978-1259663048 Chapter 32 Solutions Manual

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CHAPTER 32: THE FISCAL POLICY DILEMMA

Questions and Exercises

1. a. No effect. According to the Ricardian equivalence theorem paying for an increase

b. No effect. According to the Ricardian equivalence theorem deficit spending

c. The implication is that government ought to follow a policy of sound finance.

2. According to the Ricardian equivalence theorem, the aggregate demand curve

3. Sound finance does not depend on the Ricardian equivalence theorem because

4. Functional finance is the theoretical proposition that government should make

5. a According to sound finance theory, there is no room for activist fiscal policy

b. According to the functional finance theory, there is room for activist fiscal policy.

6. Functional finance is difficult to implement because (1) financing the deficit often

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7. When the government runs a budget deficit, it must sell bonds to finance that

8. If interest rates have no effect on investment, there would be no crowding out.

9. a. With full crowding out, the AD curve shifts back to its original position and fiscal

b. With partial crowding out, the AD curve shifts back partway to the left, but not

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c. With full crowding out, the AD curve shifts back to its original position and fiscal

policy has no effect on the economy. If private investment is more productive,

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10. a Increasing taxes shifts the aggregate demand curve in to the left, decreasing real

b. The increase in taxes will require government to finance a lower budget deficit,

which will lower interest rates. As interest rates fall, investment rises. The

Solutions Manual

c. If there is complete crowding out, the rise in investment will completely offset the

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11. In a $10 trillion dollar economy, the estimate of potential output differs by $200

12. The budget process begins a year and a half before the budget is implemented,

13. Increasing government spending shifts out aggregate demand and thereby

increases income and reduces unemployment shown as a movement from point A

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14. Increasing taxes shifts the aggregate demand curve in to the left, decreasing

15. The assumption that the size of the debt doesn’t matter has been called into

16. State balanced budget requirements are pro-cyclical because during downturns,

tax revenue generally falls, making it necessary for state governments to raise tax

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17. Automatic stabilizers reduce taxes and raise expenditures during contractions

18. Automatic stabilizers increase taxes and reduce expenditures during an expansion,

which act to slow the recovery.

Questions from Alternative Perspectives

1. Austrian

Austrians believe that individuals know what is in their best interest and that savings

2. Post-Keynesian

a. In the standard argument the unemployment was caused by a fall in aggregate

b. The standard model assumes that as demand falls, the LAS curve will not move.

Post Keynesians see the LAS curve as something of an illusion; when demand

falls, supply falls with it, which means that a fall in the price level will not solve

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3. Institutionalist

These voter initiatives are generally financed by out-of-state anti-taxation groups. Of

4. Radical

a. Radical economists believe that it would take a firm commitment by government

b. A full employment regime would give workers much more power and reduce the

c. Within today’s political environment it is highly unlikely that any true full

5. Religius

a. Society is deeply divided about the weights that should be given to various goals,

b. Religious economists believe that religious beliefs should play a central role in

Issues to Ponder

1. a. In 1995 the unemployment rate fell below the target rate of 6 percent without

b. It would shift the LAS curve to the right. Eventually the price level will fall and

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c. A 0.5 percentage point decline in the target unemployment rate would imply a rise

2. a. President Clinton’s policy does not fit well with the multiplier model because with

b. His policy might have the desired effect if a reduction in government expenditures

c. The reduction in the deficit shifts the AD curve to the left from AD0 to AD1 from

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d. I would look at interest rates and investment expenditures to see if the explanation

3. a. In the standard AS/AD model, a tax cut will shift the AD curve to the right,

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