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Fiscal Policy
32
CHECKPOINTS
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Checkpoint 32.1
Checkpoint 32.2
Problem 1
Problem 1
Problem 2
Problem 2
Problem 1
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Problem 2
Problem 3
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Problem 3
Problem 4
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In the news
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Checkpoint 32.3
In the news
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CHECKPOINT 32.1
Practice Problem 1
What are the revenues and outlays in the federal budget,
and what was the projected budget balance for Fiscal
2012?
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CHECKPOINT 32.1
Solution
The 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.
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CHECKPOINT 32.1
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?
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CHECKPOINT 32.1
Solution
In 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.
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CHECKPOINT 32.2
Practice Problem 1
Classify 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
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CHECKPOINT 32.2
Solution
A 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.
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CHECKPOINT 32.2
Practice Problem 2
Explain how aggregate demand changes when
government expenditure on national defense
increases by $100 billion.
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CHECKPOINT 32.2
Solution
An 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.
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CHECKPOINT 32.2
Study Plan Problem
When the government increases its expenditure on
national defense by $100 billion, aggregate demand
_____ by ______ $100 billion because ______
expenditure ______ .
A.
B.
C.
D.
E.
increases; more than; induced; increases
decreases; less than; discretionary; decreases
increases; more than; induced; decreases
decreases; less than; induced; increases
increases; more than; discretionary; increases
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CHECKPOINT 32.2
Practice Problem 3
Explain how aggregate demand changes when the
government increases taxes by $100 billion.
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CHECKPOINT 32.2
Solution
When 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.
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CHECKPOINT 32.2
Study Plan Problem
When the government increases taxes by $100 billion,
aggregate demand ________ by _______ $100 billion
because _____ expenditure _______ .
A.
B.
C.
D.
E.
decreases; more than; discretionary; decreases
increases; less than; induced; decreases
decreases; more than; induced; increases
decreases; more than; induced; decreases
increases; less than; discretionary; increases
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CHECKPOINT 32.2
Practice Problem 4
Explain how aggregate demand changes when
government increases both expenditure and taxes
by $100 billion.
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CHECKPOINT 32.2
Solution
An 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.
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CHECKPOINT 32.2
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.
A.
B.
C.
D.
E.
decreases; a smaller; than
decreases; a larger; than
increases; a smaller; than
doesn’t change; the same; as
increases; a larger; than
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CHECKPOINT 32.2
In the news
How 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?
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CHECKPOINT 32.2
Solution
The 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.
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CHECKPOINT 32.3
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.
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CHECKPOINT 32.3
Solution
When 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.
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CHECKPOINT 32.3
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 _______.
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
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CHECKPOINT 32.3
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.
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CHECKPOINT 32.3
Solution
With 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.
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CHECKPOINT 32.3
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.
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CHECKPOINT 32.3
Solution
If 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.
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CHECKPOINT 32.3
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 ______.
A.
B.
C.
D.
falls; decreases; decreases; increases; decreases
falls; decreases; increases; increases; increases
rises; increases; increases; increases; increases
rises; increases; decreases; decreases; decreases
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CHECKPOINT 32.3
In the news
The 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.
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CHECKPOINT 32.3
Solution
The 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.
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