Chapter 30 - Fiscal Policy, Deficits, and Debt Chapter 30 Fiscal Policy, Deficits, and Debt QUESTIONS 1. What is the role of the Council of Economic Advisers (CEA) as it relates to fiscal policy? Use an Internet search to find the names and university affiliations of the present members of the CEA. LO1 Answer: The CEA advises the President on economic matters, and provides recommendations for discretionary fiscal policy action. Try http://www.whitehouse.gov for information on CEA. 2. What are government’s fiscal policy options for ending severe demand-pull inflation? Which of these fiscal 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? How does the “ratchet effect” affect anti-inflationary fiscal policy? LO1 Answer: Options are to reduce government spending, increase taxes, or some combination of both. See Figure 30.2. 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. The ratchet effect implies that prices are rigid downward. 3. (For students who were assigned Chapter 28) Use the aggregate expenditures model to show how government fiscal policy could eliminate either a recessionary expenditure gap or an inflationary expenditure gap (Figure 28.7). Explain how equal-size increases in G and T could eliminate a recessionary gap and how equal-size decreases in G and T could eliminate an inflationary gap. LO1 Answer: Consider the figure below. At AE 2 there is an inflationary expenditure gap of $500 (assuming full-employment output is $2000). The fiscal authority could increase taxes or decrease expenditures, which will shift the aggregate expenditures schedule down to AE0 . At AE 1 there is a recessionary expenditure gap of $500 (assuming full-employment output is $2000). The fiscal authority could decrease taxes or increase expenditures, which will shift the aggregate expenditures schedule up to AE0 . 30-1
Chapter 30 - Fiscal Policy, Deficits, and Debt 500 1000 1500 2000 3000 1000 2000 3000 Inflationary expenditure gap = $500 Recessionary expenditure gap = $500 Real GDP Full employment 45 AE 1 AE0 AE 2 Agregate expenditures (bilions of dolars) Equal-size increases (decreases) in G and T could eliminate a recessionary (inflationary) expenditure gap because the multiplier effects of a change in government spending are greater than they are for a change in taxes. The effect of a change in G is found by taking the change in G times the spending multiplier. To find the effect of a change in T, the change must first be multiplied by the MPC (because the tax change will affect both
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