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

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

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

Expenditures < Revenues

Expenditures > Revenue

Discretionary changes in taxes and/or spending affect the Budget

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

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

Increase in budget deficit

Higher realinterest rates

Inflow of financial capital from abroad

Decline inprivate investment

Appreciation of the dollar

Decline in net exports

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

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

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

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

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

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

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.

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

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.

• 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

“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.

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

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.

2003 -3752004 -4002005 -3002006 -247.7

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

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

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.