Laffer Curve – Principles of Macroeconomics Quiz 29

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Real GDP, Economic Growth, Laffer Curve, Federal Reserve, Principles of Macroeconomics

The key words in this Macroeconomics course include Government Spending, Tax Rate, Real GDP, Economic Growth, Marginal Propensity, Federal Reserve, Billion, Federal Government, Laffer Curve, Fiscal Policy, Tax Revenue, Recession, Economy, Million, Region – Principles of Macroeconomics.


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

$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

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:
(Use the Laffer curve, shown here, to support your answer.)

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.

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

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
(AD).