Chapter 7

Question 1

3 Main Ways the Government can raise revenue

Answer 1

1. Tax
   2. Debt
2. Inflation

Question 2

If receipts are higher, there is a

Answer 2

budget surplus and the state is saving money

Question 3

If receipts are lower, there is a

Answer 3

budget deficit that is funded through additional borrowing.

Question 4

Structural deficit:

Answer 4

fiscal position once the short-term impact that a recession has on spending and taxes has been taken out.

Question 5

○ Tax system should have 4 maxims:

Answer 5

Proportionality
Certainty
Convenience
Economical

Question 6

In reality higher taxes reduce the

Answer 6

incentives for working and at some point we would expect people to alter their behavior.

Question 7

Dynamic Effects of Taxes

Answer 7

1. Tax evasion
2. Tax avoidance
3. Emigrating
4. Working Less

Question 8

Risks of high taxes are unseen effects:

Answer 8

the difference between the amount of activity taking place currently, versus how much would take place in an alternative tax regime. Easiest way to avoid tax is simply by avoiding work.

Question 9

Bond

Answer 9

debt security - promise to pay a certain amount of money at specified points in the future (usually this will be an annual return)

Question 10

Supply of bonds is therefore the equivalent of the

Answer 10

demand for loanable funds.

Question 11

The concept of ‘interest’ provides this reward -

Answer 11

it compensates people for giving up their ownership of resources for a period of time.

Question 12

Interest rate:

Answer 12

ratio of money in the present with money in the future. It is the price of time.

Question 13

The balance between consumption and investment is determined in the

Answer 13

market for loanable funds. Some people are patient, have money to spare and are willing to exchange present goods for even greater future goods (savers). Other people want to bring forward their future income and spent it today (borrowers). The supply and demand for loanable funds operate like any market and generate an equilibrium quantity (the amount of lending) and equilibrium ‘price’ (the interest rate).

Question 14

bond contains

Answer 14

1. Principal
2. Coupon
3. name of gilt
4. Maturity

Question 15

3 Determinants of bond prices

Answer 15

1. Inflation expectations
2. Interest rate expectations
3. Economic confidence

Question 16

Inflation expectations

Answer 16

• Inflation erodes the value of future payments, so reduces people’s desire to purchase future income streams.
  - To protect against this you can buy an index-linked gilt, where the coupon and final redemption payment are tracked to movements in the retail price index (rpi).

Question 17

Interest rate expectations

Answer 17

1. There is an inverse relationship between interest rates and the price of gilts.
   2. By contrast, if the interest rates were above the coupon, the gilt would be less attractive and the price would fall below the principal.

Question 18

Economic confidence

Answer 18

• Government’s ability to repay debt depends on their future tax revenue, therefore people may be less inclined to buy gilts if there’s a slowdown.

Question 19

current yield

Answer 19

The current yield is the interest rate based on the buying price as opposed to the nominal value. It shows us the return that the bondholder would get if they held it for a certain period of time, and can be calculated as the coupon divided by the market price. If the prices fall the yield will rise (there is an inverse relationship).

Question 20

yield to maturity

Answer 20

helps us to see what return the bondholder might expect since it incorporates as assumption that coupons are reinvested, and that the bond will be held until it matures.

Question 21

yield curve

Answer 21

relation between the interest rate (cost of government borrowing_ and the time to maturity. The long the time period the greater the interest rate needs to be to compensate lenders

Question 22

inverted yield curve

Answer 22

occurs when long term yields fall below short-term yields.

Question 23

Use bond markets for

Answer 23

1. estimate inflation expectations

2. Estimate soverign default risk

Question 24

Real Variables

Answer 24

quantities and relative prices

• Real GDP
• Capital Stock
• Real Wages
• Real Interest Rate

Question 25

Nominal Variables

Answer 25

Expressed in money terms - Money supply - Price Level - Inflation - Wages - Nominal GDP

Question 26

3 Main Evolutions in the History of money and banking

Answer 26

1. Certificates of deposit 2. fractional reserves -> central banks -> volumes of reserves 3. fiat money

Question 27

fiat money

Answer 27

money that isn't converted into something (gold, precious metals, etc.)

Question 28

GDP

Answer 28

cash value of final goods and services produced within a given time period

Question 29

3 ways to calculate GDP

Answer 29

1. output approach 2. income approach 3. expenditure approach

Question 30

output approach

Answer 30

looks at the final value of goods and services traded

Question 31

income approach

Answer 31

measures the total amount of income earned

Question 32

expenditure approach

Answer 32

total amount of money spent

Question 33

Reasons why GDP diverges from living standards; bad measure to target

Answer 33

1. non-traded labour 2. under appreciation of leisure 3. Government services measured at cost 4. ignores opportunity cost 5. short time horizon

Question 34

National Deficit

Answer 34

a) How much government is currently spending in excess of revenue

Question 35

National Debt

Answer 35

a) Total accumulation of all past deficits

Question 36

Rivalrous Good

Answer 36

A good is rivalrous if I consumed one more unit of that good there is one less unit of that good for consumption for someone else.

Question 37

Excludable Good

Answer 37

s it feasible, low cost, for me to prevent people from enjoying the good who do not give up something to get it.

Question 38

Public Good

Answer 38

Nonexcludable + nonrivalrous One a public good exists, it exists for anyone to consume. The existence of the good doesn't depend on anyone paying for it.

Question 39

Public sector provides the

Answer 39

nonexcludable goods.

Question 40

taxes create

Answer 40

- Create some amount of deadweight loss - Reduce consumer/producer surplus - Increase price of good for buyers, decrease price that sellers receive Taxes reduce quantity of trade that takes place in the market.

Question 41

How taxes are counterintuitive

Answer 41

One of the foundational theorems of public finance is that it doesn’t matter who you levy the tax on (buyers or sellers). The end result will be the same. You cannot tax one side of the market without also affecting the other side of the market. Taxes are felt by all parties in the market enough if they aren't the ones that are nominally taxed.

Question 42

The most efficient tax possible

Answer 42

raises the most amount of revenue for the smallest amount of deadweight loss.

Question 43

Laffer Curve (Taxes)

Answer 43

- If you're on the right, you're not getting as much revenue as you could get. ○ T' to T*, deadweight loss will fall; more wealth will be created. ○ You can get more revenue from the public sector you create more wealth - If you're on the left side ○ To maximize revenue, move to T* In this region, there is the tradeoff of more tax revenue but more deadweight loss inefficiencies.

Question 44

You do not necessarily increase tax revenues the higher

Answer 44

the tax rate. You can disincentive, destroys wealth, etc.

Question 45

DAFT

Answer 45

Deficits are future taxes

Question 46

When a government runs a deficit

Answer 46

it is borrowing somewhere. If raised for direct taxation, who is paying? Taxation is then and now. Deficit finance through bond issuance more popular than taxes. They do like receiving public spending. People like parks, military, etc.

Question 47

Maturity Mismatch Problem

Answer 47

Banks borrow short and lend long. Banks issue short term liabilities.

Question 48

Illiquid

Answer 48

Not necessarily inviable, just have cash flow problem

Question 49

Insolvent

Answer 49

when total liabilities > total assets