1. If an economy operates in the short run
at point a, restrictive fiscal policy will
a. increase AD and move the economy toward point c.
b. decrease AD and move the economy toward point b.
c. increase SRAS and move the economy toward point b.
d. decrease SRAS and move the economy toward point c.
2. When the economy is operating at point a, reliance
on the self-correcting mechanism will
a. result in higher resource prices and a shift to the left in the SRAS curve.
b. result in lower resource prices and a shift to the right in the SRAS curve.
c. lead to lower interest rates and a shift to the right in the AD curve.
d. lead to higher interest rates and a shift to the left in the AD curve.
e. do both a and d.
3. Which of the following will a Keynesian most likely favor if the economy is
operating at point a?
a. a tax cut
b. an increase in government expenditures
c. restrictive fiscal policy
d. an increase in the budget deficit
4. If the output of the economy is Y1,
which of the following would a Keynesian
economist be most likely to favor?
a. a reduction in government expenditures
b. an increase in government expenditures
c. an increase in taxes
d. continuation of the current tax and
expenditure policies
5. If the output of the economy is Y1, which of the following would a new
classical economist be most likely to favor?
a. a reduction in government expenditures
b. a reduction in taxes
c. an increase in taxes
d. continuation of the current tax and expenditure policies
6.
When government expenditures exceed
revenue from all sources,
a.
a budget deficit is present.
b.
the supply of money will increase.
c.
the government’s outstanding debt will
decline.
d.
all of the above are true.
7.
According to the Keynesian view, which of
the following would most likely decrease aggregate
demand?
a.
a decrease in tax rates
b.
a decrease in government expenditures
c.
an increase in transfer payments
d.
an increase in the budget deficit
Expenditures > Revenue
Expenditures < Revenues
Discretionary changes in
taxes and/or spending
affect the Budget
Price
Level
market selfadjustment
may be a lengthy
process.
LRAS
SRAS1
SRAS2
E2
P2
P1
e1
P3
E3
directs the
Economy to
full-employment
AD1 AD2
Y 1 YF
Goods & Services
(real GDP)
• Equilibrium below full employment. Two options
1. Wait for SRAS1 to shift out to SRAS2
2. Shift AD1 out to AD2
Price
Level
SRAS2
LRAS
SRAS1
P3
E3
P1
P2
e1
E2
restrains demand and
helps control inflation.
AD2 AD1
YF Y 1
Goods & Services
(real GDP)
• Equilibrium above full employment at Y1.
1. Will lead to the long-run equilibrium E3 at a
higher price level as SRAS shifts to SRAS2. or
2. Reduce demand to AD2 and lead to equilibrium E2.
Decline in
private investment
Increase in
budget deficit
Higher real
interest rates
Inflow of financial
capital from abroad
Appreciation
of the dollar
Decline in
net exports
Price
Level
SRAS1
G
H
G
P1
AD1
Y1
AD2
Goods & Services
(real GDP)
• Government deficit would shift AD1 to AD2.
• Household saving keeps demand unchanged at AD1.
Loanable Funds
Market
Real
interest
rate
S1
S2
e1
no effect on the interest
rate, real GDP,
and unemployment.
e2
r1
D1
Q1
Q2
D2
Quantity of
loanable funds
1. Government borrows from the loanable funds
market, increasing the demand (to D2).
2. People save for expected higher future taxes
(raising the supply of loanable funds to S2.)
3. Loans increase, but interest rate doesn’t.
Price
Level
LRAS
SRAS1
P0
P1
E0
e1
AD1
Y1 Y0
AD0
Goods & Services
(real GDP)
1. Equilibrium at E0
2. AD decreases to AD1 and output falls to Y1
Price
Level
LRAS
SRAS1
P0
P1
E0
e1
AD2
AD1
Y1 Y0
AD0
Goods & Services
(real GDP)
3. While policy is being enacted, private investment
has begun to recover.
4. AD has begun shifting back to AD0 on its own, the
effects of fiscal policy over-shift AD to AD2.
Price
Level
LRAS
SRAS2
SRAS1
P3
E3
P2
e2
P0
P1
E0
e1
AD2
AD0
AD1
Y1 Y0 Y2
Goods & Services
(real GDP)
• The price level in the economy rises (from P1 to P2) as
the economy is now overheating.
• Unless the expansionary fiscal policy is reversed, wages
and other resource prices will eventually increase,
shifting SRAS back to SRAS2 (driving the price level up
to P3).
Price
Level
LRAS
SRAS1
P2
P0
e2
E0
AD2
AD0
Y0 Y2
Goods & Services
(real GDP)
1. Demand shifts AD out to AD2, and prices upward to P2.
2. Restrictive Fiscal Policy is considered
Price
Level
LRAS
SRAS1
P2
e2
P0
P1
E0
e1
AD2
AD0
AD1
Y1 Y0 Y2
Goods & Services
(real GDP)
2. The price level falls (from P2 to P1) as the
economy is thrown into a recession.
3. With the timing lag, fiscal policy does not work
instantaneously.
Price
Level
LRAS
SRAS1
P2
P0
e2
Suppose that shifts in AD
are difficult to forecast.
E0
AD2
AD0
AD1
Y0 Y2
Goods & Services
(real GDP)
4. Investment returns to its normal rate
(shifting AD2 back to AD0).
5. The effects of fiscal policy over-shift AD to AD1.
Price
Level
LRAS1 LRAS2
SRAS1
SRAS2
P0
E1
E2
AD1
YF1
YF2
With time, lower tax rates
promote more rapid growth
(shifting LRAS and SRAS
out to LRAS2 and SRAS2).
AD2
Goods & Services
(real GDP)
1. Lower marginal tax rates shifts AD1 out to AD2,
and SRAS & LRAS shift to the right.
2. If the tax cuts are financed by budget deficits, AD
may expand by more than supply, bringing an
increase in the price level.
Share of personal income taxes
paid by top ½ % of earners
30 %
28 %
26 %
24 %
22 %
20 %
1964-65
Top rate cut from
91% to 70%
2001-2004
Top rate cut from
39.6% to 35%
1990-93
Top rate raised from
30% to 39.6%
1986
Top rate cut from
50% to 30%
1997
Capital gains
tax rate cut
18 %
1981
Top rate cut from
70% to 50%
16 %
14 %
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
• Their share of taxes paid has increased as the top
tax rates have declined.
• This indicates that the supply side effects are
strong for these taxpayers.
O
b
a
m
a
“Soaking the Rich?”
• Since 1986 the top tax rate has been less
than 40% .
• The top one-half percent of earners have
paid more than 25% of the personal income
tax every year since 1997.
• Well above the 14% to 19% from the 1960s
and 1970s.
1. Generally small deficits except during
recessions.
2. Budget deficits generally increased during
recessions and shrank during expansions,
(automatic stabilizers, not discretionary policy)
3. Reductions in income tax rates and sharp
increases in defense expenditures led to large
deficits during the 1980s.
4. The deficits replaced by surpluses in the 1990s.
5. Real economic growth was strong and the
inflation rate low during 80s and 90s
6. The combination of:
-the 2001 recession
-the economy’s sluggish recovery
-the Bush Administration’s tax cut, and
-increases in defense spending
quickly moved the budget from surplus to
deficit at the beginning of the new century.
2003
2004
2005
2006
-375
-400
-300
-247.7
Federal Expenditures and Revenues
Federal Government Expenditures and Revenues (as a share of GDP)
24%
Expenditures
22%
Deficits
20%
18%
Revenues
1960
1965
1970
1975
1980 1985
1990
1995
2000 2005
Growth of Real Federal Government
and Defense Expenditures
Percent
rate of change
8%
6%
Total
4%
2%
0%
Defense
-2%
-4%
1980
1985
1990
1995
2000
• During the 1980s, rapid growth of defense spending pushed federal
spending upward and contributed substantially to the large deficits of the
decade.
• During the 1990s, defense cuts retarded the growth of federal
spending and thereby helped shift the budget to surplus.
Fiscal Policy & Economic Performance:
• In the 1960s, most economists believed fiscal
policy was highly potent and could be used to
smooth out the business cycle.
• Confidence in the ability of policy makers to
implement countercyclical fiscal policy has waned.
• Most now believe that fiscal policy exerts only a
modest impact on aggregate demand, much like
the crowding-out and new classical models imply.
• Since 1980, real growth has been strong during
periods of both expanding (1980s and 2002-2006)
and contracting (1990s) deficits.