© 2013 Pearson

© 2013 Pearson

Fiscal Policy32

CHECKPOINTS

Click on the button to go to the problem

© 2013 Pearson

Problem 1Problem 1 Problem 1Problem 1

Problem 2Problem 2

Checkpoint 32.1 Checkpoint 32.3

Problem 1Problem 1

Checkpoint 32.2

Clickerversion

Clickerversion

Problem 2Problem 2

Problem 3Problem 3Problem 3Problem 3

Clickerversion

Clickerversion

Problem 4Problem 4

Clickerversion

Clickerversion

Clickerversion

Clickerversion

Clickerversion

Clickerversion

Problem 2Problem 2

In the newsIn the news

In the newsIn the news

© 2013 Pearson

Practice Problem 1 What are the revenues and outlays in the federal budget, and what was the projected budget balance for Fiscal 2012?

CHECKPOINT 32.1

© 2013 Pearson

SolutionThe revenues are personal income taxes, Social Security taxes, corporate income taxes, and indirect taxes.

The outlays are transfer payments, expenditure on goods and services, and debt interest.

The projected budget balance for Fiscal 2012 was a deficit of $1,240 billion.

CHECKPOINT 32.1

© 2013 Pearson

Practice Problem 2 In 2009, national debt was about $10 trillion and the U.S. Treasury faced a national debt limit of $12 trillion.

With projected deficits through 2019 that will increase the national debt by $9 trillion, when will the national debt limit be hit if the deficits remain constant?

CHECKPOINT 32.1

© 2013 Pearson

SolutionIn 2009, national debt was about $10 trillion.

By adding an average of $0.9 trillion ($9 trillion/10 years) per year to the 2009 national debt, the limit of $12 trillion will be hit during 2012.

CHECKPOINT 32.1

© 2013 Pearson

Practice Problem 1Classify the following items as discretionary fiscal policy or automatic fiscal policy or neither.

• A decrease in tax revenues in a recession

• Additional expenditure to upgrade highways

• An increase in the public education budget

• A cut in infrastructure expenditure in a boom

CHECKPOINT 32.2

© 2013 Pearson

SolutionA decrease in tax revenues in a recession is an automatic fiscal policy.

Expenditure to upgrade highways is a discretionary fiscal policy.

An increase in the public education budget is a discretionary fiscal policy.

A cut in infrastructure expenditure in a boom is a discretionary fiscal policy.

CHECKPOINT 32.2

© 2013 Pearson

Practice Problem 2Explain how aggregate demand changes when government expenditure on national defense increases by $100 billion.

CHECKPOINT 32.2

© 2013 Pearson

SolutionAn increase in government expenditure of $100 billion increases aggregate expenditure by $100 billion.

But because the increased government expenditure increases induced expenditure, it has a multiplier effect that aggregate demand increases by more than $100 billion.

CHECKPOINT 32.2

© 2013 Pearson

Study Plan Problem When the government increases its expenditure on national defense by $100 billion, aggregate demand _____ by ______ $100 billion because ______ expenditure ______ .

CHECKPOINT 32.2

A. increases; more than; induced; increases

B. decreases; less than; discretionary; decreases

C. increases; more than; induced; decreases

D. decreases; less than; induced; increases

E. increases; more than; discretionary; increases

© 2013 Pearson

Practice Problem 3Explain how aggregate demand changes when the government increases taxes by $100 billion.

CHECKPOINT 32.2

© 2013 Pearson

SolutionWhen the government increases taxes by $100 billion, disposable income decreases by $100 billion.

With $100 billion less of disposable income, consumption expenditure decreases by $100 billion x Marginal propensity to consume.

The decrease in consumption expenditure decreases aggregate expenditure and because the tax increase has a multiplier effect that decreases induced expenditure aggregate demand decreases by more than the decrease in consumption expenditure.

CHECKPOINT 32.2

© 2013 Pearson

Study Plan Problem When the government increases taxes by $100 billion, aggregate demand ________ by _______ $100 billion because _____ expenditure _______ .

CHECKPOINT 32.2

A. decreases; more than; discretionary; decreases

B. increases; less than; induced; decreases

C. decreases; more than; induced; increases

D. decreases; more than; induced; decreases

E. increases; less than; discretionary; increases

© 2013 Pearson

Practice Problem 4Explain how aggregate demand changes when government increases both expenditure and taxes by $100 billion.

CHECKPOINT 32.2

© 2013 Pearson

SolutionAn increase in government expenditure of $100 billion increases aggregate demand by $100 billion multiplied by the government expenditure multiplier.

An increase in taxes of $100 billion decreases aggregate demand by 100 billion multiplied by the tax multiplier.

The size of the government expenditure multiplier is larger than the size of the tax multiplier.

So the increase in both government expenditure and taxes of $100 billion increases aggregate demand.

CHECKPOINT 32.2

© 2013 Pearson

Study Plan Problem When the government increases both expenditure and taxes by $100 billion, aggregate demand _______ because the increase in government expenditure has ________ effect on aggregate demand _______ the effect of the tax increase.

CHECKPOINT 32.2

A. decreases; a smaller; than

B. decreases; a larger; than

C. increases; a smaller; than

D. doesn’t change; the same; as

E. increases; a larger; than

© 2013 Pearson

In the newsHow to curb the deficit

Senator Evan Bayh, Democrat of Indiana, noted that Democrats want to spend more than we can afford; Republicans tend to want to cut taxes more than we can afford. So we are stuck with large deficits.

Source: The New York Times, October 31, 2009

What policy will change aggregate demand the most: Democrats agreeing to cut the budget outlays or Republicans agreeing to raise taxes?

CHECKPOINT 32.2

© 2013 Pearson

SolutionThe effect of a cut in budget outlays on aggregate demand depends on whether the items cut are expenditures on goods and services (government expenditure multiplier) or transfer payments (transfer payments multiplier).

An increase in taxes will decrease aggregate demand (tax multiplier).

The magnitude of the government expenditure multiplier exceeds the other two multipliers, so a cut in government expenditure on goods and services will decrease aggregate demand the most.

CHECKPOINT 32.2

© 2013 Pearson

Practice Problem 1 The government cuts the income tax rate.

Explain the effects of this action on the supply of labor, the demand for labor, the equilibrium level of employment, the real wage rate, and potential GDP.

CHECKPOINT 32.3

© 2013 Pearson

SolutionWhen the government cuts the income tax rate, the supply of labor increases but the demand for labor does not change.

The equilibrium level of employment increases.

The real wage rate paid by employers decreases and the real wage rate received by workers increases—the tax wedge shrinks.

With increased employment, potential GDP increases.

CHECKPOINT 32.3

© 2013 Pearson

Study Plan Problem When the government cuts the income tax, the supply of labor _______ and the demand for labor ______. Employment _______, the real wage rate _______, and potential GDP _______.

CHECKPOINT 32.3

A. does not change; increases; increases; might rise or fall; increases

B. increases; decreases; either increases or decreases; rises; might increases or decreases depending on how employment changes

C. does not change; increases; increases; rises; increases

D. increases; does not change; increases; falls; increases

© 2013 Pearson

Practice Problem 2 What is the true income tax rate on interest income?

• The nominal interest rate is 8 percent a year.

• The inflation rate is 5 percent a year.

• The tax rate on nominal interest is 25 percent.

CHECKPOINT 32.3

© 2013 Pearson

SolutionWith a nominal interest rate of 8 percent a year and a tax rate of 25 percent, the tax paid is 25 percent of 8 percent, which is 2 percent.

The before-tax real interest rate is the nominal interest rate minus the inflation rate.

The before-tax real interest rate is 8 percent minus 5 percent, which is 3 percent a year.

The true tax paid is tax paid divided by before-tax real interest rate.

The true tax paid is (2 ÷ 3) x100, which is 66.67 percent.

CHECKPOINT 32.3

© 2013 Pearson

Practice Problem 3 The government cuts its outlays but keeps tax revenue unchanged.

Explain the effects of this action on saving, investment, the real interest rate, and the growth rate of real GDP.

CHECKPOINT 32.3

© 2013 Pearson

SolutionIf the government cuts outlays but keeps tax revenue unchanged, the budget deficit decreases or the budget surplus increases.

Either way, the supply of loanable funds to private borrowers increases.

The real interest rate falls and private saving decreases, but total saving increases and investment increases.

With greater investment, capital grows more quickly, and so does real GDP.

CHECKPOINT 32.3

© 2013 Pearson

Study Plan Problem If the government cuts its outlays but keeps tax revenue unchanged, the real interest rate _______. Private saving ________ and total saving _______. Investment _______ and real GDP growth ______.

CHECKPOINT 32.3

A. falls; decreases; decreases; increases; decreases

B. falls; decreases; increases; increases; increases

C. rises; increases; increases; increases; increases

D. rises; increases; decreases; decreases; decreases

© 2013 Pearson

In the newsThe logic of cutting payroll taxes

Payroll taxes are not the only thing that stops people from working, but Obama’s proposal to cut employer portion of the payroll tax for two years by 3.1 percentage points could create a million or more jobs.

Source: The New York Times, September 21, 2011

Explain how the payroll tax cut will influence employment and potential GDP.

CHECKPOINT 32.3

© 2013 Pearson

SolutionThe cut in payroll tax will decrease the tax wedge and lower the cost of labor.

It will increase the quantity of labor demanded and increase the quantity of labor employed.

It will also increase potential GDP.

When the tax cut ends after two years, employment and potential GDP will return to their previous levels, other things remaining the same.

CHECKPOINT 32.3