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Chapter_11_Key_Question_Solutions

# Chapter_11_Key_Question_Solutions - 11-2(Key Question...

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11-2 ( Key Question ) Assume that a hypothetical economy with an MPC of .8 is experiencing severe recession. By how much would government spending have to increase to shift the aggregate demand curve rightward by \$25 billion? How large a tax cut would be needed to achieve this same increase in aggregate demand? Why the difference? Determine one possible combination of government spending increases and tax decreases that would accomplish this same goal. In this problem, the multiplier is 1/.2 or 5 so, the required increase in government spending = \$5 billion. For the tax cut question, initial spending of \$5 billion is still required, but only .8 (= MPC) of a tax cut will be spent. So .8 x tax cut = \$5 billion or tax cut = \$6.25 billion. Part of the tax reduction (\$1.25 billion) is saved, not spent. One combination: a \$1 billion increase in government spending and a \$5 billion tax cut. Alternatively, one could raise both government spending and taxes by \$25 billion. 11-3 ( Key Question ) What are government’s fiscal policy options for ending severe demand- pull inflation? Use the aggregate demand-aggregate supply model to show the impact of these policies on the price level. Which of these fiscal policy options do you think might be favored by a person who wants to preserve the size of government? A person who thinks the public sector is too large? Options are to reduce government spending, increase taxes, or some combination of both. See Figure 11.2. If the price level is flexible downward, it will fall. In the real world, the goal is to reduce inflation—to keep prices from rising so rapidly—not to reduce the price level. A person wanting to preserve the size of government might favor a tax hike and would want to preserve government spending programs. Someone who thinks that the public sector is too large might favor cuts in government spending since this would reduce the size of government. 11-6 ( Key Question ) Define the “standardized budget,” explain its significance, and state why it may differ from the “actual budget.” Suppose the full-employment, noninflationary level of real output is GDP 3 (not GDP 2 ) in the economy depicted in Figure 11.3. If the economy is operating at GDP 2 instead of GDP 3 , what is the status of its standardized budget? The status of its current fiscal policy? What change in fiscal policy would you recommend? How would you accomplish that in terms of the G and T lines in the figure?

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