Back to study guide for the third exam Last revised: 03/30/2009
Answers to the Review Questions from Federal Budgets and Public Policy
1. The federal budget, the federal government’s expenditures and tax receipts, has two purposes: To finance the government’s activities and to stabilize the economy.
2. Although the formal process of creating the federal budget starts in February, when the President proposes a budget to Congress, the actual process begins much earlier. Well before February, experts project tax revenues and expenditures. These are then used in the budget proposed by the President to Congress. The Congress then debates the proposal, with each legislative body — the House and Senate — modifying the proposal. Eventually, joint committees comprising both representatives and senators meet to iron out differences, and compromise bills are passed by the House and Senate. These bills are then sent to the President, who may either veto or sign them. If a bill is vetoed, the House and Senate may override the President’s veto by a two-thirds vote of each body. The approved bills become the government’s budget.
3. The federal government has four main sources of tax revenues:
 | Personal income taxes — the largest source of federal tax receipts. Personal income taxes are the taxes paid by individuals on their income. |
| Social insurance taxes — the second largest source of federal tax receipts. Social insurance taxes include social security taxes. |
| Corporate income taxes — the third largest source of federal tax receipts. Corporate income taxes are the taxes paid by corporations on their profits. |
| Indirect taxes — the smallest source of federal tax receipts. These are excise taxes paid on gasoline, alcohol, and a few other products. |
The government has three categories of expenditures:
| Transfer payments — the largest source of expenditures. Transfer payments are payments made to individuals, business, and other levels of government. Social security is an example of a transfer payment. |
| Purchases of goods and services — the second largest source of expenditures. This component is the federal government’s purchases of products from the private sector. |
| Debt interest — the smallest source of expenditures. Debt interest is the payment of interest on the federal government’s debt. |
Of course, Japan's bubbles burst in 1989, whereas ours burst more recently.
6. The link between the government budget deficit and the government debt is the same as the link between a flow variable and a stock variable. In particular, the government deficit is the flow that adds to the total stock of the government’s debt. A surplus reduces the stock of debt. 7. As shown in Exhibit 5, page 285, the ratio of debt to GDP was at its (all time) high in 1945, when it stood at 114 percent. From the end of World War II until 1974, the ratio generally fell, due mainly to economic growth and inflation. In 1974 the ratio of debt to GDP equaled 24 percent, its lowest level since the end of World War II. From 1974 to about 1993, the ratio rose and in 1993 exceeded 50 percent. Since 1993 the ratio has hovered at roughly 40 percent, but it will rise. 8. Automatic stabilizers are fiscal policies written into existing law. An example is unemployment compensation: As the economy slides into a recession, unemployment increases and with it unemployment compensation payments automatically rise. The higher unemployment compensation payments can keep consumption expenditure from falling as much as otherwise would be the case, and so unemployment compensation payments are an automatic stabilizer. Discretionary fiscal policy requires the government to act, as for instance, a tax cut in the midst of a recession, which requires congressional and presidential action. 9. Some of you may respond that the government purchases multiplier exceeds 1 because it equals 1/(1 – g ). That is, the slope of the AE line is less than 1, so the denominator of the multiplier is less than 1 and hence the entire fraction must exceed 1. While this answer is correct, it is not complete and does not deserve full credit. Instead, a more complete answer points out that an increase in government purchases induces additional consumption expenditure by raising people’s disposable income. Indeed, a very good answer will make the previous point and then compare the government purchases multiplier with the (identically sized) investment multiplier from Chapter 10.10. The lump-sum tax multiplier is the ratio of the change in real GDP to the change in taxes. It equals –b/(1 – g ), where b= MPC, the marginal propensity to consume and g = b(1-t)-m (the slope of AE). The lump-sum tax multiplier is less in absolute value than the government spending multiplier because a change in taxes does not have a direct one-to-one impact on aggregate expenditure. For instance, a $1 billion cut in taxes increases consumption by only (MPC )($1 billion) because only a fraction (MPC) of additional disposable income is spent on consumption. Then, only the MPC fraction has the multiplier effect on aggregate expenditure. By contrast, a $1 billion increase in government purchases has a one-to-one impact on equilibrium expenditure so that the total amount has the multiplier effect on aggregate expenditure.
11. GDP increases when a change in government spending is matched by
a change in taxes because the expansionary effect from the government purchases is larger
than the contractionary effect of the higher taxes. The reason that the expansionary
effect is larger than the contractionary effect is explained in the answer to the previous
question: Government purchases have a one-to-one effect on aggregate expenditure, but
taxes have a less than one-to-one effect.
That is, if the delta (change in) G equals the delta T, all of the delta G
enters on the first round, but only (MPC x delta T) enters to offset it. Thus
autonomous expenditure increases by (1-MPC)deltaG when a balanced budget grows.
12. Both induced taxes and entitlement spending reduce the magnitude of the fiscal policy multipliers. Why? Consider an expansionary policy. During an expansion, people’s disposable incomes rise. The increase in disposable incomes leads them to increase their consumption expenditures, and these actions cause the multiplied effect on aggregate expenditure. Now, examine how income taxes and transfer payments affect the rise in disposable incomes. Because the income tax system is progressive, the rise in incomes means that people’s taxes also rise. Thus the rise in disposable income from the rise in GDP is (partially) offset by the increase in taxes. Moreover, as people’s incomes increase, entitlement spending in the form of transfer payments (e.g., unemployment compensation) falls. This change also (partially) offsets the initial rise in real GDP. Therefore the presence of income taxes and transfer payments moderate the rise in disposable income and thereby also moderate the increase in consumption expenditure, which shrinks the fiscal policy multiplier.
13. International trade — in particular, the existence of imports — reduces the magnitude of the fiscal policy multipliers. Why? As in the previous question, consider an expansionary policy that raises people’s disposable incomes. The rise in incomes leads to an induced increase in consumption expenditures, which further raises people’s incomes and hence induces yet more additional consumption expenditures. However, with international trade some of the higher disposable income is spent on imports. The spending on imports does not boost domestic residents’ income. Hence the increase in income at each round in the multiplier process is smaller because some of the increase "leaks" into spending on imports. Because domestic residents’ incomes increase by less when imports are present, the amount of induced consumption is decreased so that the multipliers become smaller.
14. The deficit tends to fluctuate with the economy, increasing when the economy is in a recession and decreasing when it moves into an expansion. This pattern occurs because tax revenues fall during a recession while expenditures rise. The structural deficit (which is the same as the cyclically adjusted deficit) estimates what the deficit would be if the level of real GDP equaled potential GDP, and thereby eliminates fluctuations in the deficit caused by the business cycle.
15. In the very short run, firms do not raise prices and are willing to produce the quantity demanded. Hence an increase in demand is met completely by increasing the amount produced and the effect on real GDP is largest. But as time passes, firms start to raise prices. As the prices of goods and services rise, the aggregate quantity demanded decreases, so the increase in real GDP is smaller than the initial increase. As time passes, the multiplier — which measures the change in real GDP — becomes smaller because the change in real GDP is becoming smaller and the change in the price level larger.
16. If real GDP equals potential GDP, the long-run effect on GDP from an increase in government purchases is nil (zero). Exhibit 5 on page 262 shows the short-run and long-run effects. The increase in government purchases increases aggregate demand, so that the aggregate demand curve shifts from AD to AD'. In the short-run, the economy stays on its initial short-run aggregate supply curve, SRAS130. GDP increases from $14.0 trillion to $14.2 trillion and the price level rises from 130 to about 136. In the short run, however, the price level has risen but money wages have not changed. Eventually money wages will rise by the same proportion as the price level. Hence in the long run short-run aggregate supply decreases and the SRAS curve shifts leftward from to SRAS140. Hence in the long run, real GDP returns to potential GDP, $14.0 trillion and the price level rises to its (permanently) higher level of 140.