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1. If an economy operates in the short run at point a, restrictive fiscal policy willa. increase AD and move the economy toward point c.b. decrease AD and move the economy toward point b.c. increase SRAS and move the economy toward point b.d. decrease SRAS and move the economy toward point c.
2. When the economy is operating at point a, reliance on the self-correcting mechanism willa. result in higher resource prices and a shift to the left in the SRAS curve.b. result in lower resource prices and a shift to the right in the SRAS curve.c. lead to lower interest rates and a shift to the right in the AD curve.d. lead to higher interest rates and a shift to the left in the AD curve.e. do both a and d.
3. Which of the following will a Keynesian most likely favor if the economy is operating at point a?
a. a tax cutb. an increase in government expendituresc. restrictive fiscal policyd. an increase in the budget deficit
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4. If the output of the economy is Y1, which of the following would a Keynesian economist be most likely to favor?
a. a reduction in government expendituresb. an increase in government expendituresc. an increase in taxesd. continuation of the current tax and
expenditure policies
5. If the output of the economy is Y1, which of the following would a new classical economist be most likely to favor?a. a reduction in government expendituresb. a reduction in taxesc. an increase in taxesd. continuation of the current tax and expenditure policies
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6. When government expenditures exceed revenue from all sources,
a. a budget deficit is present.b. the supply of money will increase.c. the government’s outstanding
debt will decline.d. all of the above are true.
7. According to the Keynesian view, which of the following would most likely decrease aggregate demand?
a. a decrease in tax ratesb. a decrease in government
expendituresc. an increase in transfer paymentsd. an increase in the budget deficit
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Expenditures < Revenues
Expenditures > Revenue
Discretionary changes in taxes and/or spending affect the Budget
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AD1
• Equilibrium below full employment. Two options
PriceLevel
LRAS
YFY1
P2
AD2
Goods & Services(real GDP)
directs theEconomy to
full-employment
SRAS1
P1
1. Wait for SRAS1 to shift out to SRAS2
SRAS2
P3
market self-adjustment
may be a lengthyprocess.
e1
E2
2. Shift AD1 out to AD2
E3
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AD1
• Equilibrium above full employment at Y1.
PriceLevel
LRAS
YF Y1
P3
AD2 Goods & Services
(real GDP)
restrains demand and helps control inflation.
SRAS2
P1
1. Will lead to the long-run equilibrium E3 at a higher price level as SRAS shifts to SRAS2. or
SRAS1
P2
E3
2. Reduce demand to AD2 and lead to equilibrium E2.
e1
E2
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Increase in budget deficit
Higher realinterest rates
Inflow of financial capital from abroad
Decline inprivate investment
Appreciation of the dollar
Decline in net exports
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AD1
PriceLevel
Y1
Goods & Services(real GDP)
SRAS1
P1
• Government deficit would shift AD1 to AD2.• Household saving keeps demand unchanged at AD1.
AD2
GG
GG
HH
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Quantity of loanable fundsQ1
S1
Q2
Loanable FundsMarketReal
interestrate
r1
S2
D2
1. Government borrows from the loanable funds market, increasing the demand (to D2).
2. People save for expected higher future taxes (raising the supply of loanable funds to S2.)
3. Loans increase, but interest rate doesn’t.
D1
no effect on the interest rate, real GDP,
and unemployment.
e1 e2
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AD0
1. Equilibrium at E0
PriceLevel
LRAS
Y0Y1
AD1 Goods & Services
(real GDP)
P0
SRAS1
P1
E0
e1
2. AD decreases to AD1 and output falls to Y1
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AD0
3. While policy is being enacted, private investment has begun to recover.
PriceLevel
LRAS
Y0Y1
Goods & Services(real GDP)
P0
SRAS1
P1
AD2
E0
e1
4. AD has begun shifting back to AD0 on its own, the effects of fiscal policy over-shift AD to AD2.
AD1
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AD1
AD0
• The price level in the economy rises (from P1 to P2) as the economy is now overheating.
PriceLevel
LRAS
Y0Y1
P2
Goods & Services(real GDP)
P0
SRAS1
P1
AD2
E0
e1
e2
Y2
• Unless the expansionary fiscal policy is reversed, wages and other resource prices will eventually increase, shifting SRAS back to SRAS2 (driving the price level up to P3).
P3
SRAS2
E3
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AD0
1. Demand shifts AD out to AD2, and prices upward to P2.
PriceLevel
LRAS
Y0
P2
Goods & Services(real GDP)
P0
SRAS1
E0
Y2
2. Restrictive Fiscal Policy is considered
AD2
e2
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AD1
AD0
2. The price level falls (from P2 to P1) as the economy is thrown into a recession.
PriceLevel
LRAS
Y0Y1
P2
Goods & Services(real GDP)
P0
SRAS1
P1
AD2
E0
e1
e2
Y2
3. With the timing lag, fiscal policy does not work instantaneously.
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4. Investment returns to its normal rate (shifting AD2 back to AD0).
PriceLevel
LRAS
Y0
Goods & Services(real GDP)
P0
SRAS1
AD2
5. The effects of fiscal policy over-shift AD to AD1.
P2 e2
Y2
AD1
Suppose that shifts in ADare difficult to forecast.
E0
AD0
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AD1
PriceLevel
LRAS1
YF2YF1
AD2
Goods & Services(real GDP)
With time, lower tax ratespromote more rapid growth (shifting LRAS and SRASout to LRAS2 and SRAS2).
SRAS1
P0
SRAS2
E1
LRAS2
E2
1. Lower marginal tax rates shifts AD1 out to AD2, and SRAS & LRAS shift to the right.
2. If the tax cuts are financed by budget deficits, AD may expand by more than supply, bringing an increase in the price level.
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• Their share of taxes paid has increased as the top tax rates have declined.
• This indicates that the supply side effects are strong for these taxpayers.
Share of personal income taxes paid by top ½ % of earners
1964-65Top rate cut from
91% to 70%
1981Top rate cut from
70% to 50%
1986Top rate cut from
50% to 30%
1990-93Top rate raised from
30% to 39.6%
30 %
28 %
26 %
24 %
22 %
20 %
18 %
1960
16 %
14 %
199519901980197519701965 1985 2000
1997Capital gainstax rate cut
2001-2004Top rate cut from
39.6% to 35%
2005
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“Soaking the Rich?”
• Since 1986 the top tax rate has been less than 40% .
• The top one-half percent of earners have paid more than 25% of the personal income
tax every year since 1997.
• Well above the 14% to 19% from the 1960s and 1970s.
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1. Generally small deficits except during recessions.
2. Budget deficits generally increased during recessions and shrank during expansions, (automatic stabilizers, not discretionary policy)
3. Reductions in income tax rates and sharp increases in defense expenditures led to large deficits during the 1980s.
4. The deficits replaced by surpluses in the 1990s.
5. Real economic growth was strong and the inflation rate low during 80s and 90s
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6. The combination of: -the 2001 recession -the economy’s sluggish recovery -the Bush Administration’s tax cut, and-increases in defense spending quickly moved the budget from surplus to deficit at the beginning of the new century.
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2003 -3752004 -4002005 -3002006 -247.7
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Federal Expenditures and RevenuesFederal Government Expenditures and Revenues (as a share of GDP)
18%
20%
22%
24%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Expenditures
Revenues
Deficits
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Growth of Real Federal Governmentand Defense Expenditures
• During the 1980s, rapid growth of defense spending pushed federal spending upward and contributed substantially to the large deficits of the decade.
• During the 1990s, defense cuts retarded the growth of federal spending and thereby helped shift the budget to surplus.
Defense
Total
8 %
6 %
4 %
2 %
0 %
- 2 %
- 4 %
Percentrate of change
1980 1985 1990 1995 2000
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Fiscal Policy & Economic Performance:
• In the 1960s, most economists believed fiscal policy was highly potent and could be
used to smooth out the business cycle. • Confidence in the ability of policy makers to
implement countercyclical fiscal policy has waned.
• Most now believe that fiscal policy exerts only a modest impact on aggregate demand, much
like the crowding-out and new classical models imply.
• Since 1980, real growth has been strong during periods of both expanding (1980s and 2002-2006)
and contracting (1990s) deficits.