∆T = change in aggregate demand / tax multiplier ∆T = -$500 billion / -4 = $125 billion The correct answer is increasing taxes by $125 billion.

1. Chapter 21
Fiscal Policy
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
©2000 South-Western College Publishing
1

2. In this chapter, you will
learn to solve these
economic puzzles:
Why Can Ronald Reagan a
Is andid Congress fight think
increase in government
spending orgovernment could
the federal a tax cut of equal
recession without by
increase tax revenues
amount the greater stimulus
taking any action?
cutting taxes?
to economic growth?
2

3. What is a Discretionary
Fiscal Policy?
The deliberate use of
changes in government
spending or taxes to alter
aggregate demand and
stabilize the economy
3

4. What are examples of
Expansionary Fiscal Policy?
• Increase government
spending
• Decrease taxes
• increase government
spending and taxes equally
4

5. What are examples of
Contractionary Fiscal Policy?
• Decrease government
spending
• Increase taxes
• Decrease government
spending and taxes equally
5

6. Government Spending to Combat a
Recession
Price Level AS
E2
155
155
E1 X
150
AD1 AD2
Full Employment
Real GDP
0 $6 $6.1 $6.2
6

7. Increase in the
price level and
the real GDP
Increase in the
aggregate
demand curve
Increase in
government
spending 7

8. With an MPC of
0.75, what is the
Spending Multiplier?
1/1-MPC = 1/1-0.75 =
1/25/100 = 1 /  = 4
8

9. How much will real GDP
increase by with an
increase in government
spending of $50 bil?
4 x $50 bil = $200 bil
9

10. What is the
Tax Multiplier?
The change in aggregate
demand (total spending)
resulting from an initial
change in taxes
10

11. What happens when
government cuts
taxes by $50 bil?
The multiplier process is
less because initial
spending increases only by
$38 bil instead of $50 bil
11

12. What is the formula for
the Tax Multiplier?
1 – spending multiplier
12

13. How much does real GDP
increase by with a cut in
taxes of $50 bil?
3 x $50 bil = $150 bil
13

14. Can we assume that the
MPC will remain fixed?
No, it can change from one
time period to another
14

15. Can Fiscal Policy be used
to combat Inflation?
Yes, this would happen
when the economy is
operating in the Classical
or Intermediate range of
the aggregate supply curve
15

16. What will happen to
AD with a cut in G
spending of 25 bil?
-$25 bil x 4 = -$100 bil
16

17. Using Fiscal Policy to
Price Level Combat Inflation
AS
160 E1
E´
155
E2 AD1
Full
AD2 Employment
0 $6 $6.1 Real GDP
17

18. Decrease in
the price level
Decrease in
the aggregate
demand curve
Decrease in
government
spending 18

19. What will happen
to AD with a cut in
Taxes of 33.3 bil?
$33.3 x -3 = -$100 bil
19

20. What is the Balanced
Budget Multiplier?
An equal change in
government spending and
taxes, which changes
aggregate demand by the
amount of the change in
government spending
20

21. What is an
Automatic Stabilizer?
Federal expenditures and
tax revenues that
automatically change
levels in order to
stabilize an economic
expansion or contraction
21

22. What are examples of
Automatic Stabilizers?
• Transfer payments
• Unemployment compensation
• Welfare
22

23. What is a
Budget Surplus?
A budget in which
government revenues
exceed government
expenditures in a
given time period
23

24. What is a Budget Deficit?
A budget in which
government expenditures
exceed government
revenues in a given time
period
24

25. $2,500 Automatic Stabilizers
T
$1,000 G Spending and Taxes
surplus
Budget
Budget
deficit
$750
$500
$250 G
Real GDP
$4 $6 $8
25

26. Budget offsets
inflation
Tax collections fall
and government
transfer payments rise
Increase in
real GDP
26

27. Budget offsets
recession
Tax collections fall
and government
transfer payments rise
Decrease in
real GDP
27

28. What is Supply-Side
Fiscal Policy?
A fiscal policy that
emphasizes government
policies that increase
aggregate supply
28

29. What is the purpose
of Supply-Side
Fiscal Policies?
To achieve long-run
growth in real output,
full employment, and
a lower price level
29

30. Demand-Side Fiscal Policy
Price Level AS
250
E2
200 Full
E1 Employment
150
AD2
100
AD1
Real GDP
0 2 4 6 8 10 12
30

31. Increase in the
aggregate
demand curve
Increase in
government
spending; decrease in
net taxes
31

32. Supply-Side Fiscal Policy
Price Level AS1
250
AS2
200
E1
150 Full
E2 Employment
100
AD
Real GDP
0 2 4 6 8 10 12
32

33. Increase in the
aggregate
supply curve
Decrease in resource
prices; technological
advances; subsidies;
decrease in
regulations
33

34. Supply-Side Policies Affect Labor
Markets tax-cut
Before After tax-cut
labor supply labor supply
E1
Wage rate
W1
W2 E2
Labor
Q of Labor Demand
0 L1 L2
34

35. Will an increase in Taxes
lead to higher
Government Revenues?
That depends on
where the economy is
on the Laffer Curve
35

36. What is the
Laffer Curve?
Puts forth the idea that
increasing taxes from zero
will increase tax revenues
up to a certain point
36

37. What happens beyond
a certain point?
Tax revenues begin to
decline as the economic
pie begins to shrink
37

38. Why does the Economic
Pie begin to shrink?
Workers have less
incentive to work and
investors have less of an
incentive to invest
38

39. The Laffer Curve
B
Rmax Federal Tax Revenue
C
R
A Federal Tax Rate D
0 Tmax T 100%
39

40. Key Concepts
40

41. Key Concepts
• What is a Discretionary Fiscal Policy?
• What are examples of Expansionary Fiscal Policy
• What are examples of Contractionary Fiscal Poli
• With an MPC of 0.75, what is the Multiplier?
• How much will real GDP increase by with an incr
41

42. Key Concepts cont.
• What is the Tax Multiplier?
•
What is the formula for the Tax Multiplier?
• Can Fiscal Policy be used to combat Inflation?
• What will happen to AD with a cut in G spend
• What is the Balanced Budget Multiplier?
42

43. Key Concepts cont.
• What is an Automatic Stabilizer?
• What is a Budget Surplus?
• What is a Budget Deficit?
• What is Supply Side Fiscal Policy?
• What is the Laffer Curve?
43

44. Summary
44

45. Fiscal policy is the use of
government spending, taxes, and
transfer payments for the purpose of
stabilizing the economy.
45

46. Discretionary fiscal policy follows
the Keynesian argument that the
federal government should manipulate
aggregate demand in order to influence
the output, employment, and price
levels in the economy. Discretionary
fiscal policy requires either new
legislation to change government
spending or taxes in order to stabilize
the economy.
46

47. Expansionary fiscal policy is a
deliberate increase in government
spending, a deliberate decrease in
taxes, or some combination of these
two options.
47

48. Contractionary fiscal policy is a
deliberate decrease in government
spending, a deliberate increase in
taxes, or some combination of these
two options. Using either
expansionary or contractionary fiscal
policy, the government can shift the
aggregate demand curve in order to
combat recession, cool inflation, or
achieve other macroeconomic goals.
48

49. Discretionary Fiscal Policies
Expansionary Contractionary
• Increase government • Decrease government
spending spending
• Decrease taxes • Increase taxes
• Increase government • Decrease government
spending and taxes spending and taxes
equally equally
49

50. The tax multiplier is the
multiplier by which an initial
change in taxes changes aggregate
demand (total spending) after an
infinite number of spending cycles.
Expressed as a formula, the tax
multiplier = 1 - spending multiplier.
50

51. A balanced budget multiplier in
not neutral. A dollar of government
spending increases real GDP more
than a dollar cut in taxes. Thus, even
though the government does not spend
more than it collects in taxes, it is still
stimulating the economy.
51

52. Combating recession and inflation
can be accomplished by changing
government spending or taxes. The
total change in aggregate demand
from a change in government
spending is equal to the change in
government spending times the
spending multiplier. The total change
in aggregate demand from a change in
taxes is equal to the change in taxes
times the tax multiplier.
52

53. Increase in the
price level and
the real GDP
Increase in the
aggregate
demand curve
Increase in
government
spending 53

54. Decrease in
the price level
Decrease in
the aggregate
demand curve
Decrease in
government
spending 54

55. A budget surplus occurs when
government revenues exceed government
expenditures. A budget deficit occurs
when government expenditures exceed
government revenues.
55

56. Automatic stabilizers are changes
in taxes and government spending that
occur automatically in response to
changes in the level of real GDP. The
business cycle therefore creates
braking power: A budget surplus slows
down an expanding economy. A
budget deficit reverses a downturn in
the economy.
56

57. $2,500 Automatic Stabilizers
T
$1,000 G Spending and Taxes
surplus
Budget
Budget
deficit
$750
$500
$250 G
Real GDP
$4 $6 $8
57

58. According to supply-side fiscal
policy, lower taxes encourage work,
saving, and investment, which shift
the aggregate supply curve rightward.
As a result, output and employment
increase without inflation.
58

59. The Laffer curve represents the
relationship between the income tax
rate and the amount of income tax
revenue collected by the government.
59

60. Chapter 21 Quiz
©2000 South-Western College Publishing
60

61. 1. Contractionary fiscal policy is deliberate
government action to influence aggregate
demand and the level of real GDP through
a. expanding and contracting the money
supply.
b. encouraging business to expand or contract
investment.
c. regulating net exports.
d. decreasing government spending or
increasing taxes.
D. The money supply is under control of the
Federal Reserve and not Congress.
61

62. 2. The spending multiplier is defined as
a. 1 / (1 - marginal propensity to consume).
b. 1 / (marginal propensity to consume).
c. 1 / (1 - marginal propensity to save).
d. 1 / (marginal propensity to consume +
marginal propensity to save.
A. The spending multiplier is also defined
as 1/MPS.
62

63. 3. If the marginal propensity to consume
(MPC) is 0.60, the value of the spending
multiplier is
a. 0.4.
b. 0.6.
c. 1.5.
d. 2.5.
D. Spending multiplier = 1 / (1 - MPC) =
1 / (1 - 0.60) = 1 / 40/100 = 5 / 2 = 2.5
63

64. 4. Assume the economy is in recession and real GDP is
below full employment. The marginal propensity to
consume (MPC) is 0.80, and the government increases
spending by $500 billion. As a result, aggregate
demand will rise by
a. zero.
b. $2,500 billion.
c. more than $2,500 billion.
d. less than $2,500 billion.
B. Change in aggregate demand (∆Y) = initial change in
government spending (∆G) x spending multiplier.
Spending multiplier = 1 / 1 - MPC) = 1 / (1 - 0.80) = 1 /
20/100 = 5
∆Y = $500 billion x 5
∆Y = $2,500 billion
64

65. 5. Mathematically, the value of the tax
multiplier in terms of the marginal
propensity to consume (MPC) is given by the
formula
a. MPC − 1.
b. (MPC − 1) MPC.
c. 1 / MPC.
d. 1 − [1 / 1 − MPC)].
D. The tax multiplier is also stated as Tax
multiplier = 1 - spending multiplier.
65

66. 6. Assume the marginal propensity to consume
(MPC) is 0.75 and the government increases
taxes by $250 billion. The aggregate demand
curve will shift to the
a. left by $1,000 billion.
b. right by $1,000 billion.
c. left by $750 billion.
d. right by $750 billion.
C. The tax multiplier is -3 (1 - spending
multiplier) and -3 times $250 equals a $750
billion decrease. The movement is left because
consumers have less money to spend.
66

67. 7. If no fiscal policy changes are made, suppose the
current aggregate demand curve will increase
horizontally by $1,000 billion and cause inflation. If
the marginal propensity to consume (MPC) is 0.80,
federal policymakers could follow Keynesian
economics and restrain inflation by
a. decreasing government spending by $200 billion.
b. decreasing taxes by $100.
c. decreasing taxes by $1,000 billion.
d. decreasing government spending by $1000 billion.
A. Change in government spending (∆G) x spending multiplier =
change in aggregate demand, rewritten:
∆G = change in aggregate demand / spending multiplier
Spending multiplier = 1 / (1-MPC) = 1 / (1-0.80) = 1 / 20/100 = 5
∆G = -$1,000/5, ∆G = -$200 billion.
67

68. 8. If no fiscal policy changes are implemented, suppose the future
aggregate demand curve will exceed the current aggregate
demand curve by $500 billion at any level of prices. Assuming
the marginal propensity to consume is 0.80, this increase in
aggregate demand could be prevented by
a. increasing government spending by $500 billion.
b. increasing government spending by $140 billion.
c. decreasing taxes by $40 billion.
d. increasing taxes by $125 billion.
D. Change in taxes (∆T) x tax multiplier = change in aggregate
demand, rewritten:
Tax multiplier = 1 - spending multiplier
Spending multiplier = 1 / (1-MPC) = 1 / (1-0.80) = 1 / 20/100 = 5
Tax multiplier = 1 - 5 = -4, ∆T x -4 = -$500 billion
T = $125 billion
68

69. 9. Suppose inflation is a threat because the
current aggregate demand curve will increase
by $600 billion at any price level. If the
marginal propensity to consume (MPC) is 0.75,
federal policy-makers could follow Keynesian
economics and restrain inflation by
a. decreasing taxes by $600 billion.
b. decreasing transfer payments by $200
billion.
c. increasing taxes by $200 billion.
d. increasing government spending by $150
billion.
C. 3 x $200 billion = $600 billion.
69

70. 10. If no fiscal policy changes are implemented, suppose
the future aggregate demand curve will shift and
exceed the current aggregate demand curve by $900
billion at any level of prices. Assuming the marginal
propensity to consume is 0.90, this increase in
aggregate demand could be prevented by
a. increasing government spending by $500 billion.
b. increasing government spending by $140 billion.
c. decreasing taxes by $40 billion.
d. increasing taxes by $100 billion.
D. Change in taxes (T) x tax multiplier = change in
aggregate demand, rewritten:
Tax multiplier = 1 - spending multiplier
Spending multiplier = 1 / (1-MPC) = 1/(1-0.90) =
1/10/100 = 10 70

71. 11. Which of the following is not an automatic
stabilizer?
a. Defense spending.
b. Unemployment compensation benefits.
c. Personal income taxes.
d. Welfare payments.
A. Defense spending does not automatically
change levels as real GDP changes.
71

72. 12. Supply-side economics is most closely
associated with
a. Karl Marx.
b. John Maynard Keynes.
c. Milton Friedman.
d. Ronald Reagan.
D. The most familiar supply-side economic
policy of the Reagan administration was
the tax cuts implemented in 1981.
72

73. 13. Which of the following statements is true?
a. A reduction in tax rates along the downward-
sloping portion of the Laffer curve would increase
tax revenues.
b. According to supply-side fiscal policy, lower tax
rates would shift the aggregate demand curve to
the right, expanding the economy and creating
some inflation.
c. The presence of automatic stabilizers tends to
destabilize the economy.
d. To combat inflation, Keynesians recommend
lower taxes and greater government spending.
A.
73

74. The Laffer Curve
B
Rmax Federal Tax Revenue
C
R
A Federal Tax Rate D
0 Tmax T 100%
74

75. Internet Exercises
Click on the picture of the book,
choose updates by chapter for
the latest internet exercises
75

76. END
76