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# 12.4: Review and Practice

## Summary

The government sector plays a major role in the economy. The spending, tax, and transfer policies of local, state, and federal agencies affect aggregate demand and aggregate supply and thus affect the level of real GDP and the price level. An expansionary policy tends to increase real GDP. Such a policy could be used to close a recessionary gap. A contractionary fiscal policy tends to reduce real GDP. A contractionary policy could be used to close an inflationary gap.

Government purchases of goods and services have a direct impact on aggregate demand. An increase in government purchases shifts the aggregate demand curve by the amount of the initial change in government purchases times the multiplier. Changes in personal income taxes or in the level of transfer payments affect disposable personal income. They change consumption, though initially by less than the amount of the change in taxes or transfers. They thus cause somewhat smaller shifts in the aggregate demand curve than do equal changes in government purchases.

There are several issues in the use of fiscal policies for stabilization purposes. They include lags associated with fiscal policy, crowding out, the choice of which fiscal policy tool to use, and the possible burdens of accumulating national debt.

## Concept Problems

1. What is the difference between government expenditures and government purchases? How do the two variables differ in terms of their effect on GDP?
2. Federally funded student aid programs generally reduce benefits by $1 for every$1 that recipients earn. Do such programs represent government purchases or transfer payments? Are they automatic stabilizers?
3. Crowding out reduces the degree to which a change in government purchases influences the level of economic activity. Is it a form of automatic stabilizer?
4. Why is it important to try to determine the size of the fiscal policy multiplier?
5. Suppose an economy has an inflationary gap. How does the government’s actual budget deficit or surplus compare to the deficit or surplus it would have at potential output?
6. Suppose the president was given the authority to increase or decrease federal spending by as much as $100 billion in order to stabilize economic activity. Do you think this would tend to make the economy more or less stable? 7. Suppose the government increases purchases in an economy with a recessionary gap. How would this policy affect bond prices, interest rates, investment, net exports, real GDP, and the price level? Show your results graphically. 8. Suppose the government cuts transfer payments in an economy with an inflationary gap. How would this policy affect bond prices, interest rates, investment, the exchange rate, net exports, real GDP, and the price level? Show your results graphically. 9. Suppose that at the same time the government undertakes expansionary fiscal policy, such as a cut in taxes, the Fed undertakes contractionary monetary policy. How would this policy affect bond prices, interest rates, investment, net exports, real GDP, and the price level? Show your results graphically. 10. Given the nature of the implementation lag discussed in the text, discuss possible measures that might reduce the lag. ## Numerical Problems 1. Look up the table on Federal Receipts and Outlays, by Major Category, in the most recent Economic Report of the President available in your library or on the Internet. 1. Complete the following table: Category Total outlays Percentage of total outlays National defense International affairs Health Medicare Income security Social Security Net interest Other 2. Construct a pie chart showing the percentages of spending for each category in the total. 2. Look up the table on ownership of U.S. Treasury securities in the most recent Economic Report of the President available on the Internet. 1. Make a pie chart showing the percentage owned by various groups in the earliest year shown in the table. 2. Make a pie chart showing the percentage owned by various groups in the most recent year shown in the table. 3. What are some of the major changes in ownership of U.S. government debt over the period? 3. Suppose a country has a national debt of$5,000 billion, a GDP of $10,000 billion, and a budget deficit of$100 billion.
1. How much will its new national debt be?
2. Compute its debt-GDP ratio.
3. Suppose its GDP grows by 1% in the next year and the budget deficit is again $100 billion. Compute its new level of national debt and its new debt-GDP ratio. 4. Suppose a country’s debt rises by 10% and its GDP rises by 12%. 1. What happens to the debt-GDP ratio? 2. Does the relative level of the initial values affect your answer? 5. The data below show a country’s national debt and its prime lending rate. Year National debt (billions of$) Lending rate (%)
1992 4,064 6.0
1993 4,411 6.0
1994 4,692 8.5
1995 4,973 8.7
1996 5,224 8.3
1997 5,413 8.5
1. Plot the relationship between national debt and the lending rate.
2. Based on your graph, does crowding out appear to be a problem?
6. Suppose a country increases government purchases by $100 billion. Suppose the multiplier is 1.5 and the economy’s real GDP is$5,000 billion.
1. In which direction will the aggregate demand curve shift and by how much?
2. Explain using a graph why the change in real GDP is likely to be smaller than the shift in the aggregate demand curve.
7. Suppose a country decreases government purchases by $100 billion. Suppose the multiplier is 1.5 and the economy’s real GDP is$5,000 billion.
1. In which direction will the aggregate demand curve shift and by how much?
2. Explain using a graph why the change in real GDP is likely to be smaller than the shift in the aggregate demand curve.
8. Suppose a country decreases income taxes by $100 billion, and this leads to an increase in consumption spending of$90 billion. Suppose the multiplier is 1.5 and the economy’s real GDP is $5,000 billion. 1. In which direction will the aggregate demand curve shift and by how much? 2. Explain using a graph why the change in real GDP is likely to be smaller than the shift in the aggregate demand curve. 9. Suppose a country increases income taxes by$100 billion, and this leads to a decrease in consumption spending of $90 billion. Suppose the multiplier is 1.5 and the economy’s real GDP is$5,000 billion.
1. In which direction will the aggregate demand curve shift and by how much?
2. Explain using a graph why the change in real GDP is likely to be smaller than the shift in the aggregate demand curve.
10. Suppose a country institutes an investment tax credit, and this leads to an increase in investment spending of $100 billion. Suppose the multiplier is 1.5 and the economy’s real GDP is$5,000 billion.
1. In which direction will the aggregate demand curve shift and by how much?
2. Explain using a graph why the change in real GDP is likely to be smaller than the shift in the aggregate demand curve.
11. Suppose a country repeals an investment tax credit, and this leads to a decrease in investment spending of $100 billion. Suppose the multiplier is 1.5 and the economy’s real GDP is$5,000 billion.
1. In which direction will the aggregate demand curve shift and by how much?
2. Explain using a graph why the change in real GDP is likely to be smaller than the shift in the aggregate demand curve.
12. Explain why the shifts in the aggregate demand curves in questions 7 through 11 above are the same or different in absolute value.