB0 to ABB1.Fiscal Policy, Part 1When the Year 1 effects are complete, the economy is in a new short-run equilibrium where:(1)Economic output has declined from Y0 to Y1,(2)Inflation has increased from π0 to π1,(3)The actual budget balance has declined from ABB0 to ABB1, and(4)The structural budget balance has not changed, i.e., SBB0 = SBB1.Fiscal Policy, Part 1d.In Year 2, the government enacts a tax rate change that affects total tax revenues by the exactmagnitude needed to eliminate Year 1’s actual budget imbalance. Based only on this additional information, clearly and accurately show in your diagrams above what, if anything happens tothe economy’s (1) economic output, (2) inflation, (3) actual budget balance, and (4) structuralbudget balance. These changes should be drawn inBLUE.e.Provide an economic explanation of what you have shown in your diagrams above. Discusswhat, if anything, happens to the economy’s (1) economic output, (2) inflation, (3) actual budget balance, and (4) structural budget balance. Be sure to explain why these effects take place andwhat causes them.In Year 2, four separate events occur:First, inflation expectations are determined by a one-period (i.e., one-year) adaptiveprocess. Because the economy had a negative short-run aggregate supply shock inYear 1, actual inflation in Year 1, π1, was greater than expected inflation in Year 1,πe1 = π0, i.e., π1 > πe1. As a result, inflation expectations in Year 2 adjust upward toactual inflation in Year 1, i.e., πe2 = π1. However, the price shock disappeared, i.e. ρ= 0. This combination is represented by a downward shift of the short-run aggregatesupply curve from SRAS1(πe = π0) to SRAS2(πe = π1). Inflation is lower for any givenlevel of economic output.Second, the government enacts a tax change that affects total tax revenues by theexact magnitude of Year 1’s actual budget imbalance. Because there was an actualbudget deficit in Year 1 of ABB1, the government must increase tax rates sufficientto raise ABB1 in additional tax revenues. This is represented by an upward rotationof the budget balance line from BB1 to BB2 which intersects the 0 line at Y1. Thisincreases the structural budget balance from SBB1 to SBB2 which is alwaysmeasured at potential output, Y P.Third, the increase in tax rates is a contractionary fiscal policy that reducesdisposable income, consumer spending, and economic output for any given inflation.This is represented by a leftward shift of the aggregate demand curve from AD1 toAD2. Economic output is lower for any given inflation.At inflation of π1, there is excess supply in the economy, causing inflation to decline. Asinflation declines the central bank reduces the real policy interest rate according to theTaylor Principal. A lower real policy interest rate decreases the cost of borrowing whichincreases the amount of borrowing and increases aggregate expenditures. This limits thedecline in economic output that occurs from the negative aggregate demand shock.Fourth, with the decline in economic output from Y1 to Y2, tax revenues are reducedendogenously along the Budget Balance Line BB2. As a result of these reduced taxrevenues, the actual budget balance decreases from 0 to ABB2.Fiscal Policy, Part 1When the Year 2 effects are complete, the economy is in a new short-run equilibrium where:(1)Economic output has declined from Y1 to Y2.(2)Inflation has declined from π1 to π2. (π2 could be >, =, or < π0 depending on theorder of magnitude of the shifts in the SRAS and AD curves.)(3)The actual budget balance has increased from ABB1 to ABB2. (ABB2 could be >,=, < ABB1 depending on the magnitude of the decline in economic output andthe rotation of the Budget Balance Line. In the “real” world, it is most likelythat ABB2 < ABB1.)(4)The structural budget balance has increased from SBB1 = SBB2.。
