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Chapter 7
Fiscal Policy

1. Fiscal policy
a. uses the federal governments power of
spending and taxation to affect employment,
price levels, and GDP.
b. uses the federal governments power over the
money supply and interest rates to affect
employment, the price level, and GDP.
c. can affect employment and price, but not the
level of GDP.

A. Fiscal policies are policies of the federal government to


influence demand. During periods of inflation we would
want demand to decrease, during periods of
unemployment we would want demand to increase.

2. At any given price level (and with other things


held constant) an increase in government
purchase or transfer payments is most likely to
decrease which of the following?
a. The amount of real GDP demanded.
b. The size of the federal debt.
c. The amount of unemployment.
d. The supply of money.

C. The purpose of an increase in government


spending when used as a fiscal policy is to
put unemployed people back to work.

3. John M. Keynes is best known for advocating


a. a policy of annually balancing the budget.
b. deficit spending during some recessions.
c. the fixed-growth-rate monetary rule.

B. Before the Great Depression of the 1930s Classical


economics was the accepted believe. According the
Classical thinking, the economy was always tending
toward a full employment equilibrium, therefore there
was no need for government intervention. Keynes
believed that the economy could tend toward a less
then full employment equilibrium, therefore, in this
case, there was need for government intervention to
move the economy to a full employment equilibrium.
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4. If government purchases of good and services increase by $10


billion when the MPC is .8 and the MPS is therefore .2, then
a. real GDP will increase by $16 billion.
b. real GDP will increase by $20 billion.
c. real GDP will increase by $40 billion.
d. real GDP will increase by $50 billion.

D. The formula for the multiplier is 1/MPS. Because


the MPS is 2/10, which equals 1/5, the multiplier
is equal to 1 divided by 1/5 or 5. Now take the
multiplier and multiply it by the spending
increase and you get 5 x $10 billion = $50 billion.

5. When automatic stabilizers kick in to partially


counteract recessionary forces
a. aggregate demand rises above its pre-recession
level.
b. the deficit falls below its pre-recession level.
c. the government tends to have more of a deficit,
which is intended to stimulate the economy.

C. An example of an automatic stabilizer is


unemployment benefits. During recessions the economy
experiences insufficient aggregate demand, the
unemployment benefits help to increase aggregate
demand.

6. The balanced budget multiplier


a. is greater than 1.
b. is less than 1.
c. is equal to 1.
d. can be more or less than 1.

A. It is greater than 1 because when the


government increases taxes and increases
spending by the same amount there is a
positive stimulus effect because if citizens
had the money they would save a portion
of it, but when the government has the
money it spends all of it.
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7. Lets say inflation remains stable and huge


government budget deficits drive up market
interest rates. This will cause
a. foreign investment in the U.S. to increase.
b. imports to decrease.
c. the foreign trade deficit to decrease.
d. the value of the dollar to depreciate
relative to foreign currencies.

A. As interest rates in America increase relative to


interests rates in foreign countries, everything
else remaining the same, will give foreigners an
incentive to put their money in America to take
advantage of the favorable interest rates.
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8. Which of the following steps does not belong in a


sequence reflecting the impact on international
markets of increased borrowing?
a. The U.S. Treasury sells securities.
b. The sale of securities drives up interest rates.
c. The rising value of the dollar leads to
increased U.S. exports and reduced imports.

C. Higher interest rates in America will attract foreign


investment. But to invest in America, foreigners need
American dollars, thus the demand for dollars increases
in the world market, increasing the dollars value.
Foreign products are now less expensive to Americans
and American products more expensive to foreigners.
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9. Which of the following would neutralize and offset


the stimulating effect of deficit spending?
a. Increased saving.
b. Increased investment spending.
c. Increased personal consumption expenditures.
d. A decrease in taxes.

A. The more people can save, the less dependent they


will be on the government when they retire.

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10. All of the following are variables that can be


manipulated to affect fiscal policy except
a. personal income taxes.
b. government expenditures on goods and services.
c. government expenditures on unemployment benefits.
d. the rate of interest.

D. A change in interest rates are influenced by the


Federal Reserve. The Feds ability to increase or
decrease the nations money supply gives it some
influence as to what happens to interest rates.

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11. A $100 billion dollar increase in government


spending increases real GDP more than a $100
billion reduction in net taxes because
a. some of the dollars consumers gain from the tax
reduction will be saved.
b. some of the dollars consumers gain from the tax
reduction will be spent on services.
c. consumers will spend some of it on foreign goods.

A. The multiple effect is greater when the government has


the $100 billion because it will spend all of it - if citizens
have the money, they will save a portion of it - depending
on the Marginal Propensity to Consume (MPS).
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12. When the MPC is .75, a decrease in net taxes of $100


billion will increase the equilibrium level of real GDP by
a. $75 billion.
b. $100 billion.
c. $300 billion.

C. -MPC/(1-MPC) = -.75/.25 = -3;


-3 x -$100 billion = $300 billion.

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13. The effect of a change in net taxes on the quantity


of real GDP demanded equals the resulting shift in
the consumption function times
a. the marginal propensity to consume.
b. the marginal propensity to save.
c. the autonomous net tax multiplier.

C. The autonomous net tax multiplier is the ratio of a


change in equilibrium real GDP demanded to the
initial change in autonomous net taxes that brought
it about; the numerical value of the multiplier is
-MPC/(1-MPC).

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14. When net taxes and government purchases are


reduced by the same amount
a. there will be an increase in real GDP equal
to the size of the reduction.
b. there will be a decrease in real GDP equal to
the size of the reduction.
c. there will be an increase in real GDP that
depends upon the size of the multiplier.
d. there will be a decrease in the real GDP
depending on the size of the multiplier.

D. The multiplier works in reverse. If there is a


reduction of X amount of spending, real GDP
will decrease by a multiple of that decrease.
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15. Which of the following is an example of fiscal policy?


a. The Federal Reserve Board reduces interest rates.
b. The local school board raises teachers salaries.
c. General Electronics Corp. borrows $100 million to
build anew factory.
d. The federal government reduces personal income
tax rates.

D. Fiscal policies are policies of the federal government


for the purpose of increasing or decreasing aggregate
demand to fight either unemployment or inflation.

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16. All of the following are components of the


aggregate expenditure function which may be
examples of fiscal policy except
a. government expenditure for social security.
b. consumption expenditure for appliances.
c. investment expenditures for capital equipment.
d. government expenditures for highway
construction.

A. Government spending on Social Security is


simply a transfer payment; money is taken
from one group and given to another group.

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17. According to Keynesian economics,


when have an unemployment problem
an effective fiscal policy might be to
a. reduce market prices.
b. reduce interest rates.
c. increase the money supply.
d. increase government purchases.

D. All of the above would help when we are in a


less than full employment equilibrium; but
only an increase in government purchases is a
fiscal policy, the others are monetary policies.

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18. According to Keynesian economics, when is


fiscal policy effective in eliminating a less than
full employment equilibrium? When it
a. increases potential GDP.
b. increases the equilibrium level of real GDP.
c. increases the rate of unemployment.
d. decreases the level of prices.

B. Fiscal policies differ from monetary polices in that


they can shift the equilibrium. With unemployment
present the economy may be tending toward a
point of less than full employment. By shifting
aggregate demand upward, the intent is to move
the equilibrium to a full employment equilibrium.
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19. According to Keynesian economics, an


appropriate fiscal policy to deal with
inflation is to
a. increase the rate of interest.
b. increase farm subsidy payments.
c. increase government purchases.
d. increase personal taxes.

D. Choice a is a monetary policy. An increase in


personal taxes would decrease taxpayers
disposable income. With the resultant decrease in
demand, prices would decline.

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20. According to Keynesian economics, when


we have inflation an effective fiscal policy
might include all of the following except
a. increase personal taxes.
b. increasing corporate taxes.
c. increasing aggregate demand.
d. decreasing government purchases.
C. With inflation the economy could be overheated.
So we want to cool it down by lowering aggregate
demand. Increasing personal taxes, increasing
corporate taxes, and decreasing government
purchases lowers aggregate demand.

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21. When the aggregate supply (AS) curve


has a positive slope, effective fiscal policy
to correct an inflation problem will
a. only reduce prices.
b. only reduce real GDP.
c. only increase prices.
d. reduce both prices and real GDP.

D. Simply draw this out on a piece of paper. With


an up-sloping curve and a down-sloping demand
curve, a shift to the left of the demand curve will
bring about a decrease in prices (vertical axis)
and an decrease in real GDP (horizontal axis).

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22. John M. Keynes influenced the use of fiscal policy


in the U.S. by arguing effectively that
a. that balancing the national budget at all times
was sound economic policy.
b. national economic forces were not necessarily
adequate to move the economy towards its
potential output level.
c. the government did not need to stimulate output
in order for the economy to achieve its potential
output level.

B. The biggest difference between Keynes and the Austrians


was that Keynes believed that the economy could tend
toward a point of less than full employment. Austrians
believe that if we allowed market forces to operate we
would tend toward a point of full employment.
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23. Prior to the Great Depression of the


1930s, the dominant fiscal policy was
a. to lower taxes whenever
unemployment began to increase.
b. to increase government purchases
whenever the nations output fell
below its potential output level.
c. to raise taxes or reduce government
purchases whenever necessary to
balance the federal budget.

C. The Austrian economists did not believe in fiscal policies


to stimulate the economy during periods of recession.
However, they did believe that it was fiscally sound for
the federal government to have a balanced budget.
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24. Which of the following is the best example of an


automatic stabilizer in fiscal policy?
a. Spending more on national highways.
b. Paying pensions to retired military personnel.
c. Paying unemployment insurance benefits.
d. Decreasing the supply of money.

C. Automatic stabilizers go into effect during periods


of unemployment and cease when the economy
recovers. Only the payment of unemployment
benefits in the above choices fits this description.

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25. Automatic stabilizers


a. have no effect on unemployment levels.
b. have no effect on output levels.
c. increase inflation.
d. reduce the magnitude of economic fluctuations.

D. Automatic stabilizers do not totally


reverse a decline in aggregate demand (for
this to happen the payments would have to
equal all of a persons loss of income), but
they do slow down the downward trend.

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26. All of the following are automatic stabilizers except


a. unemployment insurance benefits.
b. payments to welfare recipients.
c. progressive federal income taxes.
d. national defense expenditures.

D. An automatic stabilizer goes into effect


automatically when the economy takes a dive and
is taken off when the economy recovers. Such is
not the case with national defense expenditures.

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27. Which of the following is the best example of


anti-recession discretionary fiscal policy?
a. An increase in government expenditures on
public construction projects like bridges,
dams, and roads.
b. A decrease in taxes on liquor and cigarettes.
c. A decrease in welfare payments.

A. Discretionary fiscal policies differ from automatic


stabilizers in that they are not automatic, but are up
to the discretion of Congress. When the government
increases spending, it is best to spend it on building
our infrastructure, like roads and bridges.

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28. The Golden Age of fiscal policy - that


decade in which it was most in political favor
and in which it seemed to work best - was
a. the 1930s.
b. the 1940s.
c. the 1950s.
d. the 1960s.
e. the 1970s.
D. Keynesian economics was at its peak popularity
in the 1960s. The stagflation of the 1970s made
us realize the limitations of Keynesian policies.

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29. Which one of the following is not one of


the concerns most often expressed about
the effectiveness of fiscal policy?
a. The difficulty of estimating the natural
rate of unemployment.
b. The time lags involved in
implementing fiscal policy.
c. An increase in aggregate demand tends
to worsen unemployment.
C. An increase in aggregate demand will
cause an increase in employment.

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30. The rate of unemployment that occurs when the


economy is producing its potential GDP is
a. called the natural rate of unemployment.
b. naturally zero.
c. thought to be approximately 10%.
d. equal to the rate of stagflation in most years.

A. The natural rate of unemployment equals full


employment. If, lets say, five percent of the labor
force would be looking for work even in the best of
times, then five percent or less of unemployment
would be considered full employment.

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31. Which of the following does not hamper the


effectiveness of discretionary fiscal policy?
a. The difficulty of estimating the natural rate of
unemployment.
b. Time lags involved in enacting appropriate
legislation.
c. The difficulty of getting an accurate measure of
the rate of inflation.
d. Time lags involved in recognizing the need for
fiscal policy.

C. Discretionary fiscal policies would be used


more for unemployment and not inflation.
Even if they were used for inflation, we have
no difficulty in measuring the inflation rate.
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32. People will be likely to spend a higher


percentage of any additional income when
a. they believe that the increase is permanent.
b. they believe that the increase is temporary.
c. the increase is large.
d. the increase is small.

A. One of the failings of discretionary fiscal policies is


that they can bring about changes that consumers will
view as temporary and not permanent. It has been
shown that people will base their spending habits
more on what they consider their permanent income
and less so on their perceived temporary income.

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33. A temporary tax increase will fail to reduce


consumption expenditures by the amount
expected because
a. people viewed the tax increase as permanent.
b. people viewed the tax increase as temporary.
c. people chose to increase their saving.
d. consumption expenditures are unrelated to
the level of taxation.

B. This is an example of a fiscal policy that


was not effective because it was perceived
as temporary and not permanent.

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34. Changes in discretionary fiscal policy (e.g., taxes)


and automatic stabilizers (e.g., unemployment
insurance benefits) can have significant unintended
effects on all of the following except
a. the incentive to work.
b. the incentive to spend.
c. the incentive to save.
d. the incentive to purchase imported goods.

D. Whether people purchase imported goods or not


has nothing to do with discretionary fiscal policies.

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35. Raising taxes as an element of discretionary fiscal


policy is intended to reduce aggregate demand,
but it can also reduce aggregate supply if
a. the higher taxes lead workers to seek out a
second job.
b. the higher taxes cause workers to work less.
c. the government purchases goods with the
additional revenue.
B. With an increase in taxes tax-payers
disposable income decreases. If they use their
disposable income as a measure of if they
should work or not, workers will work less.

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36. President Reagan and the U.S. Congress agreed


on substantial changes in the federal budget in
the early 1980s. Among these changes was
a. a decrease in defense spending.
b. a 3% tax reduction.
c. a 13% tax reduction.
d. a 23% tax reduction.

D. We had the largest tax decrease in history


under President Reagan. The big tax
decreases in the early 1980s contributed
greatly to the prosperity of the 1990s.

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37. The lower tax rates enacted in the


early 1980s were intended to
a. increase the supply of labor.
b. increase the price level.
c. increase unemployment benefits.
d. reduce potential GDP.

A. This is what is called supply side


economics. By lowering taxes, people will
more of an incentive to work and invest.

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38. The Reagan experiment in supply-side


economics resulted in all of the following except
a. growth in employment.
b. a period of sustained economic growth.
c. a reduction in the federal debt.

C. In the long run, a decrease in taxes will lead to an increase


in real GDP do to the increase in economic growth.
However, in the short run, this decrease in taxes will
decrease government tax revenue and therefore add to the
national debt, assuming no decrease in government
spending. Government spending actually increased under
Reagan because of big increases in military spending.

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39. Large federal budget deficits


a. can best be reduced by discretionary fiscal policy.
b. make it difficult to use discretionary fiscal policy.
c. in the mid to late 1980s were the result of a severe
recession.
d. still constitute only about 1% of the GDP.

B. Large deficits make it difficult for discretionary fiscal


policy because the lower taxes and/or increases in
government spending can add to the national debt.

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40. The idea that non-inflationary economic growth


can be induced by government programs designed
to increase production and labor effort is called
a. the balanced budget multiplier.
b. the feedback effect.
c. an automatic stabilizer.
d. supply side economics.

D. Keynesian economics stresses a reliance on the


demand side of the equation. Supply side economics
dwells on the supply side of the equation. A decrease
in costs will move the aggregate supply curve to the
right, thus prices decline and real GDP increases.

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41. The depression of 1920-1921 was


a. as severe as the depression of the 1930s.
b. brief and swift.
c. a case where the economy was allowed to
correct the problem itself.

C. We did not come in and impose all kinds of


government programs as we did in the
1930s. Some economists believe that it was
government policies of the 30s which led to
the length and severity of the depression.

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42. According the budget philosophy known as


functional finance
a. the budget should be balanced annually.
b. surpluses should be run during periods of
prosperity and deficits should be run during
recessions.
c. the government should not worry about whether
the budget is balanced and worry instead about
reaching the potential output level.

C. Functional finance is a budget philosophy aiming fiscal


policy at achieving potential GDP rather than balancing
budgets either annually or over the business cycle.

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43. An annually balanced budget


a. is the surest path to economic stability.
b. is required by the U.S. Constitution.
c. accentuates cyclical swings by increasing
government spending during expansions
and reducing it during recessions.

C. During certain recessions the problem is insufficient


aggregate demand, so we would want the government
to increase its spending. During expansions, the
problem could be too much spending, so we would
want the government to spend less. A mandated
annually balance budget would hamper this process.

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44. Which of the following statements about the tax cut


enacted in 1981 during the Reagan administration is
correct?
a. The tax cut caused the recession of 1982.
b. The tax cut of 1981 and the recession of 1982 combined
to produce one of the largest peace-time deficits up to
that time.
c. The tax cut stimulated a large increase in economic
activity and led directly to the balanced budget of 1982.

B. In the long run, a tax cut will increase economics


growth and tax receipts. But, in the short run, the tax
cut will lower government receipts. During recessions,
government outlays grows while tax receipts diminish.

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45. The Budget Enforcement Act of 1990


a. was a package of spending cuts and tax
increases designed to reduce the deficit.
b. was proposed by President Clinton.
c. immediately succeeded in balancing the budget.

A. With concern about the deficit growing, Congress and


President Bush agreed to the 1990 Budget Enforcement
Act, a package of spending cuts and tax increases aimed
at trimming the projected deficit. Afterward, Congress
ignored its promise to cut spending and Bush lost the
election largely because the tax increase he agreed to
went against his read my lips, no new taxes promise.
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46. A big difference between states and the federal


government is that states have to balance their budget
each year whereas the federal government does not.
a. True
b. False

A. True. Because 48 states require an annually


balanced budget, they have not experienced the
debt problems the way the federal government has.

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47. When the unemployment rate


increases the federal deficit
a. decreases.
b. increases.
c. is not affected.

B. Recessions bring about an increase in deficits for two


reasons, first government receipts go down because
unemployed people do not pay taxes, second,
government spending increases as benefits increase.

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48. The national (or federal) debt is


a. the same thing as the federal deficit.
b. the accumulation of all past deficits and surpluses.
c. less than it was in 1946 if adjusted for inflation.
d. held entirely by U.S. firms and households.

B. The deficit how much we borrow in a given year.


The total of the deficits adds up to the national debt.

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