### Government Tax Increase & Economy-Principles of Macroeconomics

This is Principles of Macroeconomics lesson and it is about real GDP, economic growth, economy, long-run equilibrium, marginal propensity to consume, government spending, government tax increase and its impact on economy.

As an elected official, you have been informed that real GDP is below its potential and that action should be taken to encourage economic growth and bring the economy to its long-run equilibrium. If the marginal propensity to consume is 0.8 and the amount of new government spending is \$600 billion, by how much would the economy be stimulated?

\$3,000 billion – Correct

\$300 billion

\$600 billion

\$480 billion

Explanation : First calculate the multiplier. This is found by using the equation, ms = 1 ÷ (1 – MPC). With a marginal propensity to consume of 0.8, the multiplier is 5. An increase in government spending of \$600 billion multiplied by the multiplier results in a \$600 billion * 5 = \$3,000 billion increase in real GDP.

During the fall of 2007, the United States economy began a descent into deep recession.  As a result, the federal government and the Federal Reserve took action to stimulate economic growth.  Which of the following would have been an appropriate fiscal policy?

the federal government spending more money to build more infrastructure – Correct

the Federal Reserve increasing the money supply to reduce the interest rate

the federal government increasing marginal tax rates

the federal government increasing its regulation of banks

Explanation :Fiscal policy involves the use of spending or taxation by the federal government.  During the Great Recession, the federal government provided tax refunds to all taxpayers and increased spending to build infrastructure. Both actions represent a form of fiscal policy.

In a bid to be re-elected, you promise both a lower tax rate and greater tax revenue. You would only be able to back up your answer if:

the current tax rate is in Region I of the Laffer curve.

if the current tax rate is exactly t*, at the midpoint of the Laffer curve.

the current tax rate is in either region on the Laffer curve.

if the current tax rate is in Region II of the Laffer curve. – Correct

Explanation : If the tax rate is in Region I of the Laffer curve, tax revenues would increase as the tax rate falls, and you wouldn’t be able to back up your promise to voters. But if the tax rate is in Region II of the Laffer curve, tax revenue would increase as the tax rate falls, and you’d keep your promise. This is because very high taxes are a disincentive for earning income. Lowering those taxes will lead people to work more, earning enough extra taxable income that the government takes in more revenue than they did with the higher tax rate.

Suppose a small country is in recession and the government decides to increase spending to boost the economy, and decides to borrow \$50 million to build statues of famous economists. Given this knowledge, and based on the graph above, which of the following statements is true?

Investment spending will increase beyond \$530 million

Investment spending will decrease to \$480 billion – Correct

Consumption will increase by \$30 million

There is a net change in aggregate demand of +30 million

Explanation : Originally, the market is in equilibrium at point A, with an interest rate of 3% and savings and investment being equal at \$500 million. Then the demand for loans increases by \$50 million at all points when the government borrows \$50 million. This change moves the market to a new equilibrium at point B. Government spending (G) will increase by \$50 million. Total savings will increase from \$500 million to \$530 million, which means that total savings will increase by \$30 million and consumption (C) will fall by \$30 million. But because the government is borrowing \$50 million of the savings, private investment (I) will fall to \$480 million, a decrease of \$20 million. All of this means a net change of zero in aggregate demand

Suppose that the president has decided to increase government spending by building more libraries. The legislation was rushed through Congress and enacted without any delay. From here, the libraries will take 10 months to plan and 2 years to build.

Which of the following is true?

This policy shows an example of automatic stabilizers taking effect.

The planning and building of the libraries represents an impact lag of this policy. – Correct

This policy is contractionary.

The planning and building of the libraries represents a recognition lag of this policy.

Explanation : An impact lag would be present.  An impact lag is the time it takes after a policy is enacted for its effects to be completely felt in the economy. In this case, the policy is all about government spending, but because it takes a long time to build the libraries, it’s a while before all the money is completely paid to the construction workers and others doing the work.

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 – Correct

\$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 – Correct

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. – Correct

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. – Correct

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 – Correct

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.

Which of the following statements is true?

Contractionary fiscal policy is used to stimulate an economy, and eliminate contractions

Contractionary fiscal policy will lead to runaway inflation

Contractionary fiscal policy will lead to an increase in government debt

Contractionary fiscal policy can prevent an economy from overheating – Correct

Explanation : Contractionary fiscal policy would be implemented when the economy is in an expansion. The government will decrease government spending or increase taxes. If aggregate demand is too high, then the economy is operating past its natural equilibrium, with unemployment lower than the natural rate and output greater than the natural rate. This is unsustainable in the long run and causes pressures on prices to increase. Contractionary fiscal policy is used to keep prices under control.

Which of the following statements is true?

The Obama stimulus package of 2009  had significantly more  funding than the Bush 2008 package – Correct

the Obama stimulus of 2009 had the same amount of funding as the Bush   package

The Obama stimulus package of 2009 only favored rich people

The Obama stimulus package of 2009 had significantly less funding than the Bush 2008 package

Explanation : The government enacted two significant fiscal policy initiatives. The first, signed in February 2008 by President George W. Bush, was the Economic Stimulus Act of 2008. The cornerstone of this act was a tax rebate for Americans. The overall cost of this action to government was \$168 billion. In February 2009, less than one month after taking office, President Obama signed the American Recovery and Reinvestment Act (ARRA) of 2009. The focus of this second act shifted to government spending. Seventy percent of the ARRA cost was due to new government spending; the remaining 30% focused on tax credits. In addition, the size of this second fiscal stimulus— \$787 billion—was more than four times larger than the first.

Assume there is a required reserve ratio of 10% and that banks keep no excess reserves. In which of the following scenarios is there a bigger increase in the money supply.

i. Jane takes \$1,000 from under her mattress and deposits it into a checking account.
ii. The Fed purchases \$1,000 worth of government securities from a commercial bank.

Neither of them increases the money supply.

They both increase the money supply by the same amount. – Correct

Jane depositing the funds into the checking account

Explanation :Both scenarios will cause exactly the same increase in the money supply. Whether the bank receives \$1,000 from a new deposit or a \$1,000 from the sale of its assets, in either case the same amount of “new” money is entering the money supply.

Consider the balance sheet for the Wahoo Bank as presented here. Use a required reserve ratio of 10% and assume that the bank keeps no excess reserves.

What will change on the balance sheet if Bennett withdraws \$200 from his checking account?

Outstanding liabilities increase by \$200.

Required reserves decrease by \$200.

Required reserves will increase by \$200.

Outstanding liabilities decrease by \$200. – Correct

Explanation: On the liabilities side of the balance sheet, the \$200 withdrawal reduces the bank’s outstanding liabilities from \$4,000 to \$3,800. The bank will need to use its assets to fulfill Bennett’s request for a withdrawal while still maintaining the required reserve ratio. If it has \$3,800 in liabilities, then it needs \$380 in reserves. Therefore the bank can use \$20 from its reserves to fulfill the request. It will get the remaining \$180 by reducing the amount of loans it issues.

Out of fears that the money supply is too large, the Federal Reserve has decided to decrease the money supply. How could the Federal Reserve accomplish this?

lower the discount rate

lower the required reserve ratio

sell bonds to financial institutions – Correct

purchase bonds from financial institutions

Explanation: Selling bonds to financial institutions takes cash out of the hands of financial institutions and puts it in the hands of the Federal Reserve. This decreases the money supply.

Suppose that you take \$150 in currency out of your pocket and deposit it in your checking account. Assuming a required reserve ratio of 10%, what is the largest amount (in dollars) by which the money supply can increase as a result of your action?

\$1,500 – Correct

\$15

\$150

\$135

Explanation: With a required reserve ratio of 10% the corresponding money multiplier is 10. This result is given by the equation:

mm = 1 ÷ rr
mm = 1 ÷ 0.10 = 10.

With a money multiplier of 10, and with the assumptions that banks hold zero excess reserves and that all money is deposited, through the process of lending and depositing the initial \$150 becomes 10 × \$150 = \$1,500. The initial \$150 deposit is regarded as an increase to the money supply, so it does not need to be deducted out at the end.

Suppose the Federal Reserve engages in open-market operations. It sells \$20 billion in U.S. securities. It also raises the reserve ratio. This causes excess reserves to _______, the money supply to ________, and the money multiplier to ________.

decrease; decrease; decrease – Correct

decrease; increase; increase

Increase; increase; increase

increase; decrease; decrease

Explanation: When the Federal Reserve sells U.S. securities, money is taken from banks, causing excess reserves and the money supply to decrease. In addition, when the reserve ratio is increased, the money multiplier decreases.

The financial panic and credit freeze in late 2008 pointed to the Fed’s important role

creator of inflation.

promoter of price stability.

lender of last resort.- Correct

promoter of full employment.

Explanation: Discount loans dont often figure prominently in macroeconomics, but in extremely turbulent times, they reassure financial market participants. For example, when banks were struggling in 2008, financial market participants were assured that troubled banks could rely on the Federal Reserve to fortify failing banks with discount loans. In fact, for the first time in history, other financial firms were allowed to borrow from the Fed. The Fed even extended an \$85 billion loan to the insurance company American International Group because it had written insurance policies for financial securities based on failing home mortgages.

Unable to borrow from other banks, University Bank is forced to turn to the Federal Reserve for needed funds. What is the interest rate the Federal Reserve will charge University Bank called?

open market operations

discount rate – Correct

federal funds rate

required reserve ratio

Explanation: The discount rate is the interest rate that is charged to a bank by the Federal Reserve when that bank has to borrow funds from the Federal Reserves to fulfill its reserve requirements.

Using a required reserve ratio of 10% and assuming that banks keep no excess reserves, imagine that \$300 is deposited into a checking account. By how much more does the money supply increase if the Fed lowers the required reserve ratio to 7%?

\$4,285.7

\$2,285.7

\$1,285.7 – Correct

\$3,285.7

Explanation: With a required reserve ratio of 10%, the money multiplier is 1 ÷ 0.1 = 10. Thus, the \$300 deposit will cause the money supply to increase by \$300 × 10 = \$3,000.

With a required reserve ratio of 7%, the money multiplier is 1 ÷ 0.07 = 14.286. Now, the \$300 deposit will cause the money supply to increase by \$300 × 14.3 = \$4,285.7.

Therefore, lowering the reserve requirement ratio from 10% to 7% will increase the money supply by \$4,285.7 – \$3,000 = \$1,285.7.

What is a difference between fiat and commodity money?

Fiat money resolves the double coincidence of wants, whereas commodity money does not.

Fiat money has a higher intrinsic value than commodity money.

Fiat money allows an economy to easily expand the money supply, whereas it is more difficult to expand the supply of commodity money. – Correct

Inflation only occurs in an economy that relies on commodity money.

Explanation When money is tied to something that is real such as gold or silver, this limits the ability of the government to create more, as time will be required to acquire more gold and silver. However, with fiat money, no constraint exists, so the government can expand the money supply easily.

What is the difference between M1 and M2?

M1 is always larger than M2.

Everything counted in M1 is also counted in M2. – Correct

M1 includes less liquid assets like savings deposits, while M2 includes liquid assets like currency.

M2 includes credit cards, while M1 does not.

Explanation: The M2 money supply consists of the M1 money supply plus less liquid items such as certificates of deposit and savings accounts. Because the M1 money supply is found in the M2 money supply, the M2 money supply also contains liquid assets like currency. Neither M1 nor M2 include credit cards.

Which of the following statements is true?

Quantitative easing is the targeted use of open market operations in which the central bank buys securities specifically targeting certain market – Correct

Reserve requirements are just as precise or predictable as open market operations

M1 is now a better measure of our economy’s medium of exchange

Banks are not allowed to create money, as per Fed regulations

Explanation: The reserve tool is not as precise or predictable as open market operations are. Because small changes in the money multiplier can lead to large swings in the money supply, changing the reserve requirement can cause the money supply to change too much. In addition, changing reserve requirements can have unpredictable outcomes because the overall effects depend on the actions of banks. Because both checking and savings accounts are now readily available for purchasing goods and services, M2—which includes both types of deposits— is now a better measure of our economy’s medium of exchange. Banks create money whenever they extend a loan. A new loan represents new purchasing power, while the deposit that backs the loan is also considered money. Quantitative easing is a type of open market operation that focuses on targeted securities purchases in both troubled markets (such as mortgage-backed securities) and long-term Treasury securities. This is a new tool that has been used since 2008.

Which of the following statements represent a use of money that is not consistent with its definition?

“I just used my credit card as money to buy a new television.” – Correct

“A bank holds the money of its depositors in its vault.”

“I will accept either currency or gold as money for the purchase of my house.”

“I got some money at the ATM with my debit card.”

Explanation: When banks hold the money of depositors, when currency or gold is accepted as money for the purchase of a house, and when money is received at an ATM, the definition of money holds true.

Consider the impact of monetary policy over time.  In the short run, ____________ prices adjust.  In the long run, ____________ prices adjust.

all; some

some; all – Correct

some; some

all; all

Explanation: If you go to the supermarket the day after the central bank changes monetary policy, how many prices will have changed? What about a month later? A year? It takes time for new money to work its way through the economy, but by altering the amount of money available, policy makers do alter the purchasing power of money, and thus the price level for all goods. Some of these prices will adjust right away, and all of them will adjust in the long run.

In 2007, the Federal Reserve lowered interest rates in order to stimulate the economy. Which of the following is a possible explanation as to why this policy failed to restore the economy to long- run equilibrium

the cut in interest rates was accompanied by very loose fiscal policy

since monetary policy shifts the aggregate supply curve, it was not able to deal with aggregate demand issues that led to the Great Recession.

the cut in interest rates shifted the long run aggregate supply curve too far.

since monetary policy shifts the aggregate demand curve, it was not able to deal with the aggregate supply issues that led to the Great Recession – Correct

Explanation: Monetary policy does not serve to shift the long run aggregate supply curve. As a result, it cannot push the economy back to a sustainable equilibrium at the original long-run level of output.

In the past, some people believed that the Federal Reserve would expand the money supply during presidential election years in order to stimulate the economy and help the incumbent president. For this question, assume that the Fed increases inflation by 3% in every election year. Based on this assumption, which of the following statements is true?

This will cause the unemployment rate to rise.

If market participants expect 0% inflation during an election year, then the unemployment rate will fall – Correct

If market participants expect 0% inflation during an election year, then the unemployment rate will rise.

If market participants form their expectations rationally during an election year, then the unemployment rate willrise.

Explanation: If people expect 0% inflation, any positive inflation will stimulate the economy and lower the unemployment rate. If people form their inflation expectations adaptively, they will not anticipate inflation in an election year because it would be a break from their recent experience. Therefore, inflation in election years will consistently lower the rate of unemployment. Lastly, if expectations are formed rationally, then people will consider the incentives of policymakers during election years. Therefore, they will anticipate higher inflation in those years, and the inflation rate will have no effect on the unemployment rate.

In which of the scenarios listed here will the unemployment rate fall below the natural rate of unemployment?

Inflation is steady at 1% for three years but then decreases to 0% for one year.

Inflation is steady for 2% for three years, and the Fed unexpectedly increases the money supply, causing inflation to increase to 3% the following year – Correct

Inflation is steady at 0% for several years.

Inflation is steady at 5% for several years.

Explanation: No matter how expectations were formed, an unexpected increase in inflation will be a surprise to market participants. This will cause the unemployment rate to fall below the natural rate of unemployment.

Suppose that inflation is trending upward. The actual inflation rate for three periods is 0%, then 4%, and then 8%. Based on this statement, which of the following is true?

If someone is predicting rationally, the inflation rate in the fourth period will be 8%

If someone is using adaptive expectations, the inflation rate in the fourth period will be 12%

If someone is predicting rationally, the inflation rate in the fourth period will be 16%

If someone is using adaptive expectations, the inflation rate in the fourth period will be 8% – Correct

Explanation: Expectations formed rationally recognize the trend and, looking to the future, predict 12%.
This outcome is different from what would occur under adaptive expectations, which would instead imply an expectation of 8% in the fourth period, since that number is consistent with the most recent experience.

The more bonds the Fed sells, the __ the money supply grows, and the__ the inflation rate will be.

faster; higher

slower; higher

faster; lower

slower; lower – Correct

Explanation: When the Fed sells bonds to financial institutions through open market operations, the amount of money in the loanable funds market will decrease. This lowers the funds that banks can use to make loans, therefore decreasing the money supply. A decrease in the price level will accompany the decrease in the money supply.

The short-run Phillips curve is ________________ and the long-run Phillips curve is ________________.

downward sloping; horizontal

upward sloping; vertical

upward sloping; horizontal

downward sloping; vertical – Correct

Explanation: In the short run, there is a potential trade-off between inflation and unemployment. As inflation rises, unemployment falls, and vice-versa. Thus, the short-run Phillips curve is downward sloping.

In the long run, monetary policy is neutral. In other words, it does not impact real variables like unemployment. Thus, if you increase the money supply, it will increase the price level, but it will have no impact on unemployment. Therefore, the long-run Phillips Curve is vertical at the natural rate of output (u*).

The graph below shows both curves.

Which of the following describes the expected outcome of expansionary monetary policy in the short run?

higher employment, higher output, and a higher price level – Correct

higher employment, higher output, and a lower price level

lower employment, higher output, and a higher price level

lower employment, lower output, and a lower price level

Explanation: The actions of the central bank to increase the money supply should cause an increase in the aggregate demand curve. By shifting this curve in the aggregate demand–aggregate supply graph, a new short run equilibrium will result. This causes real GDP, or total output, to increase. To accomplish this, more workers are employed, resulting in higher employment levels. Comparing the old price level to the new price level will also reveal that the price level has risen.

Which of the following limits the impact of monetary policy?

recession is a result of depressed aggregate demand rather than aggregate supply.

aggregate supply changes always lead to lower real GDP.

people adjust their expectations of inflation. – Correct

money is neutral in the short run.

Explanation: Monetary policy only affects aggregate demand, so if there is a change in aggregate supply, monetary policy will be of little help to restore an economy.
In the long run, there are ways to mitigate the impact of monetary policy. Thus, in the long run we say money is neutral; monetary policy doesn’t change real variables. Given enough time, people adjust their expectations so that changing the money supply through monetary policy doesn’t lower or raise real GDP or unemployment.

Which of the following statements is true? (assuming expected inflation is built into contracts)

lenders of loanable funds will benefit when inflations is greater than expected

borrowers of loanable funds benefit when inflation is less than expected

suppliers of labor and other inputs are hurt when inflation is greater than expected – Correct

purchasers of labor and other inputs benefit when inflation is less than expected

Explanation: Purchasers of labor and other inputs, along with borrowers of loanable funds are hurt when inflation is less than anticipated, because they end up paying more in real terms than they intended to. Lenders of loanable funds and suppliers of labor and other inputs are hurt when inflation is greater than anticipated because the real value of what they are selling or getting paid back is less than they thought it was going to be.

Which of the following variables are affected by monetary policy in the long run?

real GDP

the tax rate

price level – Correct

employment

Explanation: After monetary policy is implemented, and the aggregate demand curve shifts and a new price level prevails. In the short run, a firm may not be able to adjust to this new level of prices for their inputs, but given time, firms alter their production levels consistent with the new prices. This causes the short-run aggregate supply curve to shift. The SRAS curve will shift in the opposite direction resulting in a return to the long run equilibrium level of output and employment.

With adaptive expectations, what is the inevitable consequence of an active, expansionary monetary policy in the short and long run?

higher unemployment in the short run, lower inflation in the long run

higher unemployment in the short run, higher inflation in the long run

lower unemployment in the short run, lower inflation in the long run

lower unemployment in the short run, higher inflation in the long run – Correct

Explanation: Adaptive expectations rely on past inflation to form future expectations of inflation. In the short run, you can surprise people with higher-than-expected inflation, which leads to temporary decreases in unemployment.
In the long run, prices adjust. Since money is neutral in the long run, the result is higher inflation.

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