- HOMEWORK UNIT 7
FISCAL POLICY
Chapter 12: Problems 3, 5, 6, and 13 on pages 316-318
Chapter 12 / FISCAL POLICY
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3.
An economy is in long-run macroeconom ic equilibrium when each of the
following aggregate demand shocks occurs. What kind of gap
inflationary or recessionary will the economy face after the shock, and
what type of fiscal policies would help move the economy back to potential
output?
a. A stock market boom increases the value of stocks held by households.
(6 pts)
This will create an Inflationary gap contractionary fiscal policy would move the
economy back to potential output by reducing government purchases of goods
and services, increasing taxes, or reducing government transfers.
b. Firms come to believe that a recession in the near future is likely. (6 pts)
This will create a Recessionary gap expansionary fiscal policy will help to move
the economy back in line with potential output by increasing government
purchases of goods and services, tax cuts, and an increase in government
transfers.
c. Anticipating the possibility of war, the government increases its
purchases of military equipment. (6 pts)
This will create an Inflationary gap contractionary fiscal policy would have to
be put in place by either increasing taxes or reducing government transfers.
d. The quantity of money in the economy declines and interest rates
increase. (6 pts)
Recessionary gap expansionary fiscal policy will help to move the economy
back in line with potential output by increasing government purchases of goods
and services, tax cuts, and an increase in government transfers.
Of course with fiscal policy there is a time lag, it takes time to recognize what is
happening and then time to implement the policy. Sometimes the economy has
already started self-correcting.
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5. In each of the following cases, either a recessionary or inflationary gap
exists. Assume that the aggregate supply curve is horizontal so that the
change in real GDP arising from a shift of the aggregate demand curve
equals the size of the shift of the curve.
Calculate both the change in government purc hases of goods and services
and the change in government transfers necessary to close the gap.
a. Real GDP equals $100 billion, potential output equals $160 billion, and
the marginal propensity to consume is 0.75. (8 pts)
This is a recessionary gap of $60 billion.
Simple multiplier = 1/ (1-.75) = 1/.25 = 4
The government would then have to increase its spending on goods and
merchandise by total gap divided my simple multiplier. $60 billion/ 4 = $15 billion
Transfer multiplier - Each dollar of a Transfer payment will increase real GDP by
Transfer Payment Multiplier = MPC / (1-MPC) = 0.75 / (1-0.75) = 0.75/0.25 = $3
The government must increase spending on transfer payments by total gap
divided by transfer payment multiplier = $60 billion / $3 = $20 billion
b. Real GDP equals $250 billion, potential output equals $200 billion, and
the marginal propensity to consume is 0.5. (8 pts)
This is an inflationary gap of $50 billion
Simple multiplier = 1/ = (1-0.5) 1/.5 = 2
The government would then have to decrease spending on goods and
merchandise by total gap divided by simple multiplier = $50 billion / 2 = $25
billion
Transfer multiplier = MPC / (1-MPC) =.5 / (1-.5) = .5/.5 = $1
Government must decrease spending on transfer payments by total gap divided
by transfer payment multiplier = $50 billion / 1= $50 billion
c. Real GDP equals $180 billion, potential output equals $100 billion, and
the marginal propensity to consume is 0.8. (8 pts)
This is an Inflationary gap of $80 billion.
Simple multiplier = 1/ (1-.8) = 1/ .2 = 5
Government would decrease spending by total gap divided by simple multiplier =
$80 billion / 5 = $16 billion
Transfer multiplier = MPC / (1-MPC) = .8 /(1-.8) = .8 / .2 = $4
The government has to decrease transfer payments by $80 billion / $4 = $20
billion
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6. Most macroeconomists believe it is a good thing that taxes act as
automatic stabilizers and lower the size of the multiplier. However, a
smaller multiplier means that the change in government purchases of
goods and services, government transfers, or taxes necessary to close an
inflationary or recessionary gap is larger. How can you explain this
apparent inconsistency?
Taxes acting as an automatic stabilizer and lowering the size of the multiplier is a
good thing when it comes to the demand shocks. When the economy
experiences a negative demand shock the Shock is not felt as deep throughout
the economy as it would without the taxes. Since the tax revenue decreases
when the economy contracts and increase when the economy expands , the
shocks, when we fall into a recession or into an inflationary period are smaller,
and do not require deliberate action from the government.
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13. In which of the following cases does the size of the governments debt
and the size of the budget deficit indicate potential problems for the
economy?
a. The governments debt is relatively low, but the government is running a
large budget deficit as it builds a high-speed rail system to connect the
major cities of the nation.
This scenario, while is cause for concern that running a large deficit for a rail
system connecting the major cities, should actually bring in revenue once the rail
system is in place. This revenue will help to offset the deficit that the government
is running.
b. The governments debt is relatively high due to a recently ended deficit
financed war, but the government is now running only a small budget
deficit.
This scenario is cause for concern also but just after coming out of a war the
government should be able to turn this around with several years of surplus.
c. The governments debt is relatively low, but the government is running a
budget deficit to finance the interest payments on the debt.
This scenario is the one I feel would be the most cause for concern. Running a
deficit to finance interest payments on debt is showing that the real GDP is low
and really not growing. I think in this case it will cause stagflation first and then
this economy will fall into a deep recession.