SECTION I
A. 1. There are four possible shocks that can occur in an economy:
A. Positive demand shock (e.g., consumer confidence increases) C___
B. Negative demand shock (e.g., the stock market has done poorly and people feel poorer) B___
C. Positive supply shock (e.g., new technology leads to cost savings in many industries) A_
D. Negative supply shock (e.g., the cost of oil rises due to increased unrest in the Middle East) D_
Determine which of the following statements best describes each of the shocks. Enter one letter (from the list below) of your choice for each shock described above.
a. It would be good regardless of the current state of the economy.
b. It would be good if the economy is in an inflationary gap.
c. It would be good if the economy is in a recessionary gap.
d. It would never be good for the economy.
B. Explain whether the following government policies affect the aggregate demand curve or the short-run
aggregate supply curve and how. What will happen to the aggregate price level and aggregate output in each case?
a. The government reduces the minimum nominal wage.
- The government reducing the minimum nominal wage would shift the (AD, SRAS) SRAS____
curve to the (right or R, left or L) R______. - This would (increase or +, decrease or -) – the aggregate price level and (increase or +,
decrease or -) +__ aggregate output.
b. The government increases Temporary Assistance to Needy Families (TANF) payments, government transfers to poor families with dependent children.
- The government increasing TANF payments would shift the (AD, SRAS) AD____ curve to the
(right or R, left or L) R____. - This would (increase or +, decrease or -) – the aggregate price level and (increase or +,
decrease or -) I aggregate output.
c. To reduce the budget deficit, the government announces that households will pay much higher taxes beginning next year.
- The increase in taxes would shift the (AD, SRAS) AD curve to the (right or R, left or L)
L. - This would (increase or +, decrease or -) D__ the aggregate price level and (increase or +,
decrease or -) D aggregate output.
d. The government reduces military spending.
- The decrease in military spending would shift the (AD, SRAS) AD__ curve to the (right or R,
left or L) L____. - This would (increase or +, decrease or -) -_ the aggregate price level and (increase or +,
decrease or -) -_ aggregate output.
C. An economy is in long-run macroeconomic equilibrium when each of the following aggregate demand shocks occurs.
(1) What kind of gap—inflationary or recessionary—will the economy face after the shock?
(2) What type of fiscal policies would help move the economy back to potential output?
(3) How would your recommended fiscal policy shift the aggregate demand curve?
a. A stock market bust decreases the value of stocks held by households.
- A decrease in the value of stocks held by households would cause aggregate demand to (increase or +, decrease or -) – resulting in a(n) (inflationary or I, recessionary or R) _R___ gap.
- (Contractionary or C, Expansionary or E) E__ fiscal policy would help move the economy back to potential output by shifting the aggregate demand curve to the (right or R, left or L) R______.
b. Firms come to believe that a recession in the near future is likely.
- Firms expecting a recession to occur would cause aggregate demand to (increase or +, decrease or -) – resulting in a(n) (inflationary or I, recessionary or R) R__ gap.
- (Contractionary or C, Expansionary or E) E__ fiscal policy would help move the economy back to potential output by shifting the aggregate demand curve to the (right or R, left or L) _R.
c. Anticipating the possibility of war, the government increases its purchases of military equipment.
- Increasing government purchases of military equipment would cause aggregate demand to
(increase or +, decrease or -) I_ resulting in a(n) (inflationary or I, recessionary or R) I__
gap. - (Contractionary or C, Expansionary or E) C__ fiscal policy would help move the economy back to potential output by shifting the aggregate demand curve to the (right or R, left or L) L__.
d. The quantity of money in the economy declines and interest rates increase.
- An increase in interest rates would cause aggregate demand to (increase or +, decrease or -) – _ resulting in a(n) (inflationary or I, recessionary or R) _R gap.
- (Contractionary or C, Expansionary or E) E__ fiscal policy would help move the economy back to potential output by shifting the aggregate demand curve to the (right or R, left or L) R.
D. Show why a $100 increase in government purchases of goods and services will have a larger effect on real
GDP than a $100 increase in government transfers or a $100 decrease in taxes by completing the accompanying table. The economy has a marginal propensity to consume (MPC) of 0.6.
When answers aren’t whole dollars round each answer to two (2) decimal places (e.g., 51.6678 = 51.67)
before summing in 18 – 20. All submitted answers should also be entered with two (2) decimal places.
The table below shows what happens when either government spending (G) or transfer payments (TR) are
increased by $100 or taxes (T) are decreased by $100. In the first round the increase in government spending
(G) immediately increases GDP by $100 (since the government purchased goods and services). It also immediately increases disposable income (YD) by $100 since the government spending becomes income to someone.
When transfer payments are increased by $100, or taxes (T) are decreased by the same amount GDP does not increase in the first round as no goods or services were purchased. All a change in transfer payments or
taxes does in the first round is change disposable income (YD).
In the second round, the same thing occurs in all three cases. Since YD increased by $100 in Round 1
consumption will increase by $60 in Round 2. This results because people will spend 60% of their change in income and save the other 40% (MPC = 0.6). This round GDP increases by the $60 that consumers spend on goods and services in all three cases. YD also increases by $60 as the money that consumers spend becomes income to someone else.
In Round 3 consumers will spend 60% of the $60 increase in disposable income from Round 2 ($36). Fill in the table below for additional rounds. (Remember to round your answers to two decimal places.) Then
sum the changes in GDP for the 10 rounds.
Again, notice that fiscal policy only causes a change in GDP for a change in G in the first round. The same size change in TR or T does not cause a change in GDP in the first round. Also, note that after the first round
all changes in GDP are the result of changes in C. You only need to total the Δ GDP columns.
If you have any trouble with 18 – 22 please reread the above.
Δ G = $100
(MPC = 0.6)
Δ TR = $100
(MPC = 0.6)
Δ T = – $100
(MPC = 0.6)
Rounds Δ G (or C) Δ GDP Δ YD Δ TR (or C) Δ GDP Δ YD Δ T (or C) Δ GDP Δ YD
1 Δ G = $100 $100 $100 Δ TR = $100 $0 $100 Δ T = – $100 $0 $100
2 Δ C = $60 $60 $60 Δ C = $60 $60 $60 ΔC = $60 $60 $60
3 Δ C = $36 $36 $36 Δ C = $36 $36 $36 Δ C = $36 $36 $36
4
5
6
7
8
9
10
Total X X X X X X
- When government purchases increase by $100, the sum of the changes in real GDP after the 10
rounds is $___248.51_____. This is the total of the 10 rounds. - When the government increases transfer by $100, the sum of the changes in real GDP after the 10
rounds is $__148.51______. This is the total of the 10 rounds. - When the government reduces taxes by $100, the sum of the changes in real GDP after the 10
rounds is $__148.51______. This is the total of the 10 rounds.
Using the formula for the multiplier for changes in government purchases, for changes in transfers, and for
changes in taxes calculate the total change in real GDP due to a $100 increase in government purchases, a
$100 increase in transfers, and a $100 decrease in taxes.
- The spending multiplier is 2.5__. The transfer payment multiplier is 1.5____ and the
tax multiplier is -1.5__. - The change in GDP resulting from a $100 increase in government spending is $___250_____.
The change in GDP resulting from a $100 increase in transfer payments is $__150______. The
change in GDP resulting from a $100 decrease in taxes is $___150_____.
[Your answers in 22 should be close to your answers for 18 to 20. Using a multiplier saves one from
having to determine the results for many rounds and then summing.]
SECTION II
A. In each of the following cases, either a recessionary or inflationary gap exists. Calculate the change in government purchases of goods and services, the change in government transfers, or the change in taxes necessary to close the gap. Use whole numbers (no decimals) as answers in this section.
a. Real GDP equals $100 billion, potential output equals $160 billion, and the marginal propensity to consume is 0.75.
- Government purchases must (increase or +, decrease or -) + by $__15____ billion to
close the (recessionary or R, inflationary or I) R__ gap, OR - Transfer payments must (increase or +, decrease or -) + by $___20_____ billion to close
the (recessionary or R, inflationary or I) R__ gap, OR - Taxes must (increase or +, decrease or -) – by $__20____ billion to close the
(recessionary or R, inflationary or I) R gap.
b. Real GDP equals $250 billion, potential output equals $200 billion, and the marginal propensity to consume
is 0.5.
- Government purchases must (increase or +, decrease or -) – by $____25____ billion to
close the (recessionary or R, inflationary or I) I gap, OR - Transfer payments must (increase or +, decrease or -) – by $___50___ billion to close
the (recessionary or R, inflationary or I) I gap, OR - Taxes must (increase or +, decrease or -) + by $___50___ billion to close the
(recessionary or R, inflationary or I) I gap.
c. Real GDP equals $180 billion, potential output equals $100 billion, and the marginal propensity to consume
is 0.8.
- Government purchases must (increase or +, decrease or -) – by $___16___ billion to
close the (recessionary or R, inflationary or I) I______ gap, OR - Transfer payments must (increase or +, decrease or -) – by $____20_ billion to close
the (recessionary or R, inflationary or I) __I gap, OR - Taxes must (increase or +, decrease or -) I__ by $___20_____ billion to close the
(recessionary or R, inflationary or I) __I gap.
B. Answer the following questions using whole numbers where possible and rounding to one decimal place when the answers are not whole numbers. If the budget balance is negative make sure you include a minus (-) sign.
- Suppose the government spends $500 billion during the fiscal year on goods and services. In addition, the government collects tax revenues of $480 billion and makes transfer payments equal to $150 billion. Assume the economy is producing at the potential or full employment output level. The budget balance for this economy is equal to $_-170_______ billion and the government is running a (deficit or D, surplus or S) _D.
- Suppose the national debt is $80 trillion and the government spends $800 billion during the fiscal year on goods and services. In addition, the government collects tax revenues of $600 billion and makes transfer payments equal to $300 billion. Assume the economy is producing at the potential or full employment output level. The budget balance for this economy is equal to $__-500______ billion and the national debt is $ -80.5_____ trillion.
C. 12. Holding everything else constant, the government’s budget balance
a. tends to increase during a recession.
b. tends to increase during an expansion.
c. will increase if the government pursues the expansionary fiscal policy.
d. Answers (a) and (c) are both correct.
e. Answers (b) and (c) are both correct.
- The debt-GDP ratio
a. provides a measure of government debt as a percentage of GDP.
b. provides a measure of government debt relative to the potential ability of the government to collect taxes to cover that debt.
c. can fall, even if the level of government debt is rising, provided that GDP grows faster than the debt.
d. Answers (a), (b), and (c) are all correct. - Implicit liabilities
a. are not included in the calculation of the debt-GDP ratio in the United States.
b. are promises made by the government that represents a debt that must be paid by the government at some future point in time.
c. are usually included in debt statistics.
d. Answers (a), (b), and (c) are all correct.
e. Answers (a) and (b) are both correct. - Government transfers are payments from the government
a. to households as compensation for taxes that the household has paid.
b. to households for which no good or service is provided in return.
c. that redistributes purchasing power from one group of households to another group of households.
d. Answers (a) and (c) are both correct.
e. Answers (b) and (c) are both correct. - Economists caution that
a. recessionary gaps are so threatening that the government ought to be always ready to enact discretionary fiscal policy to counteract the recessionary gap.
b. there are important time lags in the use of fiscal policy and that discretionary fiscal policy must be carefully employed if it is to result in less economic fluctuation rather than more economic fluctuation.
c. recessionary gaps are often over before discretionary fiscal policy has any impact and, thus,
the discretionary policy has no impact on the economy.
d. the existence of lags makes the implementation of fiscal policy easier than it would be without the lags. - When a government runs a deficit persistently year after year, this may
a. place financial pressure on future budgets.
b. result in higher taxes over time since the government will need to collect tax revenue to cover its interest payments on the government debt.
c. reduce the level of private investment spending as the government’s borrowing crowds out investment spending.
d. Answers (a), (b), and (c) are all correct.
e. Answers (a) and (b) are both correct. - Many economists think the largest economic issue facing the country is:
a. the size of the budget deficit.
b. the size of the national debt.
c. the size of the nation’s implicit liabilities.
d. the size of the nation’s debt-GDP ratio.