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CHAPTER 18: FISCAL POLICY
Additional Questions
Essay Questions and/or Problems:
1. According to the partisan theory model, what motivates policy makers? What differentiates
one party from another? Which party should be more concerned with budget deficits?
2. Cite the difference between a “political business cycle” and a “party cycle?” What do each
imply about the length and regularity of business cycles?
3. How do automatic fiscal stabilizers function? What do they imply about the behavior of
structural deficits over the business cycle? What do they imply about the behavior of
cyclical deficits over the business cycle?
4. True/false/Explain. Keynesians do not worry about the macroeconomic impact of budget
deficits.
5. According to the Keynesian model, if the government follows an optimal fiscal , should
deficits be positively or negatively correlated with output? Explain your answer.
FISCAL POLICY 199
6. Distinguish between structural and cyclical deficits. What has happened to the structural
deficit in the 1990s? In the 2000s?
7. “The budget situation among individual states is completely independent of what occurs at
the Federal level.” Evaluate the accuracy of this statement.
Additional Problems and/or Essay Questions:
8. There has been much public discussion of a constitutional amendment to mandate
balancing the federal budget. Summarize arguments for and against such an amendment.
9. Suppose that, within the simple Keynesian model, the level of government spending was
100, the level of investment was 95 and consumption was given by
C = 40 + 0.75YD
and net taxes are given by
T = – 20 + 0.33Y.
Calculate the level of equilibrium income in the model.
Now suppose that government spending increases to 120 units. Find the new level of
equilibrium income. Now, leaving government spending at 120, let the intercept of the tax
function go from – 20 to 0. Find the new level of equilibrium income.
10. Suppose that the tax function is
T = t0 + t1Y
the consumption function is
C = a + bYD
200 CHAPTER 18
and the level of investment and government spending are given as G0 and I0. There is no
money market in the model and the price level is fixed.
(a). Derive an expression for the government spending multiplier (ΔY/ΔG) and a tax
multiplier defined as (ΔY/Δt0).
(b). Derive an expression analogous to the balanced budget multiplier in Chapter 5, (i.e., a
multiplier showing the change in Y when G rises by 1 unit, financed by a rise of one unit in
t0).
11. Discuss future predicted changes in the government’s budget over the next 20 years. Make
sure to discuss changes in government spending and budget deficits. What are the
implications of these developments in the Keynesian model? In classical models?
12. Consider the following economy
C = 50 + .8(Y-T)
T = -200 + .25Y
I = 100
G = 210
(a). calculate equilibrium income.
(b). calculate the equilibrium budget deficit.
(c). Suppose that the government passes a balanced budget amendment that requires that
Congress must lower G by the total amount of the deficit (which you just calculated in part
(b)). Re-calculate equilibrium income and the new budget deficit at this lower level of G.
Does this amendment achieve its goal of a zero deficit? Why or why not?
13. Derive the automatic stabilizer multiplier. What are the key factors that determine the size
of this multiplier?
14. According to the partisan theory model, which party should be more concerned with budget
deficits? Does this match recent experience?
15. Do automatic stabilizers suffer from the same problems of discretionary stabilization policy
emphasized by the classical, monetarist, and new classical models? Why or why not?
16. Deficits move strongly opposite of GDP in the US. In order to deal with large budget
deficits, some have proposed a balanced budget amendment, meaning that all government
spending would have to be paid with tax revenues in the current year. Using our IS/LM and
AD/AS model, what impact would this have on size of changes in output during business
cycles? The impact of stabilization policy?
17. Sovereign debt crises often lead to hyperinflations. Explain why.
18. Do automatic fiscal policy stabilizers suffer from the same problems of time inconsistency
as discretionary fiscal policy? Explain why or why not.
FISCAL POLICY 201
Multiple-Choice Questions:
1. Automatic fiscal stabilizers
2. The higher the marginal income tax rate, the
3. Suppose that the MPC out of disposable income was 0.8 and the marginal tax rate was 0.25
for a given economy. In this case, the value of the tax multiplier in the simple Keynesian
model would be
4. Suppose that the MPC out of disposable income was 0.8 and the tax function for a given
economy was T = – 30 + 0.25Y. An increase in the intercept of the tax function of 10 units
(from – 30 to – 20) would cause equilibrium income in the simple Keynesian model to fall
by
5. If the tax function is given by T = – 20 + 0.1Y the average tax rate would
6. The role of the progressive tax system as an autonomous fiscal stabilizer requires that the
202 CHAPTER 18
7. If the tax function is T = t0 + t1Y where t1 equals 1/3, and if the marginal propensity to
consume out of disposable income is 3/4, then the change in GDP per unit change in t0
(ΔY/Δt0) will be
8. In the simple Keynesian model, if the tax function is given by T = 0.15Y and the
consumption function is C = 50 + 0.7YD then a 10-unit increase in government spending
would increase equilibrium income by
9. According to the partisan party model,
10. Advocates of the public-choice view argue that voting behavior is influenced by the
11. According to the partisan theory,
12. Keynesians believe in
13. Which of the following statements is (are) correct?
14. When automatic fiscal stabilizers are in place, a shock that causes a fall in the level of
economic activity automatically
15. According to the Keynesian model, the optimal fiscal policy is to
16. Which of the following are the most frequently utilized tools of fiscal policy in the United
States?
17. Assume that the actual deficit is $150 billion with the economy well below potential output
and that the level of economic activity rose to its potential level while tax revenues
increased by $50 billion and transfer payments fell by $20 billion. Then, what is the
structural deficit?
18. The structural deficit is
19. According to the Keynesians,
20. During the recession of 2001,
21. Advocates of the public-choice view argue that elected officials
22. Which of the following statements is (are) correct?
23. Assuming a simultaneous reduction in income taxes and transfer payments of $50 billion,
24. From the net tax function: T = t0 + t1Y, where t0 < 0 and t1 > 0, it follows that, as income
rises
25. The structural deficit is the deficit that
26. Which of the following hypotheses about voter behavior have been advanced in public-
choice literature?
27. In the IS-LM model, an easy monetary in conjunction with a tight fiscal policy
28. The cyclical deficit is that portion of the deficit
29. Automatic stabilizers drive changes in
30. According to the concept of rational expectations
31. If the Federal Reserve increases the money supply at the same time as an expansionary
fiscal policy drives up budget deficits, we would expect to see income _____ and interest
rates ____.
32. Based on current budget projections, in the U.S. over the next 20 years the
33. In the IS-LM model, when government spending and taxes increase by the same amount
34. While deficits in the United States through the 1970s, 1980s and early 1990s were high
relative to our historical peacetime experience, they
35. In the Keynesian model,
36. A change in government spending has a larger effect on income the
37. Currently, virtually the entire deficit in the U.S. is
38. One difference between the federal government budget and state and local budgets is that
39. Which of the following statements is correct?
40. The public-choice view states that
41. A social loss function is a way to
42. During the 2000s, the Federal government’s deficit
43. A change in government spending has a larger effect on income the
44. Historically, the most important cause of government budget deficits is
45. Measuring the size of future government deficits is complicated by all of the following
except uncertainty about
46. A deficit-financed tax cut will ____ national savings and _____ private consumption.
47. Which of the following statements is (are) correct?
48. According to the party cycle theory, recessions
49. Assume that the total deficit is $100 billion and the economy is above potential output.
Now the level of economic activity falls back to its potential level output, leading to an
decrease in tax revenues increase by $50 billion an increase in transfer payments fell by $10
billion. Then, what is the structural deficit?
50. During the 2000s, the Federal government’s deficit rose because of
51. During a recession the:
52. High budget deficits may:
53. Sovereign debt crises:
54. The federal government budget deficits of the late 2000s were driven by:
55. According to the public-choice view,