Answers to review quizzes marcroeconomics 12e parkin chapter 13

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W H AT I S E C O N O M I C S ? 207 FISCAL POLICY** Answers to the Review Quizzes Page 366 (page 774 in Economics) What is fiscal policy, who makes it, and what is it designed to influence? Fiscal policy is the use of the federal budget to achieve macroeconomic objectives Fiscal policy is made by the president and Congress It is designed to influence employment, economic growth, and price level stability What special role does the president play in creating fiscal policy? Each year the president proposes the budget that Congress amends and enacts What special roles the Budget Committees of the House of Representatives and the Senate play in creating fiscal policy? Each year the Budget Committees of the House of Representatives and the Senate consider the budget proposed by the president, and develop their own ideas of how it should be modified Eventually, formal conferences between the two houses resolve the differences between them and a series of spending acts and an overall budget act passed What is the timeline for the U.S federal budget each year? When does a fiscal year begin and end? Consider the budget for 2015 as an example in answering this question In February 2014 the president proposes a budget to Congress Then, from February until October 1, 2014, the Congress debates the budget, amends it, and eventually passes the necessary budget bills The president then signs or vetoes the budget bills that were presented to him When the president vetoes bills, the Congress may over-ride the veto or pass other bills acceptable to the president Fiscal year 2015 begins on October 1, 2014 and runs until September 30, 2015 During this year the Congress may pass—and the president may sign—supplementary bills Then, after the fiscal year ends, accounts are prepared and the “official” amounts of outlays, receipts, and budget deficit or surplus are reported Is the federal government budget today in surplus or deficit? Currently, the U.S federal government is running a (large) budget deficit 207 208 Page 371 (page 779 in Economics) How does a tax on labor income influence the equilibrium quantity of employment? A tax on labor income drives a wedge between the after-tax wage rate of workers and the before-tax wage rate paid by firms The tax on labor income decreases the supply of labor That is, for each before-tax wage rate, workers provide a lower quantity of labor when faced with a tax that lowers their after-tax wage The decrease in labor supply raises the before-tax wage rate, even though the after-tax wage rate received by workers falls The decrease in labor supply also means that the quantity of employment at full employment (i.e., equilibrium employment in the labor market) falls 208 How does the tax wedge influence potential GDP? By decreasing employment, the tax wedge lowers potential GDP Why are consumption taxes relevant for measuring the tax wedge? A tax on consumption raises the price paid for consumption goods and services and so is equivalent to a cut in the real wage rate from the perspective of workers Why are income taxes on capital income more powerful than those on labor income? Given positive inflation, what appears to be a moderate tax on interest income dramatically decreases the real after-tax interest rate, which is the interest rate that influences investment and saving plans In particular, by driving a wedge between the real interest rate savers receive and firms pay, the tax on interest income decreases the supply of loanable funds, which lowers investment and saving in the economy What is the Laffer curve and why is it unlikely that the United States is on the “wrong” side of it? The Laffer curve is the relationship between the tax rate and the amount of tax revenue collected The amount of tax revenue collected increases with the tax rate only up to a certain tax rate, after which, further increases in the tax rate cause tax revenue to fall When tax rates are higher than the tax rate that maximizes tax revenue, a country is said to be on the wrong side of the Laffer curve It is unlikely that the United States is on the wrong side of the Laffer curve because U.S tax rates are among the lowest in the industrial world and past changes in U.S tax rates have produced changes in tax revenues in the same direction Page 374 (page 782 in Economics) What is a present value? A present value is the amount of money that, if invested today, will grow to equal a given future amount when the interest that it earns is taken into account Distinguish between fiscal imbalance and generational imbalance Fiscal imbalance is the present value of the government’s commitments to pay benefits minus the present value of its tax revenues Generational imbalance is the division of the fiscal imbalance between the current and future generations, assuming that the current generation continues to enjoy the current levels of taxes and benefits How large was the estimated U.S fiscal imbalance in 2014 and how did it divide between current and future generations? In 2014, the fiscal imbalance was estimated to be $68 trillion The generational imbalance estimates suggest that the current generation will pay 83 percent and future generations will pay 17 percent of the fiscal imbalance What is the source of the U.S fiscal imbalance and what are the painful choices that we face? The source of the fiscal imbalance is the social security and, especially, the Medicare obligations made under current law The painful choices are to raise income taxes, raise social security taxes, cut social security benefits, or cut federal government discretionary spending How much of U.S government debt is held by the rest of the world? U.S government debt held by the rest of the world is about $5.8 trillion Page 379 (page 787 in Economics) What is the distinction between automatic and discretionary fiscal policy? FISCAL POLICY Automatic fiscal policy is triggered by the state of the economy with no need for any government action Discretionary fiscal policy, however, requires an act of Congress to either change government spending and/or change taxes How taxes and needs-tested spending programs work as automatic fiscal policy to dampen the business cycle? Taxes, such as income taxes, and needs-tested spending programs both work as automatic fiscal policy because they decrease the effect a change in income has on aggregate expenditure For instance, when income decreases, consumption expenditure and aggregate expenditure decrease But with the fall in income, income taxes decrease and needs-tested spending increase so that disposable income does not fall as much as does income The smaller fall in disposable income means that the fall in consumption expenditure is smaller, so that the fall in aggregate expenditure is likewise smaller How we tell whether a budget deficit needs discretionary action to remove it? A budget deficit needs discretionary government action to remove it when the deficit is a structural deficit If the deficit is a structural deficit, then even when the economy is at full employment, the deficit will remain However, if the deficit is a cyclical deficit, then when the economy returns to full employment, the deficit will disappear How can the federal government use discretionary fiscal policy to stimulate the economy? If the economy has a recessionary gap, the government can increase its expenditure or lower taxes to increase aggregate demand and move the economy back toward potential GDP Why might fiscal stimulus crowd out investment? Fiscal stimulus, such as an increase in government expenditure or a decrease in taxes, increases the budget deficit The increase in the budget deficit increases the (government’s) demand for loanable funds, thereby raising the real interest The higher real interest rate decreases—crowds out—investment 169 170 CHAPTER 13 Answers to the Study Plan Problems and Applications Use the following news clip to work Problems and Economy Needs Treatment It’s the debt, stupid! Only when the government sets out a credible business plan will confidence and hiring rebound Source: The Wall Street Journal, October 7, 2010 How has the U.S government debt changed since 2008? What are the sources of the change in U.S government debt? Since 2008 the U.S government debt has skyrocketed The debt dramatically rose because federal government taxes fell (as a percent of GDP) while federal government expenditures and transfer payments, shot upwards Federal government expenditures on goods and services rose but not nearly as much as transfer payments What would be a “credible business plan” for the government to adopt? A “credible business plan” would be a plan for the government that shrinks the deficit and thereby stops the rapid increase in the government debt This plan likely would involve cutting government outlays and increasing government receipts The government is considering raising the tax rate on labor income Explain the supply-side effects of such an action and use appropriate graphs to show the directions of change, not exact magnitudes What will happen to: a The supply of labor and why? The supply of labor will decrease As shown in Figure 13.1, the supply of labor curve shifts leftward from LS0 to LS1 The supply of labor decreases because at each real wage rate, the hike in the tax rate on labor income lowers the after-tax wage rate received by workers b The demand for labor and why? The demand for labor will remain the same so in Figure 13.1 the demand for labor curve remains LD The demand for labor depends on the productivity of labor, which does not change after the increase in the tax rate on labor income c Equilibrium employment and why? As Figure 13.1 shows, the equilibrium level of employment decreases In the figure, employment decreases from 310 billion hours per year to 300 billion hours per year d The equilibrium before-tax wage rate and why? As Figure 13.1 shows, the equilibrium before-tax wage rate increases from $34 per hour to $35 per hour The before-tax wage rate rises because the leftward shift of the supply of labor curve leads to a movement up along the demand for labor curve FISCAL POLICY e The equilibrium after-tax wage rate and why? The equilibrium after-tax wage rate decreases The tax wedge in the figure is $2 per hour, so the after-tax wage rate falls from $34 per hour to $33 per hour The increase in the tax rate on labor income increases the wedge between the beforetax wage rate and the after-tax wage rate The before-tax wage rate increases but not by as much as the increase in tax So the after-tax wage rate decreases 171 172 f CHAPTER 13 Potential GDP? Potential GDP decreases The equilibrium level of employment is full employment So as full employment decreases, potential GDP decreases along the aggregate production function Figure 13.2 shows this change as the movement along the aggregate production function, PF, from point A, with 310 billion hours of employment and potential GDP of $16.2 trillion, to point B, with 300 billion hours of employment and potential GDP $16.1 trillion What fiscal policy action might increase investment and speed economic growth? Explain how the policy action would work A decrease in the tax on capital income will increase investment and thereby increase economic growth A decrease in the tax on capital income increases the supply of loanable funds The real interest rate falls and investment increases The increase in investment increases economic growth Suppose that instead of taxing nominal capital income, the government taxed real capital income Use appropriate graphs to explain and illustrate the effect that this change would have on: a The tax rate on capital income The nominal interest rate is the (nominal) income from capital If the government changes the tax code to subtract the inflation rate from the (nominal) interest rate before taxes are imposed, the true tax rate on capital income falls because the part of the capital income—the inflation rate—that is received in compensation for inflation is no longer taxed b The supply of and demand for loanable funds With a lower tax rate on capital income, the supply of loanable funds increases as the after-tax real interest rate rises This change is illustrated in Figure 13.3 by the rightward shift of the supply of loanable funds curve from the initial supply of loanable funds curve, SLF0, to SLF1 The demand for loanable funds generally remains the same because it FISCAL POLICY depends in large part on investment demand Firms’ investment demand depends on how productive capital is and the productivity of capital does not necessarily change when the tax code changes In Figure 13.3, the demand for loanable funds curve does not shift c Investment and the real interest rate As shown in Figure 13.3, the increase in the supply of loanable funds shifts the supply of loanable funds curve rightward This change leads to a lower real interest rate and a higher amount of loanable funds and investment Under current policies, a plausible projection is that U.S public debt will reach 250 percent of GDP in 30 years and 500 percent in 50 years a What is a fiscal imbalance? How might the U.S government reduce the fiscal imbalance? The fiscal imbalance is the present value of the government’s commitments to pay benefits minus the present value of its tax revenues To reduce the fiscal imbalance, the government needs to decrease its benefit payments—both its present payments and those promised in the future—and increase its tax revenue —both its current tax revenue and tax revenue in the future While the annual government budget deficit is not the fiscal imbalance, it is related because, in general, the larger the budget deficit the larger the fiscal imbalance Additionally, the larger the budget deficit, the larger the accumulated public debt becomes b How would your answer to part (a) influence the generational imbalance? The generational imbalance is the division of the fiscal imbalance between the current and future generations, assuming that the current generation will enjoy the existing levels of taxes and benefits The changes in part (a) of cutting benefits and raising taxes will affect the generational imbalance if the reduction in benefits and/or the hike in taxes affects the current generation In that case the generational imbalance would change so that more of the fiscal imbalance is paid by the current generation and less by future generations The economy is in a recession, and the recessionary gap is large a Describe the discretionary and automatic fiscal policy actions that might occur Fiscal policy that increases government expenditure or decreases taxes would boost aggregate demand In terms of automatic fiscal policy, needs-tested spending increases in recessions and tax revenue falls Congress might also use discretionary policy by passing a new spending bill or a cut in tax rates b Describe a discretionary fiscal stimulation package that could be used that would not bring an increase in the budget deficit An increase in government expenditure with an offsetting increase in tax rates to boost tax revenue would not bring a budget deficit and would increase aggregate demand because the increase in government expenditure increases aggregate demand by more than the increase in taxes decreases aggregate demand c Explain the risks of discretionary fiscal policy in this situation The risk of discretionary policy is that, because of time lags, it takes effect too late and ends up moving the economy away from potential GDP An economy is in a recession with a large recessionary gap and a government budget deficit a Do we know whether the budget deficit is a structural deficit or a cyclical deficit? Explain We know that at least some of the budget deficit in a recession is a cyclical deficit as needs-tested spending is higher and tax revenue is lower than at potential GDP 173 174 CHAPTER 13 However, some of the budget deficit might be a structural deficit The structural deficit is the deficit that would exist if real GDP equaled potential GDP and the economy was at full employment b Explain how automatic fiscal policy is changing the output gap? Automatic fiscal policy is decreasing the output gap relative to what it would be otherwise in a recession because they increase aggregate demand relative to what it would be otherwise in a recession That is, aggregate demand decreases in a recession, but it would decrease by more without the increase in needs-tested spending and the decrease in tax revenue that produce the cyclical deficit c If the government increases its discretionary expenditure, explain how the structural deficit might change A discretionary increase in government expenditure, if not reversed following the end of the recession, moves the budget balance toward a structural deficit Use the following news clip and fact to work Problems to 11 Senate Approves Obama Tax Cut Plan The U.S Senate has passed legislation extending Bush-era tax cuts for highincome earners to middle-class Americans earning up to $250,000 per year Source: Financial Times, July 26, 2012 Fact: Middle and low-income earners spend almost all their disposable incomes High-income earners save a significant part of their disposable incomes a Explain the intended effect of extending tax cuts for middle-class Americans but not for high-income families Draw a graph to illustrate the intended effect The goal of extending the tax cuts for middle-class Americans has an intended effect of increasing consumption expenditure, which increases aggregate demand Figure 13.4 shows the intended effect of this policy where, including the multiplier effect, the aggregate demand curve shifts rightward from AD0 to AD1 As a result real GDP increases, in the figure from $15.7 trillion to $15.9 trillion In the figure real GDP remains below potential GDP but the recessionary gap becomes smaller b Explain why the effect of tax cuts depends on who receives them The effect of this fiscal policy depends on the size of the impact on aggregate demand The more of the tax cut that is spent (which means the less that is saved) the larger the magnitude of the effect on aggregate demand If the tax rebates go to people who spend more of the rebate, that is, middle and low-income earners, the effect of this fiscal policy is larger 10 What would have a larger effect on aggregate demand: extending the Bushera tax cuts to everyone; extending them for middle-class only; or extending them for high-income earners only? How would each alternative compare with no tax cuts but an equivalent increase in government expenditure? Extending the income tax cuts to everyone will have the largest effect on FISCAL POLICY aggregate demand Middle-income tax payers will spend most of the tax cut and high-income tax payers, while spending only a small fraction of their income, still spend some In general, tax cuts have a larger effect on real GDP than increases in government expenditure because the tax cuts have stronger supplyside effects So whichever tax cut policy—extending the tax cuts to everyone, to only middle-class taxpayers, or to only high-income tax payers—has the largest supply-side effect also has the largest effect on real GDP 11 Compare the impact on equilibrium real GDP of a same-sized decrease in taxes and increase in government expenditure on goods and services According to the aggregate demand/aggregate supply model, the government expenditure multiplier exceeds the tax multiplier, so government expenditure has a larger impact on real GDP Some economists, such as Robert Barro and Harald Uhlig disagree and assert that the tax multiplier exceeds the government expenditure multiplier because taxes affect aggregate demand and aggregate supply In this case the decrease in taxes has a larger impact on real GDP 175 176 CHAPTER 13 Answers to Additional Problems and Applications 12 2012 Deficit: Smaller, But Still Big The Congressional Budget Office said the budget deficit was about $1.1 trillion in fiscal year 2012 That is about $200 billion smaller than in 2011, but still ranks as the fourth-largest deficit since World War II Source: The Congressional Budget Office, October 5, 2012 Of the components of government outlays and receipts, which have changed most to contribute to the huge budget deficits in 2011 and 2012? In general, since 2008 outlays have increased substantially while receipts have risen slightly The major factor leading to the massive rise in the budget deficit is an increase in transfer payments An increase in government expenditure on goods and services also has lead to increasing the budget deficit but the effect from this factor is dwarfed by the rise in transfer payments Use the following information to work Problems 13 and 14 Suppose that investment is $1,600 billion, saving is $1,400 billion, government expenditure on goods and services is $1,500 billion, exports are $2,000 billion, and imports are $2,500 billion 13 Calculate the amount of tax revenue and the government budget balance Tax revenue equals $1,200 billion From the circular flow of expenditure and income, we know that I = S + T – G + M – X Rearranging the equation gives T = I– S + G + X – M, which equals $1,200 billion 14.a Explain the impact of the government budget balance on investment The government has a budget deficit It is exerting a negative influence on investment by increasing the demand for loanable funds, which increases the real interest rate and crowds out investment b What fiscal policy action might increase investment and speed economic growth? Explain how the policy action would work A decrease in the budget deficit by increasing taxes or decreasing government expenditure decreases the demand for loanable funds, which lowers the real interest rate and increases investment The increase in investment increases economic growth 15 Suppose that capital income taxes are based (as they are in the United States) on nominal interest rates If the inflation rate increases by percent a year, explain and use appropriate graphs to illustrate the effect of the rise in inflation on: a The tax rate on capital income The increase in the inflation rate increases the true tax rate on capital income because the interest income that is received in compensation for inflation is larger so that the tax paid on capital income increases FISCAL POLICY b The supply of loanable funds With a higher tax rate on capital income, the supply of loanable funds decreases and the after-tax real interest rate falls This change is illustrated in Figure 13.5 by the leftward shift of the supply of loanable funds curve from the initial supply of loanable funds curve SLF0 to the new supply, SLF1, when the inflation rate is higher c The demand for loanable funds The demand for loanable funds generally remains the same because it depends in large part on investment demand Firms’ investment demand depends on how productive capital is and the productivity of capital does not change when the tax code changes d Equilibrium investment As illustrated in Figure 13.5, when the supply of loanable funds decreases, the supply of loanable funds curve shifts leftward from SLF0 to SLF1 The real interest rate rises from percent a year to percent a year, and the equilibrium quantity of loanable funds deceases from $2.5 trillion to $2.4 trillion Investment decreases e The equilibrium real interest rate The decrease in the supply of loanable funds leads to a higher equilibrium real interest rate In the figure the real interest rate rises from percent to percent Use the following news clip to work Problems 16 and 17 Singapore Budget 2015: Parliament Passes Record $79.9 Billion Budget New schemes announced by the budget statement include ten new hawker centers by 2027, a third desalination plant, SkillsFuture initiative to support lifelong learning for adults, and a second edition of Construction Productivity Roadmap to boost the industry’s capabilities Source: The Straits Times, March 13, 2015 16 Explain the supply-side effects of building ten new hawker centers and a third desalination plant The construction of ten new hawker centers and a third desalination plant creates more job opportunities, thereby boosting employment 17.a Explain the potential supply-side and demand-side effects of SkillsFuture initiative The SkillsFuture initiative will give adult Singaporeans the opportunity to develop new skills and respond to the constantly evolving needs of industry This will help many employees to keep their jobs or make progress in their career The initiative, thus, may not necessarily create more employment Therefore, aggregate supply may or may not increase However, as employees’ real wages increase due to better skills and better employment opportunities, consumption expenditure rises, so aggregate demand increases from what it would be otherwise 177 178 CHAPTER 13 b Explain the potential supply-side and demand-side effects of adopting new technologies to boost productivity in the construction industry Use of new technologies increases both short-run and long-run aggregate supply More capital investment by construction companies will increase aggregate demand as well FISCAL POLICY c Draw a graph to illustrate the combined demand-side and supply-side effect of the fiscal policy measures in part (a) Figure 13.6 shows the combined effects of the policy compared to what the situation would be if the policies not implemented Aggregate demand increases, so the aggregate demand curve shifts rightward from AD0 to AD1 The effect on aggregate supply is ambiguous Implementing the initiative may or may not increase aggregate supply If aggregate supply does not change, the aggregate supply curve does not shift In Figure 13.6 the shift of the aggregate demand curve increases real GDP, and the price level rises Use the following news clip to work Problems 18 and 19 China pulls back tax breaks for foreign companies Incentives such as lower land prices and tax breaks have helped Chinese cities attract multinational firms in the recent years In 2014 alone, it secured foreign investment worth $120 billion Now, the central government is ordering municipalities to pull back the incentives to curb the country’s growing debt and local spending Source: CNN Money, March 27, 2015 18 Explain the potential supply-side effects of China’s plan to pull back tax breaks? When there are no more tax breaks, foreign firms in China will expect decreased profits Investment in the country’s capital stock decreases Aggregate supply and potential GDP both decrease 19 How does withdrawing tax breaks that were granted to foreign firms curb the country’s debt? Explain your answer with the aid of the Laffer curve After tax breaks are pulled back, foreign firms will have to pay more tax The tax rate imposed on foreign firms lies on the upward-sloping portion of the Laffer curve, which indicates that an increase in the tax rate increases the tax revenue The budget deficit decreases, exerting less pressure on the accumulating debt of the country 179 180 CHAPTER 13 20 Hong Kong Launches Rainy-day Fund Despite of HK$950b Reserves by 2020 By 2019–20, the fiscal reserves are predicted to reach HK$950 billion, enough to cover 22 months of the government’s projected expenditure However, Finance Secretary John Tsang’s working group on long-term fiscal planning has warned that HK could face a structural deficit by 2022–23 due to an ageing population The group proposes to set up a “future fund” for a rainy day, to be used if HK’s reserves drops to a critical level Source: South China Morning Post, Feb 26, 2015 What is the difference between structural deficit and cyclical deficit? Explain how an ageing population may lead to a structural deficit If the source of the future fund is the existing fiscal reserves, who would benefit from the establishment of the fund and who would pay? A structural deficit is the budget deficit at the potential GDP, while a cyclical deficit is the actual deficit minus structural deficit As more people retire, the workforce shrinks, fewer people pay taxes and the income tax revenue decreases On the other hand, the social expenditure on the elderly grows The fiscal deficit eventually turns into a structural deficit while the ageing population continues to age For the future fund, if the government broadens the tax base, the current generation would pay but the future generation would benefit because they not have to pay higher taxes to cover the fiscal deficit 21 The economy is in a boom and the inflationary gap is large a Describe the discretionary and automatic fiscal policy actions that might occur Fiscal policy that decreases expenditure or increases taxes would decrease aggregate demand In terms of automatic fiscal policy, need-tested spending decreases in expansions and tax revenue increases Congress might also use discretionary policy by cutting spending programs or increasing tax rates b Describe a discretionary fiscal restraint package that could be used that would not produce serious negative supply-side effects A decrease in government expenditure with an offsetting decrease in autonomous taxes would not bring a change in government saving and so would not change investment and the growth of real GDP c Explain the risks of discretionary fiscal policy in this situation The risk of discretionary policy is that, because of time lags, it takes effect too late and ends up moving the economy away from potential GDP 22 The economy is growing slowly, the inflationary gap is large, and there is a budget deficit a Do we know whether the budget deficit is structural or cyclical? Explain your answer The economy is at an above full-employment equilibrium because there is an inflationary gap Real GDP exceeds potential GDP There is a budget deficit, but with potential GDP greater than real GDP there is a cyclical surplus The structural deficit is larger than the total budget deficit because the cyclical surplus offsets some of structural deficit So the budget deficit is composed of a structural deficit and a cyclical surplus FISCAL POLICY b Do we know whether automatic stabilizers are increasing or decreasing aggregate demand? Explain your answer We know that automatic stabilizers are decreasing aggregate demand relative to what it would be otherwise in an inflationary gap c If a discretionary decrease in government expenditure occurs, what happens to the structural budget balance? Explain your answer A discretionary decrease in government expenditure decreases the structural deficit Following the change in fiscal policy, government outlays would be smaller even when the economy returned to full employment Use the following news clip to work Problems 23 to 25 Is Fiscal Stimulus Necessary? China’s economy is slowing from its normal percent or higher rate to just below percent The source of the slowdown is the global economic slowdown that is restricting exports growth and the government’s deliberate decision to discourage unproductive investment The situation now is not like that in 2008 when real GDP growth dropped from percent to 6.8 percent and fiscal stimulus does not appear to be urgently needed Source: China Daily, June 8, 2012 23 Explain why fiscal stimulus was needed in 2008 but not in 2012 Fiscal stimulus was needed in 2008 because the growth rate of the Chinese economy significantly slowed The slowdown in the growth rate in 2012 is much milder and hence fiscal stimulus is not needed 24 Would you expect automatic stabilizers to be operating in 2012 and if so, what effects might they have? China’s automatic stabilizers will operate in 2012 China has fewer automatic stabilizers than the United States because China has fewer unemployment benefit programs and fewer welfare programs China’s income tax, however, will operate as an automatic stabilizer as fewer people rise into higher tax brackets and some fall into lower tax brackets 181 182 25 CHAPTER 13 Why might a stimulus come too late? What are the potential consequences of a stimulus coming too late? Stimulus might come too late because forecasters’ predictions that the slowdown in China’s growth will be slight might prove incorrect So stimulus might be delayed until the economy was actually in a recession If this outcome occurred, the unemployment rate would already have risen and real GDP already have decreased because of the delay in implementing the program Additionally, if the program is implemented too late, then GDP might already be rising and unemployment falling when the program’s impacts occur, which could result in a significantly higher price level Economics in the News 26 After you have studied Reading Between the Lines on pp 380–381 (788–789 in Economics), answer the following questions a What was the state of the Japanese economy in 2013? After a long period of slow economic growth, in 2013 Japan’s economy was in a recessionary gap Gross government debt was 250 percent of GDP The nation’s population as ageing and its Social Security payments had skyrocketed to about a third of the government’s total budget b Explain the effects of Japan’s high level of government spending and debt the level of employment and potential GDP The high level of government debt and deficit had crowded out private investment, thereby decreasing potential GDP The decrease in potential GDP decreased employment c Explain how inflation and faster growth might lower Japan’s government debt ratio and why neither is an attractive option Increasing either inflation or faster growth reduces the ratio of debt to nominal GDP Faster growth is hard to achieve and increasing inflation would adversely affect workers with long-term labor contracts (because higher inflation reduces their real wage rates) and savers (because higher, unanticipated inflation reduces the real value of the savings) FISCAL POLICY d Explain how monetary policy might be used to offset a fiscal-policy induced decrease in aggregate demand and draw a graph to illustrate your answer Monetary policy can be used to increase aggregate demand, thereby offsetting the decrease brought about by fiscal policy This offset prevents real GDP and employment from decreasing In Figure 13.7, the initial aggregate demand curve is AD0 so that real GDP is ¥540 trillion and the price level is 122 Fiscal policy designed to decrease the deficit decreases aggregate demand to AD1 so that real GDP decreases to ¥520 trillion yen But the expansionary monetary policy could increase aggregate demand, shifting it from AD1 back to AD0 Real GDP remains at ¥540 trillion 27 More Fiscal Stimulus Needed? In New York Times articles and in blogs, economists Paul Krugman and Joseph Stiglitz say there is a need for more fiscal stimulus in both the United States and Europe despite the large federal budget deficit and large deficits in some European countries a Do you agree with Krugman and Stiglitz? Why? Students who agree with Mr Krugman and Mr Stiglitz likely believe that the U.S economy will not return to full employment rapidly without further government stimulus Students who disagree with Mr Krugman and Mr Stiglitz likely believe that the U.S economy is on track to return to full employment b What are the dangers of not engaging in further fiscal stimulus? If the economy is not returning to full employment, fiscal stimulus might be necessary In this situation, if there is no fiscal stimulus, the economy will remain mired in a recessionary gap and unemployment will exceed natural unemployment c What are the dangers of embarking on further fiscal stimulus when the budget is in deficit? The fiscal stimulus will further increase the budget deficit The rise in the deficit increases the government’s demand for loanable funds and thereby raises the real interest rate The higher real interest rate decreases—crowds out—investment The net effect on aggregate demand is uncertain: The fiscal stimulus increases aggregate demand; however, the decrease in investment expenditure decreases aggregate demand If aggregate demand does not change, there is no immediate effect on real GDP But the decrease in investment lowers the future capital stock, which means that aggregate supply does not increase as much as otherwise so that U.S economic growth will be slower 183 184 CHAPTER 13 28 Payroll Tax Cut Is Unlikely to Survive Into Next Year The payroll tax holiday in 2012 reduced workers’ tax by $700 for an income of $35,000 a year and by $2,202 for incomes of $110,100 and over If the tax holiday ends, the Economic Policy Institute recommends replacing the payroll tax cut with infrastructure spending Source: The New York Times, September 30, 2012 a Explain how a payroll tax affects the before-tax and after-tax wage rate and employment and unemployment The payroll tax places a wedge between the before-tax wage rate and the after-tax wage rate The payroll tax raises the before-tax wage rate (though by less than the amount of the tax) and lowers the after-tax wage rate Employment decreases and unemployment increases b Explain the effects of an increase in infrastructure spending on employment and unemployment In the short-run, an increase in infrastructure increases aggregate demand, which increases real GDP and thereby increases employment and decreases unemployment In the longer-run, an increase in infrastructure spending increases the nation’s productive resources, which increases potential GDP and short-run aggregate supply The increase in short-run aggregate supply increases employment and decreases unemployment c Which fiscal policy action would have the bigger effect on employment: continuing the payroll tax cut or new infrastructure spending? The payroll tax cut has only an aggregate supply effect; the infrastructure spending increases both aggregate supply and aggregate demand Because the increase in infrastructure spending affects both aggregate demand and aggregate supply, it might have a larger effect on employment FISCAL POLICY 185 ... will operate as an automatic stabilizer as fewer people rise into higher tax brackets and some fall into lower tax brackets 181 182 25 CHAPTER 13 Why might a stimulus come too late? What are the... interest rate decreases—crowds out—investment 169 170 CHAPTER 13 Answers to the Study Plan Problems and Applications Use the following news clip to work Problems and Economy Needs Treatment It’s... capital stock, which means that aggregate supply does not increase as much as otherwise so that U.S economic growth will be slower 183 184 CHAPTER 13 28 Payroll Tax Cut Is Unlikely to Survive Into
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