ECON 10020/20020 Principles of Macroeconomics Problem Set 4 Solutions

Transcription

1 ECON 10020/20020 Principles of Macroeconomics Problem Set 4 Solutions Dennis C. Plott University of Notre Dame Department of Economics March 26, dennis.plott@gmail.com 1

2 Name: Dennis C. Plott 1. Due: Thursday 19 th March 2015 by 4:30 p.m. General Instructions 2. Read and follow all instructions/directions carefully. An inability to follow instructions/directions will result in points being deducted. 3. All problems sets submitted must be stapled, handwritten, and include the cover page. 4. Only problem sets submitted in person and/or in class will be accepted. 5. Answer all questions in blue or black ink only; i.e., no pencils or colored inks. The only exception: graphs may be drawn in pencil. Note: use a guide of some sort (e.g., a ruler) for all graphs. Do not use white out or similar products, but neatly cross/scratch out any mistakes. 6. Write, mark, and draw your answers neatly and clearly. If your answer is illegible (i.e., difficult to read in the least), then it will not be graded. It is your job to clearly communicate. 7. Label all graphs fully and completely; i.e., axes, intersections, curves, etc. 8. Support your answers as thoroughly as possible; i.e., graphically, conceptually, and mathematically. Note: this may not be feasible or necessary for all questions asked. State and define any concept utilized and list and name any equation used. In other words, show all of your work. 9. Do not copy from another student. 10. Note: only use materials from this class, listed textbooks, and suggested resources to answer questions. The Google can be quite useful and tempting, but very often a question has been constructed in a very specific manner; i.e., using a certain set of assumptions. Another source may have a very similar problem, but with slightly different underlying assumptions that change the answer completely. This is typically not obvious and will likely leave you very confused. 11. For the True/False/Uncertain questions clearly indicate your choice by writing either True, False, or Uncertain underneath the respective question. Unless explicitly instructed otherwise, a justification is required to receive credit. 12. For the multiple choice questions [2 points each], choose the best answer and mark the letter in the spaces provided at the bottom of the page. Only clearly written letters in the allocated space will be graded. Original Score (%) Adjustment (%) 0 Actual Score (%) 2

3 1. Which of the following would be classified as (discretionary) fiscal policy? (A) The federal government passes tax cuts to encourage firms to reduce air pollution. (B) The Federal Reserve cuts interest rates to stimulate the economy. (C) A state government cuts taxes to help the economy of the state. (D) The federal government cuts taxes to stimulate the economy. D 2. Which of the following is an objective of fiscal policy? (A) homeland security (B) health care coverage for all Americans (C) discovering a cure for AIDs (D) high rates of economic growth D 3. The increase in the amount that the government collects in taxes when the economy expands and the decrease in the amount that the government collects in taxes when the economy goes into a recession is an example of (A) automatic stabilizers. A (B) discretionary fiscal policy. (C) discretionary monetary policy. (D) automatic monetary policy. 4. Which of the following would not be considered an automatic stabilizer? (A) legislation increasing funding for job retraining passed during a recession A (B) decreasing unemployment insurance payments due to decreased jobless during an expansion (C) rising income tax collections due to rising incomes during an expansion (D) declining food stamp payments due to more persons finding jobs during an expansion 5. The largest source of federal government revenue in 2012 was (A) sales taxes. (B) corporate income taxes. (C) individual income taxes. C (D) payroll taxes to fund Social Security and Medicare programs. 1. D 2. D 3. A 4. A 5. C 3

4 6. The tax increases necessary to fund future Social Security and Medicare benefit payments would be (A) small, and have little effect on economic growth. (B) small, but could discourage work effort, entrepreneurship and investment, thereby slowing economic growth. (C) large, but would have little effect on economic growth. (D) large, and could discourage work effort, entrepreneurship and investment, thereby slowing economic growth. D 7. Which of the following is a government expenditure, but is not a government purchase? (A) The federal government buys a Humvee. (B) The federal government pays the salary of an FBI agent. (C) The federal government pays out an unemployment insurance claim. C (D) The Federal government pays to support research on Aids. 8. Social Security (A) has not been successful in reducing poverty among elderly Americans. (B) is a system whereby current retirees are paid from taxes collected from current workers. B (C) has a greater number of workers per retiree today as compared to when it started. (D) currently pays retirees benefits equal to what they paid into the system. 9. If the economy is falling below potential real GDP, which of the following would be an appropriate fiscal policy to bring the economy back to long-run aggregate supply? An increase in (A) the money supply and a decrease in interest rates. (B) government purchases. B (C) oil prices. (D) taxes. 10. The problem causing most recessions is too little (A) money (currency plus checking accounts). (B) spending. B (C) unemployment. (D) taxes. 6. D 7. C 8. B 9. B 10. B 4

5 11. Which of the following would be most likely to induce Congress and the president to conduct expansionary fiscal policy? A significant (A) decrease in investment spending. A (B) decrease in oil prices. (C) increase in consumption spending. (D) increase in net exports. 12. If real GDP exceeded potential real GDP and inflation was increasing, which of the following would be an appropriate fiscal policy? (A) a decrease in the money supply and an increase in the interest rate (B) an increase in government spending (C) an increase in taxes C (D) an increase in oil prices 13. The aggregate demand curve will shift to the left the initial decrease in government purchases. (A) by less than (B) by more than B (C) by the same amount as (D) sometimes by more than and other times by less than 14. A change in consumption spending caused by income changes is change in spending, and a change in government spending that occurs to improve roads and bridges is change in spending. (A) an induced; an autonomous A (B) an expansionary; a contractionary (C) an autonomous; an induced (D) a contractionary; an expansionary 15. Which of the following would increase the size of the government purchases multiplier? (A) an increase in the tax rate (B) an increase in the quantity of imports purchased by households from an increase in income (C) a decrease in the amount of consumption spending by households from an increase in income (D) a decrease in the amount saved by households from an increase in income D 11. A 12. C 13. B 14. A 15. D 5

6 16. Suppose the government spending multiplier is 2. The federal government cuts spending by $40 billion. What is the change in GDP if the price level is not held constant? (A) an increase of less than $80 billion (B) an increase equal to $80 billion (C) an increase of greater than $80 billion (D) a decrease of less than $80 billion D 17. If the tax multiplier is 1.5 and a $200 billion tax increase is implemented, what is the change in GDP, holding everything else constant? (Assume the price level stays constant.) (A) a $300 billion decrease in GDP A (B) a $300 billion increase in GDP (C) a $30 billion increase in GDP (D) a $ billion decrease in GDP 18. Suppose Congress increased spending by $100 billion and raised taxes by $100 billion to keep the budget balanced. What will happen to real equilibrium GDP? (A) Real equilibrium GDP will fall. (B) Real equilibrium GDP will rise. B (C) There will be no change in real equilibrium GDP. (D) Real equilibrium GDP will initially rise, but then fall below its previous equilibrium value. 19. Suppose real GDP is $12.6 trillion and potential GDP is $12.4 trillion. To move the economy back to potential GDP, Congress should (A) lower government purchases by an amount less than $200 billion. A (B) lower government purchases by $200 billion. (C) raise taxes by $200 billion. (D) lower taxes by $200 billion. 20. Suppose real GDP is $12.1 trillion and potential GDP is $12.6 trillion. To move the economy back to potential GDP, Congress should (A) lower taxes by an amount less than $500 billion. A (B) raise government purchases by $500 billion. (C) raise government purchases by more than $500 billion. (D) lower taxes by $500 billion. 16. D 17. A 18. B 19. A 20. A 6

7 21. An equal increase in government purchases and taxes will cause (A) an increase in real GDP. A (B) no change in real GDP. (C) an increase in the budget surplus. (D) a reduction in cyclically adjusted budget surplus. 22. If the government purchases multiplier equals 2, and real GDP is $14 trillion with potential real GDP $14.5 trillion, then government purchases would need to increase by to restore the economy to potential real GDP. (A) $7.25 trillion (B) $1 trillion (C) $500 billion (D) $250 billion D 23. A one-time tax rebate, which is not expected to be extended in future years, will (A) have a small positive effect on consumption and aggregate demand. A (B) have no effect on consumption and aggregate demand. (C) have a significant positive effect on consumption and aggregate demand, with aggregate demand growing by a multiple of the tax rebate. (D) increase aggregate supply and aggregate demand. 24. The use of fiscal policy to stabilize the economy is limited because (A) changes in government spending and tax rates have a small effect on aggregate demand. (B) changes in government spending and tax rates have a small effect on interest rates. (C) the legislative process can be slow, which means that it is difficult to make fiscal policy actions in a timely way. C (D) the Internal Revenue Service (IRS) resists changes in tax rates because of all the changes they would have to make to the tax code. 25. The crowding out of private spending by government spending will be greater the (A) less sensitive consumption, investment, and net exports are to changes in interest rates. (B) more sensitive consumption, investment, and net exports are to changes in interest rates. B (C) less sensitive consumption, investment, and net exports are to changes in the price level. (D) more sensitive consumption, investment, and net exports are to changes in the price level. 21. A 22. D 23. A 24. C 25. B 7

8 26. The impact of crowding out may be the least (A) during a deep recession. A (B) when real GDP is above but close to potential GDP. (C) during an expansion. (D) when real GDP is below but close to potential GDP. 27. To evaluate the size of the federal budget deficit or surplus over time, it would be best to look at the (A) absolute size of the budget deficit or surplus. (B) budget deficit or surplus as a percentage of GDP. B (C) budget deficit or surplus as a percentage of tax revenues. (D) budget deficit or surplus as a percentage of government spending. 28. A recession tends to cause the federal budget deficit to because tax revenues and government spending on transfer payments. (A) increase; rise; falls (B) increase; fall; rises B (C) decrease; rise; falls (D) decrease; fall; rises 29. For the federal deficit to be lowered, (A) the federal government must decrease its spending and increase net exports. (B) the federal government s expenditures must be lower than its tax revenue. B (C) the Federal Reserve must raise interest rates and lower the required reserve ratio. (D) the Federal Reserve must reduce the money supply. 30. Which of the following is a reason why we should consider the federal national debt a problem? (A) The federal government is in danger of defaulting on its debt. (B) If the debt drives up interest rates, crowding out will occur. B (C) If the debt was incurred to finance improvements in infrastructure, crowding out will occur. (D) If the debt was incurred to finance research and development, crowding out will occur. 26. A 27. B 28. B 29. B 30. B 8

9 31. Suppose the government wants to maintain a balanced budget. To achieve this goal, when the economy falls into recession government would need to taxes, which would cause aggregate demand to. (A) decrease; decrease (B) decrease; increase (C) increase; decrease C (D) increase; increase 32. The government budget for the country of Economia is in surplus in 2011, and in deficit in the following year, We can conclude the (A) government must have raised tax rates or cut spending. (B) government must have cut tax rates or increased spending. (C) government fiscal policy did not change between 2011 and (D) none of the above D 33. The Council of Economic Advisers (A) proposes the president s budget each year. (B) approves fiscal policy changes. (C) helps the president and the public stay informed about the state of the economy. C (D) helps the president make changes in monetary policy. 34. You are hired by the Council of Economic Advisors (CEA) as an economic consultant. The Chairperson of the CEA tells you that she believes the current unemployment rate is too high. The unemployment rate can be reduced if aggregate output increases. She wants to know what policy to pursue to increase aggregate output by $300 billion. The best estimate she has for the MPC is 0.8. Which of the following policies should you recommend? (A) Increase government purchases by $60 billion. A (B) Increase government purchases by $150 billion. (C) Cut taxes by $60 billion. (D) Cut taxes by $60 billion and to increase government purchases by $60 billion. 35. Fiscal policy is determined by (A) the Federal Reserve. (B) the president and the Federal Reserve. (C) Congress and the Federal Reserve. (D) Congress and the president. D 31. C 32. D 33. C 34. A 35. D 9

10 36. The Financial Times 1 reports Australia s economy has been free from recession for nearly a quarter of a century because of a mining boom and economic reforms. However, the mining boom is fading away and businesses are restraining their spending. The fall off in mining has restricted business profits and is expected to continue for the foreseeable future. (a) [10 points] Demonstrate the change in expected future business profits using the closed AD SRAS LRAS graph, ceteris paribus, in both the short-run and long-run. Clearly explain the economic rationale for why the curve(s) shift, if at all. State explicitly what occurs to the (i) price level, (ii) natural rate of output, (iii) output, (iv) nominal wage, (v) investment, and (vi) government expenditure; i.e., increase, decrease, unchanged, or ambiguous. P LRAS AS 0 (W 0 ) AS 1 (W 1 ) P 0 a P 1 b P 2 z Y 1 Y 0 = Y 0 = Y 2 AD 1 (I 1 ) AD 0 (I 0 ) Y expected future business profits ceteris paribus I AD curve shifts leftward Short-Run (a b) P < 0 (P 1 < P 0 ) Y < 0 (Y < Y ) Y = 0 W = 0 I < 0 G = 0 Long-Run (b z) Nominal wages become flexible in the long-run. In the short-run, due to the decline in investment, Y < Y ; i.e., recessionary pressure. When contracts are renegotiated or new workers hired, workers will receive a lower nominal wage ( W ). W lowers input prices for firms allowing for increased production. The SRAS will subsequently shift rightward until the economy returns to long-run equilibrium (Y = Y ). P < 0 (P 2 < P 0 ) Y = 0 (Y = Y ) Y = 0 W < 0 I < 0 G = 0 1 Financial Times Australia GDP Data Set Stage for Rate Cut 4 March 2015 by Jamie Smyth 10

11 (b) [10 points] The self-correcting mechanism (i.e., when the economy returns to the natural rate of output without any intervention but through nominal wage changes), particularly in the case of a recession, may take a long time to adjust towards the natural rate of output. As a result, policy makers may wish to intervene in order to, at least, expedite the adjustment process. Suggest a fiscal policy to target output; i.e., expansionary or contractionary change in government expenditure. Demonstrate the change in fiscal policy using the closed AD SRAS LRAS graph, ceteris paribus, after the initial short-run shock (i.e., short-run from part (a) above), but before the nominal wages and prices are fully flexible. Clearly explain the economic rationale for why the curve(s) shift, if at all. State explicitly what occurs to the (i) price level, (ii) natural rate of output, (iii) output, (iv) nominal wage, (v) investment, and (vi) government expenditure; i.e., increase, decrease, unchanged, or ambiguous. How does the fiscal policy situation differ, comparing the variables of interest, from the self-correcting version? P LRAS AS 0 (W 0 ) P 0 = P 2 z P 1 b AD 0 (I 0, G 0 ) = AD 2 (I 1, G 1 ) Y 1 Y 0 = Y 0 = Y 2 AD 1 (I 1, G 0 ) Y expected future business profits ceteris paribus I AD curve shifts leftward Short-Run (a b) [Identical to part (a) above] P < 0 (P 1 < P 0 ) Y < 0 (Y < Y ) Y = 0 W = 0 I < 0 G = 0 Fiscal Policy (b z) Note: long-run, by definition, is when everything is able to fully adjust; e.g., nominal wages, price level, etc. The fiscal policy intervenes before this occurs. Expansionary fiscal policy: G > 0. P = 0 (P 2 = P 0 ) Y = 0 (Y = Y ) Y = 0 W = 0 I < 0 G > 0 11

12 37. [10 points] Recently in the State of the State address, Governor Mike Pence proposed a balanced budget amendment to Indiana s constitution 2. Although every state, save Vermont, has provisions in their constitution regarding the state budget and several states have passed amendments requiring balanced budgets, there is no balanced budget provision in the U.S. Constitution. True or False: A law requiring the federal government to balance its budget in each year would serve as an automatic stabilizer. False. Automatic stabilizers serve to dampen or mute contractions in the business cycle (i.e., economic downturns recessions) without the approval of Congress or the President. Automatic stabilizers include having a progressive tax structure and transfer payments (e.g., unemployment insurance), often causing or exacerbating budget deficits during recessions. A balanced budget amendment would not, in general, allow for budget deficits, thereby making economic situations worse/less stable by requiring taxes to increase if government outlays increase. Without special provisions, a balanced budget amendment would act like an automatic destabilizer. Note: The above response is paraphrased from one of your classmates answers; I thought it was better than my original solution. 2 Indianapolis Star Pence Calls for Balanced Budget Amendment in State of State Address 14 January 2015 by Tony Cook 12