Chapter 12: Fiscal Policy

Question 1

Define ‘Fiscal policy’.

Answer 1

Government decisions about the level of taxation and government spending.

Question 2

Define ‘Expansionary fiscal policy’.

Answer 2

Fiscal policy that increases aggregate demand.
Expands demand.
Increase gov. spending or decrease taxes and is response to recession.

Question 3

Define ‘Contractionary fiscal policy’.

Answer 3

Fiscal policy that decreases aggregate demand.

Decrease gov. spending or increases taxes and is response to overheating economy with threat of excessive inflation.

Question 4

Define ‘Automatic stabilizers’.

Answer 4

Taxes and government spending that affect fiscal policy without specific action from policy makers.
I.e. % of income taxes.

Question 5

Define ‘Multiplier effect’.

Answer 5

The increase in consumer spending that occurs when spending by one person causes others to spend more, too, increasing the impact of the initial spending on the economy.
Feedback loop: Increased consumption, increased income, Increased consumption…

Question 6

Define ‘Marginal propensity to consume (MPC)’.

Answer 6

The amount that consumption increases when after-tax income increases by $1.

Question 7

Define ‘Government-spending multiplier’.

Answer 7

The amount by which GDP increases when government spending increases by $1.
GSM = 1 / (1 - MPC)

Question 8

Define ‘Taxation multiplier’.

Answer 8

The amount GDP decreases when government taxes increase by $1.
TM = -MPC / (1 - MPC)

Question 9

Define ‘Transfer payments’.

Answer 9

Payments from government accounts to individuals for programs, like Social Insurance, that do not involve a purchase of goods and services.

Question 10

Define ‘Budget deficit’,

Answer 10

The amount of money a government spends beyond the revenue it brings in.

Question 11

Define ‘Budget surplus’.

Answer 11

The amount of revenue a government brings in beyond what it spends.

Question 12

Define ‘Public debt’.

Answer 12

The total amount of money that a government owes at a point in time.

Question 13

The government can use fiscal policy to counteract ___-___ fluctuations.

Answer 13

Business-cycle.

Question 14

What are 2 primary potential challenges when implementing fiscal policy?

Answer 14

1. Time lags

2. Ricardian equivalence

Question 15

What are some forms of time lags?

Answer 15

• Information lags: How long it takes to get the right info about the overall health of the economy
• Formulation lags: Getting everyone to agree on the right policy
• Implementation lags: How long it takes fiscal policy to have an effect on the economy
• Some aspects of fiscal policy automatically stimulate or slow the economy to get around lags

Question 16

What is Ricardian equivalence?

Answer 16

A theory that predicts that if the governments cut taxes but not public spending, people will continue to save rather than spend, consumption will not increase, and the tax cut will be unsuccessful in changing aggregate demand. The government will have to borrow to cover the financial shortfall and at some point in the future, taxes will go up to repay the debt incurred by tax cuts.

Question 17

Why is the government-spending multiplier larger than the taxation multiplier?

Answer 17

Government spending directly affects income, whereas taxation does so indirectly, through consumption.

Question 18

The government budget includes…?

Answer 18

All the revenue it collects in taxes and all the money it spends on government programs.

Question 19

What is the relationship between debt and deficit?

Answer 19

The budget deficit tells us how much the gov. borrows each year, and the debt tells us the total that the government has borrowed and not yet paid back over time. The debt is the cumulative sum of all deficits and surpluses.

Question 20

What are benefits and costs of government debt?

Answer 20

Benefits: Allows gov. to spend more than revenue, respond to unexpected events and to undertake expansionary fiscal policy.
Costs: Interest on debt, inefficient spending, high deficits may affect interests rates and reduce investment in the economy.