Solutions to Section 6 Problems 323 AP Krugman Section 6 Problem Solutions 1. It’s impossible to determine which policy maker is correct given the information available. Everything else being equal, the government’s budget surplus will rise either if real GDP is growing or if Macroland is using contractionary fiscal policy. When the economy grows, tax revenue rises and government transfers fall, leading to an increase in the government’s budget surplus. However, if the government uses contractionary fiscal policy, then the government purchases fewer goods and services, increases taxes, or reduces government transfers. Any of those three changes will result in a temporary increase in the government’s budget surplus, although the reduction in real GDP will eventually cause tax revenue to fall and government transfers to rise, which will partly reduce the budget surplus. 2. You might respond that balanced-budget rules are usually proposed because the government is running a budget deficit and many people think of deficits as bad. When the government runs a budget deficit, it adds to the public debt. If the government persists in running budget deficits, interest payments become an increasing part of government spending and the budget deficit itself. As a result, the debt–GDP ratio may rise. However, budget deficits themselves are not the problem; the problem arises when budget deficits become persistent. In the United States, there has been a strong relationship between the federal government’s budget balance and the business cycle: when the economy expands, the budget moves toward surplus, and when the economy experiences a recession, the budget moves into deficit. The major disadvantage of a balanced- budget rule is that it would undermine the role of taxes and government transfers as automatic stabilizers and force the government to respond to a recessionary gap with contractionary fiscal policies. You might recommend, as most economists do, that rather than a balanced-budget rule,
324 Section 6: Inflation, Unemployment, and Stabilization Policies the government only balance its budget on average; it should run budget deficits during recessions and budget surpluses during expansions. 3. a. If the government has relatively little debt but is running a large budget deficit as it builds a high-speed rail system, this should not indicate potential problems for the economy. Like funding a war effort, it is difficult, if not impossible, to finance major improvements in a nation’s infrastructure without borrowing. As long as the budget deficit ends with the building project, this should not create long-term problems. b. If the government’s debt is relatively high but the government has reduced its budget deficit, this should not indicate potential problems for the economy. However, the government needs to be careful that the deficits do not become persistent.
- Fall '13
- Inflation, budget deficits, budget deficit, contractionary fiscal policy, aggregate price level, real inflation tax