File: Chapter 32 The Modern Fiscal Policy Dilemma
True/False
[QUESTION]
1. According to the Ricardian equivalence theorem, people increase savings when the government
increases deficits because they recognize the link between government deficits and higher future
taxes.
2. Sound finance holds that government spending should be directed toward sound investment.
3. During the early 20th century, economists who held that the Ricardian equivalence theorem was
theoretically true could support either sound or functional finance.
4. Financing expansionary fiscal policy by increasing the deficit does not generally affect interest
rates.
5. If the government knew the level of potential income and had sufficient information about the
economy (i.e., the mpe, and such), it could fine-tune the economy.
6. Crowding out is the offsetting effect on private expenditures caused by the government’s sale of
bonds to finance expansionary fiscal policy.
7. The elimination of automatic stabilizers would decrease the need for other fiscal policies.
8. Automatic stabilizers are government programs or policies that will counteract the business
cycle without any new government action.
9. The 2008–2009 deficit stimulus spending by the federal government is an example of
expansionary sound finance.
10. The application of Keynesian economics to public finance and fiscal policy by Abba Lerner,
and its incorporation into Paul Samuelson’s economic principles textbook, was known as
procyclical finance.
11. The government’s running of a deficit or a surplus with the objective of affecting the level of
output in the economy is called:
A. public finance.
B. fiscal policy.
C. the Ricardian equivalence.
D. sound finance.
12. Which of the following best describes most economists’ approach to economic stabilization
until the 1930s?
A. Maintain a balanced budget at all times, under the principle of sound finance.
B. Use a sound finance approach during normal economic times, and a functional finance
approach during a recession or a boom.
C. Run larger deficits during recessions and smaller deficits during economic booms, counting on
economic growth to be high enough to keep the debt-to-GDP ratio low.
D. Economists were wholly concerned with microeconomics and had ignored problems of
government deficits, debt, recessions, and economic growth.
13. The concept of fiscal policy refers to the:
A. running of a deficit or surplus to affect the level of output in the economy.
B. changing of interest rates to affect the level of output in the economy.
C. management of exchange rates to affect the trade deficit in the economy.
D. setting of wage policies by institutions to affect spending in the economy.
14. The view that the government budget should always be balanced except in wartime refers to:
A. public finance.
B. fiscal policy.
C. the Ricardian equivalence.
D. sound finance.
15. The theoretical proposition that government deficits do not affect the level of output because
individuals realize that they have to pay the deficits in the future and therefore increase their
savings is called:
A. purchasing power parity.
B. functional finance.
C. the Ricardian equivalence theorem.
D. sound finance.
16. According to the Ricardian equivalence theorem, government deficits do not affect the level of
output because people:
A. do not understand the relationship between deficits and aggregate demand.
B. know that current deficits must be paid in the future and therefore reduce savings today.
C. recognize that current deficits must be paid by future generations and therefore spend more
today.
D. recognize that current deficits must be paid in the future and therefore increase savings today to
pay higher future taxes.
17. According to the Ricardian equivalence theorem, people increase savings today when the
government increases deficits because they recognize that:
A. government deficits imply higher future taxes.
B. government deficits imply lower future taxes.
C. consumption reduces future taxes.
D. consumption increases future taxes.
18. According to the Ricardian equivalence theorem, government deficits do not affect output
because people:
A. save more when government deficits decrease.
B. save more when government deficits increase.
C. consume more when government deficits increase.
D. do not change consumption nor savings.
19. The Ricardian equivalence theorem is correct if two assumptions are true. These assumptions
are that people have:
A. access to savings instruments and recognize the link between deficits and future taxes.
B. no access to savings instruments and recognize the link between deficits and future taxes.
C. access to savings instruments but cannot recognize the link between deficits and future taxes.
D. no access to savings instruments and cannot recognize the link between deficits and taxes.
20. Economists who believe in sound finance would say that in a recession, the government
should:
A. run a budget deficit because the Ricardian equivalence theorem is true both in theory and in
practice.
B. run a budget deficit despite the truth of the Ricardian equivalence theorem.
C. maintain a balanced budget because the Ricardian equivalence theorem is true in practice.
D. maintain a balanced budget for political and moral reasons.
21. A key difference between functional finance and sound finance is that in the functional finance
approach the government has the potential for:
A. a more active role in spending and taxing decisions.
B. a less active role in spending and taxing decisions.
C. no role since functional finance holds that on moral principle the budget should be balanced.
D. more active role in spending and taxing but only during depressions.
22. Which of the following is most representative of the functional finance view of the
macroeconomy?
A. The economy is self-regulating and the best thing the government can do to enhance stability is
to stay out of the way.
B. Budgets should be balanced. Doing otherwise is morally wrong.
C. The government should decide on tax and spending plans based on their effects on the
economy.
D. Crowding out almost completely cancels out any deficit spending, so fiscal policy is likely to
be ineffective.
23. An economist who follows a functional finance principle believes that the government should:
A. do nothing in response to a recession.
B. do nothing in response to a recession due to the Ricardian equivalence theorem.
C. run either a deficit or surplus depending on the state of the economy.
D. run a balanced budget.
24. When the economy is experiencing inflation, an economist who follows a functional finance
principle is most likely to suggest that the government should:
A. do nothing.
B. run a deficit.
C. run a surplus.
D. run a balanced budget.
25. Functional finance:
A. is based on empirical evidence that fiscal policy can be effective in smoothing business cycles.
B. is based on the political realities of voters wanting their government to respond to recessions.
C. is a theoretical proposition, not a moral proposition.
D. is a proposition supported by public choice economists.
26. In the early 2000s, car sales in China slowed because the government had been restricting
credit growth. This action is consistent with the effects of:
A. contractionary fiscal or monetary policy.
B. contractionary fiscal policy but not contractionary monetary policy.
C. contractionary monetary policy but not contractionary fiscal policy.
D. expansionary fiscal policy.
27. Even as the U.S. government ran large budget deficits in the early 2000s, the interest rate did
not rise substantially. Which of the following is among the reasons that crowding out did not raise
interest rates at that time?
A. Americans increased their willingness to save at the same time that the budget deficits
appeared.
B. The government spent the borrowed money in such a way that productivity and therefore the
availability of savings dramatically increased.
C. The Federal Reserve decreased the money supply.
D. Foreigners were willing to finance the U.S. deficit with their abundant supply of savings.
28. Fiscal policy would be more effective if:
A. potential income was unknown.
B. the government could change taxes and expenditures rapidly.
C. the size of the government debt didn’t matter.
D. crowding out occurred more often.
29. Using fiscal policy to stabilize the economy is difficult because:
A. potential income is known.
B. the effects of policy changes is known with certainty.
C. there are time lags involved in the use of fiscal policy.
D. the size of the government debt doesn’t matter.
30. Fine tuning the economy with fiscal policy is:
A. relatively simple because the government has access to the best information available.
B. difficult because the government lacks important information about the economy.
C. relatively simple because the political process usually works smoothly and without significant
lags.
D. difficult because economists have not developed any theoretical models of the macroeconomy.
31. According to most economists, fiscal policy is:
A. not an effective tool for fine tuning the economy.
B. least useful in a serious economic crisis.
C. always ineffective because of crowding out.
D. effective only when potential output is perfectly known.
32. Refer to the graph shown. Expansionary fiscal policy is most likely to shift the aggregate
demand curve from:
A. AD0 to AD2 if crowding out does not occur and from AD0 to AD1 if crowding out does occur.
B. AD0 to AD2 if crowding out does not occur and from AD0 to AD3 if crowding out does occur.
C. AD2 to AD0 if crowding out does not occur and from AD1 to AD2 if crowding out does occur.
D. AD2 to AD0 if crowding out does not occur and from AD1 to AD3 if crowding out does occur.
33. Refer to the graph shown. Expansionary fiscal policy shifts the aggregate demand curve from:
A. AD0 to AD2 but then back to AD1 if crowding out occurs.
B. AD0 to AD2 but then out to AD3 if crowding out occurs.
C. AD0 to AD2 whether or not crowding out occurs.
D. AD2 to AD1 and then from AD1 to AD0 if crowding out occurs.
34. Refer to the graph shown. Suppose the government borrows $50 million to finance an
increase in its spending and that as a result, the level of investment is reduced by $50 million. In
this case, the aggregate demand curve will:
A. shift from AD0 to AD2 but then back to AD1.
B. shift from AD0 to AD2 but then out to AD3.
C. shift from AD0 to AD2.
D. not shift.
35. If a government finances an increase in its expenditures by selling bonds to the public, then the
aggregate demand curve will:
A. not shift.
B. shift out but not as much as it would if crowding out didn’t occur.
C. shift out by the same amount regardless of whether crowding out occurs.
D. shift out more if crowding out occurs.
36. When the government runs a deficit, the interest rate tends to:
A. rise.
B. fall.
C. remain unchanged.
D. rise or fall, depending on how the deficit is financed.
37. Reducing the budget deficit by cutting government spending could conceivably:
A. increase income if interest rates fall enough and private investment is more productive than
government spending.
B. increase income if interest rates rise enough and government spending is more productive than
private investment.
C. decrease income if interest rates fall too much and private investment is more productive than
government investment.
D. decrease income if interest rates rise enough and private investment is more productive than
government investment.
38. Between 1999 and 2009, the U.S. federal budget deficit moved from a record surplus to a
record deficit. Other things being equal, the most likely effect of this shift would be:
A. higher interest rates and increased investment.
B. higher interest rates and decreased investment.
C. lower interest rates and increased investment.
D. lower interest rates and decreased investment.
39. Although macroeconomics textbooks have taught the logic of fiscal policy for over half a
century, actual use of discretionary fiscal policy has been rare. When President George W. Bush
persuaded Congress to enact a large tax cut early in his presidency, it was the first time in several
decades that the fiscal policy rationale was taken seriously. Why has fiscal policy been used so
infrequently?
A. It has inherent conflicts with monetary policy.
B. Concern about exchange-rate stabilization has limited its effectiveness.
C. The political processes of democracy make timely fiscal policy difficult.
D. Fiscal policy has proven to be too strong a medicine for the small economic fluctuations we
have had.
40. Crowding out would most likely occur when:
A. workers lose jobs as a result of anti-inflationary fiscal policies.
B. the federal government engages in bond sales to finance its budget deficit.
C. Congress enacts budget cuts to balance the budget.
D. tax receipts rise more slowly than anticipated, resulting in the need to cut government
spending.
41. Crowding out is associated with:
A. a reduction in business investment resulting from an increase in government borrowing and
higher interest rates.
B. an increase in business investment resulting from an increase in government borrowing and
higher interest rates.
C. an increase in private savings caused by higher future tax liabilities when government increases
borrowing.
D. a decrease in government spending caused by a shortage of available credit.
42. When the government runs a deficit it must:
A. buy bonds to finance the deficit.
B. sell bonds to finance the deficit.
C. decrease the money supply to finance the deficit.
D. raise taxes immediately.
43. When interest rates go up, it is:
A. more expensive for businesses to borrow, so investment falls.
B. more expensive for businesses to borrow, so investment increases.
C. cheaper for businesses to borrow, so investment falls.
D. cheaper for businesses to borrow, so investment increases.
44. If private investment is relatively sensitive to interest rates, then a fiscal expansion financed by
government bond sales will:
A. have no effect on output.
B. raise output by a relatively small amount.
C. raise output by a relatively large amount.
D. have an ambiguous effect on output.
45. If a fiscal expansion financed by government bond sales does not affect interest rates, then:
A. no crowding out will occur.
B. crowding out will be relatively small.
C. crowding out will be relatively large.
D. crowding out will be so great that output will decline.
46. Suppose the government increases spending by $30 billion and raises taxes by $20 billion at
the same time. Then:
A. interest rates will most likely stay the same.
B. interest rates will most likely increase.
C. business investment is not likely to change.
D. business investment is likely to increase due to crowding out.
47. If interest rates adjust to equate savings and investment, then an expansionary fiscal policy is:
A. more likely to increase interest rates and less likely to crowd out investment.
B. more likely to increase interest rates and more likely to crowd out investment.
C. less likely to increase interest rates and less likely to crowd out investment.
D. less likely to increase interest rates and more likely to crowd out investment.
48. Crowding out will be less likely to occur if:
A. interest rates rise when the budget deficit increases.
B. interest rates fall when the budget deficit decreases.
C. business investment does not depend on interest rates.
D. business investment depends on interest rates.
49. Crowding out:
A. increases the multiplier effect, so that an increase in government spending raises income by
more.
B. increases the multiplier effect, so that an increase in government spending raises income by
less.
C. decreases the multiplier effect, so that an increase in government spending raises income by
more.
D. decreases the multiplier effect, so that an increase in government spending raises income by
less.
50. The crowding out effect:
A. increases the multiplier effect, so that an increase in taxes reduces income by more.
B. increases the multiplier effect, so that an increase in taxes reduces income by less.
C. decreases the multiplier effect, so that an increase in taxes reduces income by more.
D. decreases the multiplier effect, so that an increase in taxes reduces income by less.
51. Expansionary fiscal policy that raises the budget deficit may:
A. reduce business investment by increasing interest rates.
B. reduce business investment by reducing interest rates.
C. increase business investment by increasing interest rates.
D. increase business investment by reducing interest rates.
52. A decrease in the budget deficit will have a:
A. more negative effect on income when crowding out is strong.
B. more positive effect on income when crowding out is weak.
C. less negative effect on income when crowding out is strong.
D. less positive effect on income when crowding out is weak.
53. Contractionary fiscal policy that reduces the budget deficit may:
A. reduce business investment by increasing interest rates.
B. reduce business investment by reducing interest rates.
C. increase business investment by increasing interest rates.
D. increase business investment by reducing interest rates.
54. If the government knew the precise values of the multiplier and potential income, fine-tuning
the economy would:
A. be possible.
B. be much easier but mistakes would still occur occasionally.
C. still be very difficult.
D. be more difficult.
55. In practice, economists:
A. agree about what the level of potential output is but disagree about what policies are
appropriate.
B. disagree about what the level of potential output is but agree about what policies are
appropriate.
C. agree about what the level of potential output is and about what policies are appropriate.
D. disagree about what the level of potential output is and about what policies are appropriate.