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15
FISCAL POLICY*
Key Concepts
The Federal Budget
The federal budget is an annual statement of the governments expenditures and tax revenues. Using the
federal budget to achieve macroeconomic objectives
such as full employment, sustained economic growth,
and price level stability is fiscal policy.
The President proposes a budget to Congress, Congress
passes budget acts, and the President vetoes or signs the
acts. The Employment Act of 1946 commits the government to strive for full employment. The Council of
Economic Advisers is a group of economists who
monitor the economy and keep the President and the
public informed about the current state of the economy
and the best available forecasts of where it is heading.
Tax revenues are received from four sources: personal income taxes, social security taxes, corporate
income taxes, and indirect taxes. The largest source
of revenue is the personal income tax.
Expenditures are classified as transfer payments,
purchases of goods and services, and interest payments on the debt. The largest expenditure item is
transfer payments.
The budget balance equals tax revenues minus expenditures.
A budget surplus occurs if tax revenues exceed
expenditures; a budget deficit occurs if tax revenues are less than expenditures; and a balanced
budget occurs if tax revenues equal expenditures.
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HELPFUL HINTS
1. MULTIPLIERS : The expenditure multiplier was
discussed in Chapter 13 (or 29). This chapter continues the discussion by introducing additional
multipliers, such as the government purchases multiplier and tax multiplier. All multipliers exist for
the same reason: An initial autonomous change
that affects peoples disposable income leads them
to change their consumption expenditure. In turn,
the consumption changes affect other peoples income, which creates yet more induced changes in
consumption expenditure. So, for all multipliers,
aggregate demand changes because of the initial
autonomous change and because of the further induced changes in consumption expenditure.
Questions
True/False and Explain
The Federal Budget
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Multiple Choice
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18. How do induced taxes, such as the income tax, affect the size of the multiplier effects?
a. Induced taxes increase the size of the multiplier.
b. Induced taxes have no effect on the size of the
multiplier.
c. Induced taxes reduce the size of the multiplier.
d. The answer depends on the presence or absence
of needs-tested spending in the economy in addition to induced taxes.
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5. Figure 15.2 shows the market for saving and investment. The governments budget is balanced.
a. Show the effect of a $400 billion government
budget deficit if there is no Ricardo-Barro ef-
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Answers
True/False Answers
The Federal Budget
16. d Because the tax hike decreases the supply of labor, equilibrium employment decreases and so
does potential GDP.
17. b An income tax lowers the after-tax wage rate so
that it is less than the before tax-wage rate.
18. a Though it is possible for the tax rate to be so
high that an increase in it lowers tax revenue,
most economists think that in the United States
the tax rate is not that high.
The Supply Side: Investment, Saving, and
Economic Growth
FISCAL POLICY
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2.
3.
14. a Because the tax increase does not occur automatically, it is a discretionary fiscal policy.
15. c The balanced budget multiplier shows that an
increase in government purchased balanced by
an identical increase in tax revenue increases
aggregate demand.
16. c A deflationary gap needs an expansionary policy
to offset it, so an increase in government purchases is the correct policy.
17. b Both the decrease in government purchases and
the increase in taxes decrease aggregate demand,
but the government purchases multiplier is larger than the tax multiplier, so the decrease in
government purchases has a larger effect on aggregate demand.
18. c Induced taxes reduce the change in disposable
income that results from a change in GDP. So
induced taxes decrease the amount of induced
consumption that results from a change in GDP
and thereby reduce the size of the multipliers.
19. c During a recession, tax revenues fall and transfer
expenditures rise, thereby decreasing a budget
surplus.
20. d A structural deficit is a deficit that exists even
when the economy is producing at full employment.
Answers to Short Answer Problems
1. For most of the past two decades, the United States
has had a government budget deficit. The deficit
was particularly large during the middle of the
4.
5.
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6. a. In an inflationary gap, real GDP exceeds potential GDP, so contractionary policies are appropriate. Igors economists should suggest a
decrease in government purchases or an increase
in taxes.
b. In a deflationary gap, real GDP is less than potential GDP, so expansionary policies are appropriate. Igors economists should suggest an
increase in government purchases or a decrease
in taxes.
c. Because Igors economists predict the presence
of a deflationary gap, the policies they suggest
are expansionary policies: An increase in government purchases and/or a tax cut. Both policies increase aggregate demand. But
Transylvania is already at full employment when
these policies take effect, so the increase in aggregate demand pushes Transylvania into an
equilibrium with an inflationary gap. Real GDP
exceeds potential GDP and the price level rises.
d. Igor lost his day job because of the difficulty of
economic forecasting combined with the lawmaking lag. Other lags that hamper fiscal policy
are the recognition lag, which is the time it takes
to figure out that fiscal policy actions are
needed, and the impact lag, which is the time
between when a fiscal policy change is passed
and when its effects on real GDP are felt. All
these lags make fiscal policy difficult.
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Chapter Quiz
11. A balanced budget occurs when the governments
a. expenditures exceeds its tax revenues.
b. expenditures equal its tax revenues.
c. expenditures are less than its tax revenues.
d. total debt equals zero.
12. As a fraction of GDP, the public debt
a. has risen each year for the past 50 years.
b. has fallen each year for the past 50 years.
c. both rose and fell after 1974 and today is higher
than it was in 1974.
d. generally rose until about 1974 and today is
lower than it was in 1974.