Chapter 13 – Fiscal Policy, Deficits, and Debt
13-1
CHAPTER 13
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
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.
7. Comment on the statement: “Increasing government spending is preferred to a cut in taxes when the U.S.
government seeks to fight a recession.”
8. Explain what is meant by a built-in stabilizer and give two examples.
9. “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.
10. Explain how the below graph illustrates the built-in stability of a progressive tax structure.
11. 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?
12. What is the difference between the actual deficit, the cyclically adjusted deficit, and the cyclical deficit?
Chapter 13 – Fiscal Policy, Deficits, and Debt
13. 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?
14. 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
_____
15. What does the “cyclically adjusted budget” measure and of what significance is this concept?
16. Describe the characteristics of fiscal policy from 2000 to 2007. Was it expansionary or contractionary?
17. Describe the characteristics of fiscal policy in the Great Recession. Was it expansionary or contractionary?
18. What fiscal policy actions did the U.S. government take in 2008 and 2009?
0
10
20
30
40
50
60
70
80
90
100
010 20 30 40 50 60 70 80
Real Domestic Output, GDP
T3
T2
G
Chapter 13 – Fiscal Policy, Deficits, and Debt
13-3
19. 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
$ 800
$825
2
850
850
3
900
875
4
950
900
5
1000
925
(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?
(c) What is the public debt in this economy over the five years?
(d) If the size of the economy (GDP) was $4000 billion, what would be the public debt as a percentage of
GDP?
20. 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?
(c) What is the public debt in this economy over the five years?
(d) If the size of the economy (GDP) was $6000 billion what would the public debt in year 5 as a
percentage of GDP.
21. Comment on the statement: “Discretionary fiscal policy offers an ideal approach to dealing with the
nation’s economic problems. It is without problems, criticisms, or complications.”
22. Explain the five problems, criticisms, or complications that arise in the implementation of fiscal policy.
23. 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
act.”
24. How do expectations about the future by households and businesses affect the effectiveness of fiscal
policy? Cite examples.
25. “If economic forecasting was a more exact science, the business cycle could be entirely corrected by fiscal
measures.” Do you agree?
26. What are political business cycles and how could they be created?
27. Explain the crowding-out effect.
28. 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?
Chapter 13 – Fiscal Policy, Deficits, and Debt
13-4
29. Given all the complications that can result with fiscal policy, is fiscal policy still considered an effective
policy tool for stabilizing business cycle fluctuations?
30. Differentiate between the Federal deficit and the Federal debt.
31. What information would be important for assessing the size of the public debt beside the absolute amount
of the public debt?
32. In 2009 the public debt was $11.9 trillion. Put this number in perspective by relating the debt to GDP, to
other countries’ debt, to the amount of interest payments on the debt, and to ownership of the debt.
33. Can the large public debt cause the nation to go bankrupt? Explain.
34. Is the public debt a burden on future generations? Explain.
35. Is it possible to impose a burden on future generations by increasing the public debt?
36. Adam Smith once wrote: “What is prudence in the conduct of every private family can scarce be folly in
that of a great kingdom.” Evaluate in terms of the national debt.
37. In what fundamental way do the spending-taxation decisions of government differ from the consumption–
saving plans of households? Why is this difference significant?
38. 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
liabilities and reduce expenditures enough to reduce the deficits or increase revenues enough to pay our
bills and have some left over to pay the old bills. Evaluate this statement.
39. Why is the ownership of the public debt an important issue?
40. What are four real and potential problems with the public debt?
41. If the public debt is a debt that we owe to ourselves, then there are obviously no problems connected with
such a debt. Critically evaluate.
42. Crowding out can weaken the effect of an expansionary fiscal deficit. Explain.
43. 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
(a) Use the Id1 schedule. Assume that the government needs to finance a budget deficit and this public
borrowing increases the interest rate from 5 percent to 6 percent. How much crowding-out of private
investment will occur?
(b) Now assume that the deficit is used to improve the performance of the economy, and that as a
consequence the investment-demand schedule changes from Id1 to Id2. At the same time, the interest
rate rises from 5 percent to 6 percent as the government borrows money to finance the deficit. How
much crowding-out of private investment will occur in this case?
(c) Graph the two investment-demand schedules on the graph below and show the difference between the
two events. Put the interest rate on the vertical axis and the quantity of investment demanded on the
horizontal axis.
Chapter 13 – Fiscal Policy, Deficits, and Debt
13-5
44. What two factors could reduce the net economic burden that might be shifted to future generations from the
public debt?
45. (Last Word) What is the long-run financial problem for Social Security?
46. (Last Word) What is the long-run financial problem for Medicare?
47. (Last Word) What options have been suggested for shoring up the finances of Social Security and
Medicare? Why are they unpleasant ones to consider?
Chapter 13 – Fiscal Policy, Deficits, and Debt
13-6
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.
Chapter 13 – Fiscal Policy, Deficits, and Debt
13-7
7. Comment on the statement: “Increasing government spending is preferred to a cut in taxes when the U.S.
government seeks to fight a recession.”
8. Explain what is meant by a built-in stabilizer and give two examples.
9. “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.
10. Explain how the below graph illustrates the built-in stability of a progressive tax structure.
Chapter 13 – Fiscal Policy, Deficits, and Debt
13-8
11. 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?
12. What is the difference between the actual deficit, the cyclically adjusted deficit, and the cyclical deficit?
13. 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
T3
T2
G
Chapter 13 – Fiscal Policy, Deficits, and Debt
14. 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
_____
(1)
Year
(2)
Actual budget
surplus (+)
(3)
Cyclically adjusted
surplus (+)
(4)
fiscal policy
1
2
3
5
6
15. What does the “cyclically adjusted budget” measure and of what significance is this concept?
16. Describe the characteristics of fiscal policy from 2000 to 2007. Was it expansionary or contractionary?
17. Describe the characteristics of fiscal policy in the Great Recession. Was it expansionary or contractionary?
Chapter 13 – Fiscal Policy, Deficits, and Debt
13–10
18. What fiscal policy actions did the U.S. government take in 2008 and 2009?
19. 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
$ 800
$825
2
850
850
3
900
875
4
950
900
5
1000
925
(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?
(c) What is the public debt in this economy over the five years?
(d) If the size of the economy (GDP) was $4000 billion, what would be the public debt as a percentage of
GDP?
20. 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?
(c) What is the public debt in this economy over the five years?
(d) If the size of the economy (GDP) was $6000 billion what would the public debt in year 5 as a
percentage of GDP.
Chapter 13 – Fiscal Policy, Deficits, and Debt
21. Comment on the statement: “Discretionary fiscal policy offers an ideal approach to dealing with the
nation’s economic problems. It is without problems, criticisms, or complications.”
22. Explain the five problems, criticisms, or complications that arise in the implementation of fiscal policy.
23. 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
act.”
24. How do expectations about the future by households and businesses affect the effectiveness of fiscal
policy? Cite examples.
Chapter 13 – Fiscal Policy, Deficits, and Debt
25. “If economic forecasting was a more exact science, the business cycle could be entirely corrected by fiscal
measures.” Do you agree?
26. What are political business cycles and how could they be created?
27. Explain the crowding-out effect.
28. 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?
29. Given all the complications that can result with fiscal policy, is fiscal policy still considered an effective
policy tool for stabilizing business cycle fluctuations?
Chapter 13 – Fiscal Policy, Deficits, and Debt
30. Differentiate between the Federal deficit and the Federal debt.
31. What information would be important for assessing the size of the public debt beside the absolute amount
of the public debt?
32. In 2009 the public debt was $11.9 trillion. Put this number in perspective by relating the debt to GDP, to
other countries’ debt, to the amount of interest payments on the debt, and to ownership of the debt.
33. Can the large public debt cause the nation to go bankrupt? Explain.
34. Is the public debt a burden on future generations? Explain.
35. Is it possible to impose a burden on future generations by increasing the public debt?
Chapter 13 – Fiscal Policy, Deficits, and Debt
36. Adam Smith once wrote: “What is prudence in the conduct of every private family can scarce be folly in
that of a great kingdom.” Evaluate in terms of the national debt.
37. In what fundamental way do the spending-taxation decisions of government differ from the consumption–
saving plans of households? Why is this difference significant?
38. 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
liabilities and reduce expenditures enough to reduce the deficits or increase revenues enough to pay our
bills and have some left over to pay the old bills. Evaluate this statement.
39. Why is the ownership of the public debt an important issue?
Chapter 13 – Fiscal Policy, Deficits, and Debt
13–15
40. What are four real and potential problems with the public debt?
41. If the public debt is a debt that we owe to ourselves, then there are obviously no problems connected with
such a debt. Critically evaluate.
42. Crowding out can weaken the effect of an expansionary fiscal deficit. Explain.
43. 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
(a) Use the Id1 schedule. Assume that the government needs to finance a budget deficit and this public
borrowing increases the interest rate from 5 percent to 6 percent. How much crowding-out of private
investment will occur?
(b) Now assume that the deficit is used to improve the performance of the economy, and that as a
consequence the investment-demand schedule changes from Id1 to Id2. At the same time, the interest
rate rises from 5 percent to 6 percent as the government borrows money to finance the deficit. How
much crowding-out of private investment will occur in this case?
(c) Graph the two investment-demand schedules on the graph below and show the difference between the
two events. Put the interest rate on the vertical axis and the quantity of investment demanded on the
horizontal axis.
Chapter 13 – Fiscal Policy, Deficits, and Debt
44. What two factors could reduce the net economic burden that might be shifted to future generations from the
public debt?
45. (Last Word) What is the long-run financial problem for Social Security?
46. (Last Word) What is the long-run financial problem for Medicare?
47. (Last Word) What options have been suggested for shoring up the finances of Social Security and
Medicare? Why are they unpleasant ones to consider?
Chapter 13 – Fiscal Policy, Deficits, and Debt
13–17