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Page 285 1a. Because real output falls short of its potential level, an expansionary fiscal policy is called for, which means government purchases should be increased. b. With unemployment below its natural rate, a contractionary fiscal policy should be used. This means government purchases should be decreased. c. With the economy already at potential output and the corresponding natural rate of unemployment, there is no need for fiscal policy. 2a. With shrinking incomes and spending, tax revenues fall. Meanwhile government transfer payments and subsidies rise. The result is a reduction in net tax revenues, which has a stabilizing expansionary effect on the economy. b. With expanding incomes and spending, tax revenues rise. Government transfer payments and subsidies, meanwhile, fall. This leads to a rise in net tax revenues, which has a stabilizing contractionary impact on the economy. Page 292 1a. Withdrawals will have to rise by the same amount of $1 million to bring injections and withdrawals back into balance. b. With an MPW of 0.67, then incomes and output must rise by $1.5 million, since each $1.50 in extra income will create $1 [= (0.67 x $1.50)] in additional withdrawals. c. The $1.5 million found in part b can be derived by multiplying the initial $1 million increase in injections by the spending multiplier [= ($1 million x (1/0.67))]. 2a. With a $10 billion fall in government purchases, the AD curve shifts to the left by -$16.67 billion [= (-$10 billion x (1/0.60)]. b. The initial $25 billion rise in spending due to the tax cut causes the AD curve to shift to the right by $31.25 billion [= ($25 billion x (1/0.80)]. c. An MPC of 0.25 means that the economy’s MPW is 0.75 [= (1 – 0.25)]. Therefore, with a $15 billion rise in government purchases, the AD curve shifts to the right by $20 billion [= ($15 billion x (1/0.75)]. d. An MPC of 0.45 means the economy’s MPW is 0.55 [= (1 – 0.45)]. With a $30 billion tax rise, the AD curve shifts to the left by -$22.5 billion [= -(0.45 x $30 billion) x (1/0.60)]. Page 297 1a. With expenditures of $10 billion and tax revenues of $15 billion, there is a budget surplus of $5 billion [= ($15 billion - $10 billion)], and the government’s debt falls to $95 billion [= ($100 billion - $5 billion)]. b. If expenditures are $12.5 billion and tax revenues are $10 billion, there is a budget deficit of -$2.5 billion [= ($10 billion - $12.5 billion)]. The government’s debt therefore rises instead to $102.5 billion [= ($100 billion + $2.5 billion)]. 2a. If a government applies the guideline on annually balanced budgets, public debt does not rise, which is a potential advantage to the economy. However, this policy guideline has a potential problem, since its use worsens the severity of the business cycle. During economic contractions, falling tax revenues mean that the guideline can be met only by cutting government purchases. This magnifies the contraction in incomes and spending. Similarly, during economic expansions, the rise in tax revenues allows for an increase in government purchases, which magnifies the expansion in incomes and spending. b. If the guideline of cyclically balanced budgets is followed, public debt does not rise, as in the case of annually balanced budgets. Again, this is a potential advantage to the economy. The potential problem with this guideline, however, is the fact that governments may not succeed in meeting it, given the difficulty in ensuring that periods of budget deficits and budget surpluses exactly balance. c. The potential advantage of using the functional finance guideline is that unemployment is minimized. The potential problem, meanwhile, is the fact that public debt may rise to unsustainable levels. |