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Question 1
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For each of the following fiscal policy proposals, determine whether
the primary focus is on aggregate demand or aggregate supply or
both:
i.
$1,000 per person tax reduction
ii.
a 5% reduction in all tax rates
iii.
Pell Grants, which are government subsidies for college education
iv.
government-sponsored prizes for new scientific discoveries
v.
an increase in unemployment compensation
Selected
Answer: (i) demand-side; (ii) both; (iii) supply-side; (iv) supply-
side; (v) both
Correct
Answer: (i) demand-side; (ii) both; (iii) supply-side; (iv) supply-
side; (v) both
Response
Feedback
:
Correct FEEDBACK: Of the five choices, only a per-person
tax reduction is a sole demand-side policy. This policy is
designed to give people more money in hopes of
increasing consumption. Pell grants and government-
sponsored prizes are supply-side policies with the intent to
increase human capital and to encourage innovation and
production. The other two policies are demand- and
supply-sided policies. A 5% reduction on all tax rates
increases incomes for individuals, which leads to more
consumption, and provides incentives for businesses to
produce more. The increase in unemployment
compensation is intended to promote more consumption
among the unemployed; however, it also decreases the
incentives for individuals to work to some degree.
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Question 2
The graph below shows initial equilibrium in the loanable funds
market at $800 million and an interest rate of 4%, point A. Now
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assume that the government increases spending by $100 million that
is entirely deficit-financed. The new equilibrium in the loanable funds
market is now $840 million and an interest rate of 5%, point B.
Click to view larger image.
If we assume there was no government debt prior to the fiscal
stimulus, determine the new quantities for the blanks below.
Savings:
million
Investment:
million
Government spending:
million
Private consumption decreases by:
million
Selected
Answer: $840; $740;
$100; $40
Correct
Answer: $840; $740;
$100; $40
Response
Feedback
:
Correct FEEDBACK: When the demand for loanable funds
shifts to the right, total savings increases by $40 million,
for a new level of savings of $840 million. Government
spending increases by $100 million as stated in the
question. This means that private investment has $740
million of savings available ($840 million – $100 million).
Finally, private consumption falls by $40 million as
anything not consumed is considered savings. Recall that
total savings increased by $40 million.
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Question 3
The new classical critique of activist fiscal policy is theoretically
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different from the crowding-out critique. Crowding-out occurs when
private spending
in response to government spending.
Under the new classical critique, increased government spending
leads people to
their current savings in order to help pay for
higher taxes in the future, which increases the
of loanable
funds.
Selected
Answer: decreases; increase;
supply
Correct
Answer: decreases; increase;
supply
Response
Feedback
:
Correct FEEDBACK: Crowding-out occurs when increased
government spending causes a decrease in private
spending. The new classical critique explains how saving
shifting occurs. As government spending increases, people
know they will have to pay higher taxes eventually, which
increases current savings. An increase in savings results in
the increase in the supply of loanable funds.
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Question 4
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As an elected official, you have been informed that real GDP is below
its potential and that action should be taken to encourage economic
growth and bring the economy to its long-run equilibrium. If the
marginal propensity to consume is 0.8 and the amount of new
government spending is $600 billion, by how much would the
economy be stimulated?
Selected
Answer: $3,000
billion
Correct
Answer: $3,000
billion
Response
Feedback:
Correct FEEDBACK: First calculate the multiplier. This is
found by using the equation, m
s
=
1
÷
(1 – MPC).
With a marginal propensity to consume of 0.8, the
multiplier is 5. An increase in government spending of
$600 billion multiplied by the multiplier results in a
$3,000 billion increase in real GDP.
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Question 5
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When fiscal policy is used to manage the economy, there are a
number of factors that can delay its impact.
Which of the following is an example of a recognition lag?
Selected
Answer: Although economic conditions seem bad enough to
warrant government action, it takes time for economists
to confirm that conditions are bad enough.
Correct
Answer: Although economic conditions seem bad enough to
warrant government action, it takes time for economists
to confirm that conditions are bad enough.
Response
Feedback:
Correct FEEDBACK: A recognition lag occurs over the time
period it takes to recognize and verify the existence of a
situation that may require government action. A
recognition lag occurs when economists take time to
determine if conditions are bad enough.
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Question 6
Suppose that the president has decided to increase government
spending by building more libraries. The legislation was rushed
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through Congress and enacted without any delay. From here, the
libraries will take 10 months to plan and 2 years to build.
Which of the following is true?
Selected
Answer: The planning and building of the libraries represents an
impact lag of this policy.
Correct
Answer: The planning and building of the libraries represents an
impact lag of this policy.
Response
Feedback
:
Correct FEEDBACK: An impact lag would be present. An
impact lag is the time it takes after a policy is enacted for
its effects to be completely felt in the economy. In this
case, the policy is all about government spending, but
because it takes a long time to build the libraries, it’s a
while before all the money is completely paid to the
construction workers and others doing the work.
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Question 7
In a bid to be re-elected, you promise both a lower tax rate and
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greater tax revenue. Would you be able to back up this promise with
economic reasoning? Use the Laffer curve, shown here, to support
your answer.
Click to view larger image.
Selected
Answer: Yes, but only if the current tax rate is in Region II of
the Laffer curve.
Correct
Answer: Yes, but only if the current tax rate is in Region II of
the Laffer curve.
Response
Feedback
:
Correct FEEDBACK: If the tax rate is in Region I of the
Laffer curve, tax revenues would increase as the tax rate
falls, and you wouldn’t be able to back up your promise to
voters. But if the tax rate is in Region II of the Laffer
curve, tax revenue would increase as the tax rate falls,
and you’d keep your promise. This is because very high
taxes are a disincentive for earning income. Lowering
those taxes will lead people to work more, earning enough
extra taxable income that the government takes in more
revenue than they did with the higher tax rate.
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Question 8
0 out of 0 points
During the fall of 2007, the United States economy began a descent
into deep recession. As a result, the federal government and the
Federal Reserve took action to stimulate economic growth. Which of
the following would have been an appropriate fiscal policy?
Selected
Answers: the Federal Reserve increasing the money supply to
reduce the interest rate
Correct
Answers:
the federal government providing tax refunds to all
taxpayers
Response
Feedback:
the federal government spending more money to build
more infrastructure
Incorrect FEEDBACK: For a fiscal policy, ask yourself who
the actor is that engages in the action. Is it the
government or the Federal Reserve? Second, think about
what kind of action represents a fiscal policy.
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Question 9
0 out of 0 points
When the economy is in a recession, expansionary fiscal policy can be
used to stimulate and encourage economic growth. Which of the
following scenarios represent expansionary fiscal policies from both a
supply and demand perspective at the same time?
Selected
Answers: The government lowers tax rates and undertakes a
replacement of old bridges and roads.
The Federal Reserve increases the money supply and
lowers the interest rate while the government
simultaneously reduces future taxes.
Correct
Answers: The government lowers tax rates and undertakes a
replacement of old bridges and roads.
Response
Feedback:
The government lowers tax rates and issues a partial
refund of taxes that have already been paid.
Incorrect FEEDBACK: Look for answer options with meet
three descriptions: (1) being expansionary, (2) being
fiscal policies, and (3) involving both the supply side and
the demand side.
