978-0077660772 Chapter 13 Solution Manual Part 1

Chapter 13 – Fiscal Policy, Deficits, and Debt

20e McConnell, Brue, and Flynn

DISCUSSION QUESTIONS

1. What is the role of the Council of Economic Advisers (CEA) as it relates to fiscal policy? Use

an Internet search to find the names and university affiliations of the present members of the

CEA. LO1

Answer: The CEA advises the President on economic matters, and provides

2. What are government’s fiscal policy options for ending severe demand-pull inflation? Which of

these fiscal options do you think might be favored by a person who wants to preserve the size of

government? A person who thinks the public sector is too large? How does the “ratchet effect”

affect anti-inflationary fiscal policy? LO1

Answer: Options are to reduce government spending, increase taxes, or some

combination of both. See the figure blow. If the price level is flexible downward,

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Chapter 13 – Fiscal Policy, Deficits, and Debt

3. (For students who were assigned Chapter 29) Use the aggregate expenditures model to show

how government fiscal policy could eliminate either a recessionary expenditure gap or an

inflationary expenditure gap (Figure 29.7). Explain how equal-size increases in G and T could

eliminate a recessionary gap and how equal-size decreases in G and T could eliminate an

inflationary gap. LO1

Answer: Consider the figure below. At AE2 there is an inflationary expenditure

gap of $500 (assuming full-employment output is $2000). The fiscal authority

Equal-size increases (decreases) in G and T could eliminate a recessionary

(inflationary) expenditure gap because the multiplier effects of a change in

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Chapter 13 – Fiscal Policy, Deficits, and Debt

Example: Recessionary (inflationary) expenditure gap of $500 billion, MPC of

0.5. An increase (decrease) in G of $500 billion will generate a $1000 billion

4. Some politicians have suggested that the United States enact a constitutional amendment

requiring that the Federal government balance its budget annually. Explain why such an

amendment, if strictly enforced, would force the government to enact a contractionary fiscal

policy whenever the economy experienced a severe recession. LO1

Answer: When the economy enters a recession, net tax revenue falls. Specifically,

revenues from income and excise taxes decline as unemployment rises and

5. Explain how built-in (or automatic) stabilizers work. What are the differences between

proportional, progressive, and regressive tax systems as they relate to an economy’s built-in

stability? LO2

Answer: In a phrase, “net tax revenues vary directly with GDP.” When GDP is

rising so are tax collections, both income taxes and sales taxes. At the same time,

government payouts—transfer payments such as unemployment compensation,

and welfare—are decreasing. Since net taxes are taxes less transfer payments, net

A progressive tax system would have the most stabilizing effect of the three tax

systems and the regressive tax would have the least built-in stability. This follows

from the previous paragraph. A progressive tax increases at an increasing rate as

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Chapter 13 – Fiscal Policy, Deficits, and Debt

6. Define the cyclically-adjusted budget, explain its significance, and state why it may differ from

the actual budget. Suppose the full-employment, noninflationary level of real output is GDP3 (not

GDP2) in the economy depicted in Figure 13.3. If the economy is operating at GDP2, instead of

GDP3, what is the status of its cyclically-adjusted budget? The status of its current fiscal policy?

What change in fiscal policy would you recommend? How would you accomplish that in terms of

the G and T lines in the figure? LO3

Answer: The cyclically-adjusted budget measures what the Federal deficit or

surplus would be if the economy reached full-employment level of GDP with

Looking at Figure 13.3, if full-employment GDP is GDP3, then the cyclically-

adjusted budget is contractionary since a surplus would exist. Even though the

7. Briefly state and evaluate the problem of time lags in enacting and applying fiscal policy.

Explain the idea of a political business cycle. How might expectations of a near-term policy

reversal weaken fiscal policy based on changes in tax rates? What is the crowding-out effect, and

why might it be relevant to fiscal policy? In view of your answers, explain the following

statement: “Although fiscal policy clearly is useful in combating the extremes of severe recession

and demand-pull inflation, it is impossible to use fiscal policy to fine-tune the economy to the

full-employment, noninflationary level of real GDP and keep the economy there indefinitely.”

LO5

Answer: It takes time to ascertain the direction in which the economy is moving

(recognition lag), to get a fiscal policy enacted into law (administrative lag); and

A political business cycle is the concept that politicians are more interested in

reelection than in stabilizing the economy. Before the election, they enact tax cuts

A decrease in tax rates might be enacted to stimulate consumer spending. If

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Chapter 13 – Fiscal Policy, Deficits, and Debt

The crowding-out effect is the reduction in investment spending caused by the

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Chapter 13 – Fiscal Policy, Deficits, and Debt

As suggested, the other answers help explain the quote. While fiscal policy is

useful in combating the extremes of severe recession with its built-in “safety nets”

and stabilization tools, and while the built-in stabilizers can also dampen spending

Even if it were possible to do any fine tuning to get the economy to its ideal level

8. How do economists distinguish between the absolute and relative sizes of the public debt? Why

is the distinction important? Distinguish between refinancing the debt and retiring the debt. How

does an internally held public debt differ from an externally held public debt? Contrast the effects

of retiring an internally held debt and retiring an externally held debt. LO6

Answer: There are two ways of measuring the public debt: (1) measure its

absolute dollar size; (2) measure its relative size as a percentage of GDP. The

distinction is important because the absolute size doesn’t tell you about an

Refinancing the public debt simply means rolling over outstanding debt—selling

An internally held debt is one in which the bondholders live in the nation having

the debt; an externally held debt is one in which the bondholders are citizens of

However, the dollars gained could be simply exchanged for foreign currency and

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Chapter 13 – Fiscal Policy, Deficits, and Debt

9. True or false? If false, explain why. LO6

a. The total public debt is more relevant to an economy than the public debt as a percentage of

GDP.

b. An internally held public debt is like a debt of the left hand owed to the right hand.

c. The Federal Reserve and Federal government agencies hold more than three-fourths of the

public debt.

d. The portion of the U.S. debt held by the public (and not by government entities) was larger as a

percentage of GDP in 2009 than it was in 2000.

e. As a percentage of GDP, the total U.S. public debt is the highest such debt among the world’s

advanced industrial nations.

Answer: a. False. There are two ways of measuring the public debt: (1) measure

its absolute dollar size and (2) measure its relative size as a percentage of

b. True, but this does not mean a large debt is entirely problem free.

10. Why might economists be quite concerned if the annual interest payments on the U.S. public

debt sharply increased as a percentage of GDP? LO6

Answer: The weight of the debt is not its absolute size. Indeed, if there were no

interest to be paid on the debt and refinancing was automatic, there would be no

11. Trace the cause-and-effect chain through which financing and refinancing of the public debt

might affect real interest rates, private investment, the stock of capital, and economic growth.

How might investment in public capital and complementarities between public capital and private

capital alter the outcome of the cause-effect chain? LO6

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Chapter 13 – Fiscal Policy, Deficits, and Debt

Answer: Cause and effect chain: Government borrowing to finance the debt

competes with private borrowing and drives up the interest rate; the higher

12. LAST WORD What do economists mean when they say Social Security and Medicare are

“pay-as-you-go” plans? What are the Social Security and Medicare trust funds, and how long will

they have money left in them? What is the key long-run problem of both Social Security and

Medicare? Do you favor increasing taxes or do you prefer reducing benefits to fix the problem?

Answer: Social Security and Medicare are largely an annual “pay-as-you-go” plan,

Social Security and Medicare trust funds are assets held by these programs to help pay

The key problem is that the United States’ population is aging. That is, the fraction of the

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