CHAPTER 33
Fiscal Policy, Deficits, and Debt
A. Short-Answer, Essays, and Problems
1. Give a brief definition of fiscal policy. What are its economic goals?
2. What is the Council of Economic Advisers?
3. Explain the effect of a discretionary cut in taxes of $40 billion on the economy when the economy’s
marginal propensity to consume is .75. How does this discretionary fiscal policy differ from a
discretionary increase in government spending of $40 billion?
4. Explain the effect of a discretionary increase in government spending of $50 billion on the economy when
5. Explain the aspects of expansionary and contractionary fiscal policy. During which phases of the business
cycle would each be appropriate?
6. Differentiate between discretionary fiscal policy and nondiscretionary or built-in stabilization policy.
7. Determine whether the following government actions are discretionary or nondiscretionary spending.
8. When in a recession a government has the option to increase government spending or decrease taxes to
9. Comment on the statement: “Increasing government spending is preferred to a cut in taxes when the U.S.
11. Examine whether the following items are built-in stabilizers or discretionary changes.
12. “The more progressive a tax system, the greater is the economy’s built–in stability.” Explain this statement
13. Explain how the below graph illustrates the built-in stability of a progressive tax structure.
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14. Use the graph below to show the effect of a discretionary increase in government spending. Assume the
15. In Year 1, the cyclically adjusted budget showed a deficit of about $100 billion and the actual budget
showed a deficit of $150 billion one year. In Year 2, the full employment budget showed a deficit of about
16. What is the difference between the actual deficit, the cyclically adjusted deficit, and the cyclical deficit?
17. Use the graph below to analyze the following questions. Assume the economy starts at full-employment
GDP at $40 billion.
18. Complete the table below by stating whether the direction of discretionary fiscal policy was contractionary
(C), expansionary (E), or neither (N), given the hypothetical budget data for an economy.
(1)
Year
(2)
Actual budget
deficit (−) or
surplus (+)
(3)
Cyclically adjusted
budget deficit (−) or
surplus (+)
(4)
Direction of
fiscal policy
1
−3.9%
−2.1%
2
−4.5
−2.6
_____
3
−4.7
−3.0
_____
4
−3.9
−2.6
_____
5
−2.9
−2.0
_____
6
−2.2
−1.9
_____
0
10
20
30
40
50
60
70
80
90
100
010 20 30 40 50 60 70 80
Real Domestic Output, GDP
Government Expenditures, G, and Tax
revenues, T (billions)
T3
T1
T2
G
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19. What does the “cyclically adjusted budget” measure and of what significance is this concept?
20. Describe the characteristics of fiscal policy from 2000 to 2007. Was it expansionary or contractionary?
21. Describe the characteristics of fiscal policy in the Great Recession. Was it expansionary or contractionary?
22. What fiscal policy actions did the U.S. government take in 2008 and 2009?
23. Describe the characteristics of fiscal policy from 2009 to 2012. Was it expansionary or contractionary?
Year
Government Spending
Tax Revenues
1
$ 800
$825
2
850
850
3
900
875
4
950
900
5
1000
925
25. The following table shows government spending and tax revenue for a hypothetical economy over a five–
year period. All figures are in billions.
Year
Government Spending
Tax Revenues
1
$1100
$1050
2
1150
1100
3
1250
1150
4
1250
1300
5
1300
1250
(a) In what years were there budget deficits and what were the amounts?
(b) In what year was there a budget surplus and what was the amount?
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26. Comment on the statement: “Discretionary fiscal policy offers an ideal approach to dealing with the
27. Explain the five problems, criticisms, or complications that arise in the implementation of fiscal policy.
28. Explain the problems giving rise to this statement: “You would think the government would want to do
something to improve economic conditions when the economy is in trouble, but the government is slow to
29. How do expectations about the future by households and businesses affect the effectiveness of fiscal
30. “If economic forecasting was a more exact science, the business cycle could be entirely corrected by fiscal
measures.” Do you agree?
33. What fiscal policy is most likely to be invoked during a period of recession and high unemployment? A
period of rapid inflation? What political, investment, and international problems might the U.S. Congress
encounter in enacting these policies and putting them into effect?
34. Given all the complications that can result with fiscal policy, is fiscal policy still considered an effective
policy tool for stabilizing business cycle fluctuations?
36. What information would be important for assessing the size of the public debt beside the absolute amount
of the public debt?
37. In 2009 the public debt was $11.9 trillion. Put this number in perspective by relating the debt to GDP, to
40. Is it possible to impose a burden on future generations by increasing the public debt?
41. Adam Smith once wrote: “What is prudence in the conduct of every private family can scarce be folly in
42. In what fundamental way do the spending-taxation decisions of government differ from the consumption-
saving plans of households? Why is this difference significant?
43. If we as individuals would continue to spend more than we made, we would sooner or later have to pay up
or go bankrupt. Our government is in the same position or will be unless we get serious about our
44. Why is the ownership of the public debt an important issue?
45. What are four real and potential problems with the public debt?
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48. The table below gives data on interest rates and investment demand in a hypothetical economy. Figures are
in billions.
Interest rate
Id1
Id2
7%
$500
$ 600
6
600
700
5
700
800
4
800
900
3
900
1000
49. What two factors could reduce the net economic burden that might be shifted to future generations from the
public debt?
50. (Last Word) What is the long-run financial problem for Social Security?
51. (Last Word) What is the long-run financial problem for Medicare?
52. (Last Word) What options have been suggested for shoring up the finances of Social Security and
Medicare? Why are they unpleasant ones to consider?
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B. Answers to Short-Answer, Essays, and Problems
1. Give a brief definition of fiscal policy. What are its economic goals?
2. What is the Council of Economic Advisers?
3. Explain the effect of a discretionary cut in taxes of $40 billion on the economy when the economy’s
marginal propensity to consume is .75. How does this discretionary fiscal policy differ from a
discretionary increase in government spending of $40 billion?
4. Explain the effect of a discretionary increase in government spending of $50 billion on the economy when
the economy’s marginal propensity to consume is .75.
5. Explain the aspects of expansionary and contractionary fiscal policy. During which phases of the business
cycle would each be appropriate?
6. Differentiate between discretionary fiscal policy and nondiscretionary or built-in stabilization policy.
Discretionary fiscal policy is the deliberate manipulation of taxes and government spending by the
Congress to alter real domestic output and employment, to control inflation, and to stimulate economic
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7. Determine whether the following government actions are discretionary or nondiscretionary spending.
(a) Spending on unemployment benefits increase when more people become unemployed during a
recession.
(b) Congress decides to increase taxes during a period of expansion.
(c) Congress votes to expand spending on infrastructure.
(d) During a recession households often experience a decrease in income, moving them into a lower tax
bracket.
8. When in a recession a government has the option to increase government spending or decrease taxes to
stimulate the economy. Discuss which piece of GDP is being targeted when each is used.
9. Comment on the statement: “Increasing government spending is preferred to a cut in taxes when the U.S.
government seeks to fight a recession.”
10. Explain what is meant by a built-in stabilizer and give two examples.
11. Examine whether the following items are built-in stabilizers or discretionary changes.
(a) Unemployment benefits
(b) Tax cuts
(c) An increase in government spending on road work
(d) Progressive tax system
12. “The more progressive a tax system, the greater is the economy’s built–in stability.” Explain this statement
for both recessionary and peak phases of the business cycle.
13. Explain how the below graph illustrates the built-in stability of a progressive tax structure.
14. Use the graph below to show the effect of a discretionary increase in government spending. Assume the
economy is currently in an expansionary period. Discuss how this effects the federal budget.
15. In Year 1, the cyclically adjusted budget showed a deficit of about $100 billion and the actual budget
showed a deficit of $150 billion one year. In Year 2, the full employment budget showed a deficit of about
$125 billion and the actual budget showed a deficit of $150 billion. Based on these data, what can be
concluded about the direction of fiscal policy?
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16. What is the difference between the actual deficit, the cyclically adjusted deficit, and the cyclical deficit?
17. Use the graph below to analyze the following questions. Assume the economy starts at full-employment
GDP at $40 billion.
(a) Suppose the economy suddenly faces an expansion in output and GDP grows to $60 billion. What is
the cyclically adjusted budget surplus at this output?
(b) Suppose the government is afraid of rampant demand-pull inflation and decides to increase taxes to
control the expansion. Which tax line (T2 or T3) would represent this increase in taxes and how much
would the budget surplus grow by?
(c) Suppose the economy comes into a recession and GDP falls to $20 billion. To promote growth the
government reduces taxes. Which tax line (T2 or T3) would reflect the proper tax shift? What is the
built-in cyclically adjusted budget deficit and what is the deficit as a result of the government action?
0
10
20
30
40
50
60
70
80
90
100
010 20 30 40 50 60 70 80
Real Domestic Output, GDP
Government Expenditures, G, and Tax
revenues, T (billions)
T3
T1
T2
G