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Initial Equilibrium, Government Spending, Loanable Funds, Principles of Macroeconomics

The key words in this Macroeconomics course include Initial Equilibrium, Government Spending, Loanable Funds, Interest Rate, Fiscal Stimulus, Fiscal Policy, Tax Rates, Savings, Supply, Demand

The graph below shows initial equilibrium in the loanable funds market at $800 million and an interest rate of 4%, point A. Now, assume that the government increases spending by $100 million that is entirely deficit-financed. The new equilibrium in the loanable funds market is now $840 million and an interest rate of 5%, point B.

If we assume there was no government debt prior to the fiscal stimulus, determine the new quantities for the blanks below.
Savings: _______ million
Investment: _______ million
Private consumption decreases by: _______ million

$740; $740; $60

$840; $840; $40

$840; $740; $40

$840; $840; $60

Explanation: When the demand for loanable funds shifts to the right, total savings increases by $40 million, for a new level of savings of $840 million. Government spending increases by $100 million as stated in the question. This means that private investment has $740 million of savings available ($840 million – $100 million). Finally, private consumption falls by $40 million as anything not consumed is considered savings. Recall that total savings increased by $40 million.

The new classical critique of activist fiscal policy is theoretically different from the crowding-out critique. Crowding-out occurs when private spending __________ in response to government spending. Under the new classical critique, increased government spending leads people to __________ their current savings in order to help pay for higher taxes in the future, which increases the __________ of loanable funds.

decreases; increase; supply

increases; increase; demand

decreases; decrease; supply

decreases; decrease; demand

Explanation : Crowding-out occurs when increased government spending causes a decrease in private spending. The new classical critique explains how saving shifting occurs. As government spending increases, people know they will have to pay higher taxes eventually, which increases current savings. An increase in savings results in the increase in the supply of loanable funds.

When fiscal policy is used to manage the economy, there are a number of factors that can delay its impact.  

Which of the following is an example of a recognition lag?

After an elected official proposes to spend more money to stimulate economic growth, it takes time for other elected officials to agree and take action.

After the policy takes effect, it takes time for its complete effects to ripple through the economy.

After a law is passed that authorizes government spending, the bureaucracy within the government needs time to set up needed processes and procedures, and to identify areas that have the greatest need for federal spending.

Although economic conditions seem bad enough to warrant government action, it takes time for economists to confirm that conditions are bad enough.

Explanation : A recognition lag occurs over the time period it takes to recognize and verify the existence of a situation that may require government action. A recognition lag occurs when economists take time to determine if conditions are bad enough.

When the economy is in a recession, expansionary fiscal policy can be used to stimulate and encourage economic growth. Which of the following scenarios represent expansionary fiscal policies from both a supply and demand perspective at the same time?

The government raises tax rates and reduces unemployment insurance payments.

The Federal Reserve decreases the money supply and raises the interest rate while the government simultaneously reduces future taxes.

The government lowers tax rates.

The government lowers tax rates and issues a partial refund of taxes that have already been paid.

Explanation : From a supply-side perspective, the government can lower tax rates. This gives people the incentive to work harder and earn more income. In the process, more output is produced, thus shifting the short- and long-run aggregate supply curves. From a demand-side perspective, either partially refunding previously paid taxes or undertaking an infrastructure project (increasing government spending) should increase aggregate demand. Both represent an expansionary fiscal policy.

Which of the following proposals is not likely to shift the aggregate supply curve?

a change in the supplier of school lunches at public schools

a 5% reduction in tax rates for those in the top 0.000001% of the income distribution

Pell Grants, which are government subsidies for college education

An increase in social security payments

Explanation : Pell grants are supply-side subsidies with the intent to increase human capital, which will increase future innovation and production. In general, demand-side fiscal policy focuses on incentives to increase spending, while supply-side fiscal policy focuses on incentives to increase production.