C h a p t e r 30 FISCAL POLICY**

Answers to the Review Quizzes

Page 326 (page 732 in Economics)
1. What is fiscal policy, who makes it, and what is it designed to
influence?
Fiscal policy is the use of the federal budget to achieve
macroeconomic objectives. Fiscal policy is made by the president and
Congress. It is designed to influence employment, economic growth,
and price level stability.
2. What special role does the president play in creating fiscal
policy?
Each year the president proposes the budget that Congress amends and
enacts.
3. What special roles do the Budget Committees of the House of
Representatives and the Senate play in creating fiscal policy?
Each year the Budget Committees of the House of Representatives and
the Senate consider the budget proposed by the president, and
develop their own ideas of how it should be modified. Eventually,
formal conferences between the two houses resolve the differences
between them and a series of spending acts and an overall budget act
passed.
4. What is the timeline for the U.S. federal budget each year? When
does a fiscal year begin and end?
Consider the budget for 2013 as an example in answering this
question. In February 2012 the president proposes a budget to
Congress. Then, from February until October 1, 2012, the Congress
debates the budget, amends it, and eventually passes the necessary
budget bills. The president then signs or vetoes the budget bills
that were presented to him. When the president vetoes bills, the
Congress may over-ride the veto or pass other bills acceptable to
the president. Fiscal year 2013 begins on October 1, 2012 and runs
until September 30, 2013. During this year the Congress may pass—and
the president may sign—supplementary bills. Then, after the fiscal
year ends, accounts are prepared and the “official” amounts of
outlays, receipts, and budget deficit or surplus are reported.
5. Is the federal government budget today in surplus or deficit?
Currently, the U.S. federal government is running a (large) budget
deficit.

*
* This is Chapter 13 in Economics.
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Page 331 (page 737 in Economics)

1. How does a tax on labor income influence the equilibrium quantity
of employment?
A tax on labor income drives a wedge between the after-tax wage rate
of workers and the before-tax wage rate paid by firms. The tax on
labor income decreases the supply of labor. That is, for each
before-tax wage rate, workers provide a lower quantity of labor when
faced with a tax that lowers their after-tax wage. The decrease in
labor supply raises the before-tax wage rate, even though the after-
tax wage rate received by workers falls. The decrease in labor
supply also means that the quantity of employment at full employment
(i.e., equilibrium employment in the labor market) falls.
2. How does the tax wedge influence potential GDP?
By decreasing employment, the tax wedge lowers potential GDP.
3. Why are consumption taxes relevant for measuring the tax wedge?
A tax on consumption raises the price paid for consumption goods and
services and so is equivalent to a cut in the real wage rate from
the perspective of workers.
4. Why are income taxes on capital income more powerful than those
on labor income?
Given positive inflation, what appears to be a moderate tax on
interest income dramatically decreases the real after-tax interest
rate, which is the interest rate that influences investment and
saving plans. In particular, by driving a wedge between the real
interest rate savers receive and firms pay, the tax on interest
income decreases the supply of loanable funds, which lowers
investment and saving in the economy.
5. What is the Laffer curve and why is it unlikely that the United
States is on the “wrong” side of it?
The Laffer curve is the relationship between the tax rate and the
amount of tax revenue collected. The amount of tax revenue collected
increases with the tax rate only up to a certain tax rate, after
which, further increases in the tax rate cause tax revenue to fall.
When tax rates are higher than the tax rate that maximizes tax
revenue, a country is said to be on the wrong side of the Laffer
curve. It is unlikely that the United States is on the wrong side of
the Laffer curve because U.S. tax rates are among the lowest in the
industrial world and past changes in U.S. tax rates have produced
changes in tax revenues in the same direction.

Page 334 (page 740 in Economics)

1. What is a present value?
A present value is the amount of money that, if invested today, will
grow to equal a given future amount when the interest that it earns
is taken into account.
2. Distinguish between fiscal imbalance and generational imbalance.
Fiscal imbalance is the present value of the government’s
commitments to pay benefits minus the present value of its tax
revenues. Generational imbalance is the division of the fiscal

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imbalance between the current and future generations, assuming that

the current generation continues to enjoy the current levels of
taxes and benefits.
3. How large was the estimated U.S. fiscal imbalance in 2010 and how
did it divide between current and future generations?
In 2010, the fiscal imbalance was estimated to be $79 trillion. The
generational imbalance estimates suggest that the current generation
will pay 43 percent and future generations will pay 57 percent of
the fiscal imbalance.
4. What is the source of the U.S. fiscal imbalance and what are the
painful choices that we face?
The source of the fiscal imbalance is largely the social security
and Medicare obligations made under current law. The painful choices
are to raise income taxes, raise social security taxes, cut social
security benefits, or cut federal government discretionary spending.
5. How much of U.S. government debt is held by the rest of the world?
U.S. government debt held by the rest of the world is about $4.8
trillion.

Page 339 (page 745 in Economics)

1. What is the distinction between automatic and discretionary
fiscal policy?
Automatic fiscal policy is triggered by the state of the economy
with no need for any government action. Discretionary fiscal policy,
however, requires an act of Congress to either change government
spending and/or change taxes.
2. How do taxes and needs-tested spending programs work as automatic
fiscal policy to dampen the business cycle?
Taxes, such as income taxes, and needs-tested spending programs both
work as automatic fiscal policy because they decrease the effect a
change in income has on aggregate expenditure. For instance, when
income decreases, consumption expenditure and aggregate expenditure
decrease. But with the fall in income, income taxes decrease and
needs-tested spending increase so that disposable income does not
fall as much as does income. The smaller fall in disposable income
means that the fall in consumption expenditure is smaller, so that
the fall in aggregate expenditure is likewise smaller.
3. How do we tell whether a budget deficit needs discretionary
action to remove it?
A budget deficit needs discretionary government action to remove it
when the deficit is a structural deficit. If the deficit is a
structural deficit, then even when the economy is at full employment,
the deficit will remain. However, if the deficit is a cyclical
deficit, then when the economy returns to full employment, the
deficit will disappear.
4. How can the federal government use discretionary fiscal policy to
stimulate the economy?

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If the economy has a recessionary gap, the government can increase

its expenditure or lower taxes to increase aggregate demand and move
the economy back toward potential GDP.
5. Why might fiscal stimulus crowd out investment?
Fiscal stimulus, such as an increase in government expenditure or a
decrease in taxes, increases the budget deficit. The increase in the
budget deficit increases the (government’s) demand for loanable
funds, thereby raising the real interest. The higher real interest
rate decreases—crowds out—investment.

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Answers to the Study Plan Problems and Applications

Use the following news clip to work Problems 1 and 2.
Economy Needs Treatment
It’s the debt, stupid! Only when the government sets out a credible
business plan will confidence and hiring rebound.
Source: The Wall Street Journal, October 7, 2010
1. How has the U.S. government debt changed since 2006? What are the
sources of the change in U.S. government debt?
Since 2006 the U.S. government debt has skyrocketed, particularly
after 2008. The debt dramatically rose because federal government
taxes fell (as a percent of GDP) while federal government
expenditures and transfer payments, shot upwards. Federal government
expenditures on goods and services rose but not nearly as much as
transfer payments.
2. What would be a “credible business plan” for the government to
adopt?
A “credible business plan” would be a plan for the government that
shrinks the deficit and thereby stops the rapid increase in the
government debt. This plan likely would involve cutting government
outlays and increasing government receipts.
3. At the end of 2011, the government of China’s debt was ¥12.2
trillion. (¥ is yuan, the currency of China.) In 2012, the
government spent ¥12.7 trillion and ended the year with a debt of
¥11.6 trillion. How much did the government receive in tax
revenue in 2012? How can you tell?
The government received ¥13.3 trillion in tax revenue. The
government’s debt fell by ¥0.6 trillion, which means that the
government’s budget surplus was ¥0.6 trillion. With total outlays of
¥12.7 trillion, a surplus of ¥0.6 trillion means that tax revenues
were ¥12.7 trillion + ¥0.6 trillion, or ¥13.3 trillion.
4. The government is considering raising the tax rate on labor
income and asks you to report on the supply-side effects of such
an action. Answer the following questions using appropriate
graphs. You are being asked about directions of change, not exact
magnitudes. What will happen to:
a. The supply of labor and why?
The supply of labor will decrease.
As shown in Figure 13.1, the
supply of labor curve shifts
leftward from LS0 to LS1. The
supply of labor decreases because
at each real wage rate, the hike
in the tax rate on labor income
lowers the after-tax wage rate
received by workers.
b. The demand for labor and why?
The demand for labor will remain
the same so in Figure 13.1 the
demand for labor curve remains LD.

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The demand for labor depends on the productivity of labor, which

does not change after the increase in the tax rate on labor income.
c. The equilibrium level of employment and why?
As Figure 13.1 shows, the equilibrium level of employment decreases.
In the figure, employment decreases from 310 billion hours per year
to 300 billion hours per year.
d. The equilibrium before-tax wage rate and why?
As Figure 13.1 shows, the equilibrium before-tax wage rate increases
from $29 per hour to $30 per hour. The before-tax wage rate rises
because the leftward shift of the supply of labor curve leads to a
movement up along the demand for labor curve.
e. The equilibrium after-tax wage rate and why?
The equilibrium after-tax wage rate decreases. The tax wedge in the
figure is $2 per hour, so the after-tax wage rate falls from $29 per
hour to $28 per hour. The increase in the tax rate on labor income
increases the wedge between the before-tax wage rate and the after-
tax wage rate. The before-tax wage rate increases but not by as much
as the increase in tax. So the after-tax wage rate decreases.
f. Potential GDP?
Potential GDP decreases. The
equilibrium level of employment
is full employment. So as full
employment decreases, potential
GDP decreases along the aggregate
production function. Figure 13.2
shows this change as the movement
along the aggregate production
function, PF, from point A, with
310 billion hours of employment
and potential GDP of $12.2
trillion, to point B, with 300
billion hours of employment and
potential GDP $12.1 trillion.

5. What fiscal policy action might increase investment and speed

economic growth? Explain how the policy action would work.
A decrease in the tax on capital income will increase investment and
thereby increase economic growth. A decrease in the tax on capital
income increases the supply of loanable funds. The real interest
rate falls and investment increases. The increase in investment
increases economic growth.

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6. Suppose that instead of taxing nominal capital income, the

government taxed real capital income. Use appropriate graphs to
explain and illustrate the effect that this change would have on:
a. The tax rate on capital income.
The nominal interest rate is the (nominal) income from capital. If
the government changes the tax code to subtract the inflation rate
from the (nominal) interest rate before taxes are imposed, the true
tax rate on capital income falls because the part of the capital
income—the inflation rate—that is received in compensation for
inflation is no longer taxed.
b. The supply of and demand for loanable funds.
With a lower tax rate on capital income, the supply of loanable
funds increases as the after-tax real interest rate rises. This
change is illustrated in Figure 13.3 (on the next page) by the
rightward shift of the supply of loanable funds curve from the
initial supply of loanable funds curve, SLF0, to SLF1.
The demand for loanable funds
generally remains the same
because it depends in large part
on investment demand. Firms’
investment demand depends on how
productive capital is and the
productivity of capital does not
necessarily change when the tax
code changes. In Figure 13.3, the
demand for loanable funds curve
does not shift.
c. Investment and the real interest
rate.
As shown in Figure 13.3, the
increase in the supply of
loanable funds shifts the supply
of loanable funds curve rightward.
This change leads to a lower real
interest rate and a higher amount
of loanable funds and investment.

7. Fiscal Policy Priorities

In 2008, the Obama administration proposed the following fiscal
policy actions:
(1) Increased spending on universal health insurance ($65 billion),
alternative energy ($15 billion), help for homeowners ($20 billion),
infrastructure ($60 billion), a scheme to pay college tuition in
exchange for public service ($10 billion), and many other projects.
(2) End Bush-era tax cuts on families with incomes greater than
$250,000, increase payroll taxes on high-income earners, increase the
tax rate on capital gains to 25 percent, increase the tax on

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dividends, and end arrangements that enable corporations to lower

their taxes.
Source: Fortune, June 23, 2008
Explain the potential supply-side effects of the various components
of Obama’s fiscal plan. How would you expect these policy actions to
change potential GDP and its growth rate?
The supply-side effects of Mr. Obama’s economic plan are mixed. The
plan for universal health care might slightly increase aggregate
supply and potential GDP by increasing the health of the labor force.
But this effect is likely small. The plan to increase alternative
energy sources also might increase potential GDP and aggregate
supply. The plan to help homeowners’ avoid default on their
mortgages has no direct supply-side effects. However by reducing the
default risk and increasing the supply of loanable funds, the
program might lower the real interest rate and increase investment,
but these effects likely would be small. The spending on
infrastructure and college tuition would both increase potential GDP
and aggregate supply. Ending the Bush tax cuts and raising payroll
taxes on the wealthy would decrease their supply of labor, which
decreases potential GDP and aggregate supply. Cutting taxes on
middle-income earners would increase their labor supply and increase
potential GDP and aggregate supply. Increasing taxes on investment
and closing “corporate tax loopholes” would decrease potential GDP
and aggregate supply. They also would decrease the growth rate of
potential GDP.
8. Under current policies, a plausible projection is that U.S.
public debt will reach 250 percent of GDP in 30 years and 500
percent in 50 years.
a. What is a fiscal imbalance? How might the U.S. government reduce
the fiscal imbalance?
The fiscal imbalance is the present value of the government’s
commitments to pay benefits minus the present value of its tax
revenues. To reduce the fiscal imbalance, the government needs to
decrease its benefit payments—both its present payments and those
promised in the future—and increase its tax revenue—both its current
tax revenue and tax revenue in the future. While the annual
government budget deficit is not the fiscal imbalance, it is related
because, in general, the larger the budget deficit the larger the
fiscal imbalance. Additionally, the larger the budget deficit, the
larger the accumulated public debt becomes.
b. How would your answer to part (a) influence the generational
imbalance?
The generational imbalance is the division of the fiscal imbalance
between the current and future generations, assuming that the
current generation will enjoy the existing levels of taxes and
benefits. The changes in part (a) of cutting benefits and raising
taxes will affect the generational imbalance if the reduction in
benefits and/or the hike in taxes affects the current generation. In
that case the generational imbalance would change so that more of

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the fiscal imbalance is paid by the current generation and less by

future generations.
9. Increase in Payroll Taxes Needed for Social Security
Social Security faces a $5.3 trillion shortfall over the next 75
years, but a congressional report says the massive gap could be
erased by increasing payroll taxes paid by both employees and
employers from 6.2 percent to 7.3 percent and by raising the
retirement age to 70.
Source: USA Today, May 21, 2010
a. Why is Social Security facing a $5.3 trillion shortfall over the
next 75 years?
Social Security is facing the massive $5.3 trillion shortfall
because the promised payments exceed the predicted tax revenue.
b. Explain how the suggestions in the news clip would reduce the
shortfall.
By raising the retirement age, the suggestion in the news clip
decreases the expected payments made to retired workers. By
increasing the payroll tax rates paid by employees and employers,
the suggestion in the news clip increases the expected tax revenue.
Both these changes decrease the predicted shortfall.
c. Would the suggestions in the news clip change the generational
imbalance?
If the changes affect the current generation (as well as future
generations) the generational imbalance is changed. The current
generation would pay more of the imbalance and therefore future
generations would pay less.
10. The economy is in a recession, and the recessionary gap is large.
a. Describe the discretionary and automatic fiscal policy actions
that might occur.
Fiscal policy that increases government expenditure or decreases
taxes would boost aggregate demand. In terms of automatic fiscal
policy, needs-tested spending increases in recessions and tax
revenue falls. Congress might also use discretionary policy by
passing a new spending bill or a cut in tax rates.
b. Describe a discretionary fiscal stimulation package that could
be used that would not bring an increase in the budget deficit.
An increase in government expenditure with an offsetting increase in
tax rates to boost tax revenue would not bring a budget deficit and
would increase aggregate demand because the increase in government
expenditure increases aggregate demand by more than the increase in
taxes decreases aggregate demand.
c. Explain the risks of discretionary fiscal policy in this
situation.
The risk of discretionary policy is that, because of time lags, it
takes effect too late and ends up moving the economy away from
potential GDP.
Use the following news clip to work Problems 11 to 13.
Fiscal Stimulus for Growth
When China was hit by the global financial meltdown of 2008, its

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government increased spending on infrastructure investment, building

miles and miles of expressway and subway systems.
Source: The Nation, October 6, 2012
11. What would be the effect on China’s budget deficit and real GDP
of increased government spending on infrastructure?
Increased government spending on infrastructure would, by itself,
increase China’s budget deficit. Increased government spending on
infrastructure increases aggregate demand. However increasing the
budget deficit would raise the real interest rate and decrease
investment, which would decrease aggregate demand. If the increase
in aggregate demand from the increase in government spending exceeds
the decrease from the decrease in investment, China’s real GDP would
increase. But if the increase in aggregate demand from the increase
in government spending is less than the decrease in aggregate demand
from the decrease in investment, then China’s real GDP would
decrease.
12. What would be the effect on jobs of increased government spending
on infrastructure?
If, as explained in the previous answer, real GDP increases, then
employment and jobs increase. However, if real GDP decreases, then
jobs and employment decrease.
13. If the government of China froze its current spending and instead
cut taxes, what would be the effect on investment and jobs?
If the government cut its taxes, the supply of loanable funds would
increase so investment would increase. Additionally the supply of
labor would increase so employment—jobs—would increase.
14. An economy is in a recession, the recessionary gap is large, and
the economy has a budget deficit.
a. Do we know whether the budget deficit is a structural deficit or
a cyclical deficit? Explain your answer.
We know that at least some of the budget deficit in a recession is a
cyclical deficit as needs-tested spending is higher and tax revenue
is lower than at potential GDP. However, some of the budget deficit
might be a structural deficit. The structural deficit is the deficit
that would exist if real GDP equaled potential GDP and the economy
was at full employment.
b. Do we know whether automatic fiscal policy is increasing or
decreasing the output gap? Explain your answer.
We know that automatic fiscal policy is decreasing the output gap
relative to what it would be otherwise in a recession because they
increase aggregate demand relative to what it would be otherwise in
a recession. That is, aggregate demand decreases in a recession, but
it would decrease by more without the increase in needs-tested
spending and the decrease in tax revenue that produce the cyclical
deficit.
c. If a discretionary increase in government expenditure occurs,
what happens to the structural deficit? Explain.
A discretionary increase in government expenditure, if not reversed
following the end of the recession, moves the budget balance toward

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a structural deficit.
15. Do Tax Cuts Ever Increase Government Revenues?
Republican politicians insist that tax cuts “pay for themselves,”
increasing receipts by goosing economic growth. Democrats and
virtually all economists say they're wrong.
Source: Slate, June 24, 2011
a. Explain what is meant by tax cuts paying for themselves. What
does this statement imply about the tax multiplier?
The idea of “tax cuts paying for themselves” refers to the Laffer
curve. If the tax rate is on the “wrong side” of the Laffer curve, a
reduction in the tax rate raises the total tax revenue collected so
that, instead of lowering total tax revenue, the tax cut “pays for
itself” by raising total tax revenue. When a tax cut pays for itself,
each dollar of the tax cut generates more than a dollar increase in
aggregate demand, so the multiplier is greater than 1.
b. Why would tax cuts not pay for themselves?
The evidence strongly suggests that the United States is not on the
“wrong side” of the Laffer curve, that is, to the right of the
maximum point. In the United States a cut in the tax rate decreases
the government’s total tax revenue. This outcome occurs if the tax
cut leads to only a moderate rather than a huge increase in
potential GDP.
Use the following news clip to work Problems 16 and 17.
Summers Calls for Infrastructure Spending
Larry Summers, the outgoing director of the White House National
Economic Council, said the United States must ramp up spending on
domestic infrastructure to drive the economic recovery. He said that
a combination of low borrowing costs, cheap building costs and high
unemployment in the construction industry make this the ideal time to
rebuild roads, bridges, and airports.
Source: Ft.com, October 7, 2010
16. Is this infrastructure spending a fiscal stimulus? Would such
spending be a discretionary or an automatic fiscal policy?
This spending is a fiscal stimulus because it, like any other
government expenditure on goods and services, increases aggregate
demand and thereby increases real GDP. The spending is discretionary
because new spending laws would be required to implement it.
17. Explain how the rebuilding of roads, bridges, and airports would
drive the economic recovery.
The rebuilding of roads, bridges, and airports would initially add
to aggregate demand. This increase in aggregate demand would raise
real GDP. After these infrastructure projects are completed, they
will increase potential GDP and aggregate supply. This effect, too,
would increase real GDP.

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Use the following news clip and fact to work Problems 18 to 20.
Senate Approves Obama Tax Cut Plan
The U.S. Senate has passed legislation extending Bush-era tax cuts
for middle-class Americans earning up to $250,000 per year.
Source: Financial Times, July 26, 2012
Fact: Middle and low-income earners spend almost all their disposable
incomes. High-income earners save a significant part of their
disposable incomes.
18. a. Explain the intended effect
of extending tax cuts for
middle-class Americans but not
for high-income families. Draw
a graph to illustrate the
intended effect.
The goal of extending the tax
cuts for middle-class Americans
has an intended effect of
increasing consumption
expenditure, which increases
aggregate demand. Figure 13.4
shows the intended effect of this
policy where, including the
multiplier effect, the aggregate
demand curve shifts rightward
from AD0 to AD1. As a result real
GDP increases, in the figure from
$12.7 trillion to $12.9 trillion.
In the figure real GDP remains below potential GDP but the
recessionary gap becomes smaller.
b. Explain why the effect of tax cuts depends on who receives them.
The effect of this fiscal policy depends on the size of the impact
on aggregate demand. The more of the tax cut that is spent (which
means the less that is saved) the larger the magnitude of the effect
on aggregate demand. If the tax rebates go to people who spend more
of the rebate, that is, middle and low-income earners, the effect of
this fiscal policy is larger.
19. What would have a larger effect on aggregate demand: extending
the Bush-era tax cuts to everyone; extending them for middle-
class only; or extending them for high-income earners only? How
would each alternative compare with no tax cuts but an equivalent
increase in government expenditure?
Extending the income tax cuts to everyone will have the largest
effect on aggregate demand. Middle-income tax payers will spend most
of the tax cut and high-income tax payers, while spending only a
small fraction of their income, still spend some. In general, tax
cuts have a larger effect on real GDP than do increases in
government expenditure because the tax cuts have stronger supply-
side effects. So whichever tax cut policy—extending the tax cuts to
everyone, to only middle-class taxpayers, or to only high-income tax
payers—has the largest supply-side effect also has the largest

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effect on real GDP.

20. Explain whether a stimulus package centered around a one-time
consumer tax rebate is likely to have a small or a large supply-
side effect.
The supply-side effects of a one-time consumer tax rebate are likely
to be small. The tax rebate has no effect on the tax wedge and so
does not affect the supply of labor or employment. It also has no
effect on the incentive to save and so does not affect the supply of
loanable funds or investment.
21. Compare the impact on equilibrium real GDP of a same-sized
decrease in taxes and increase in government expenditure on goods
and services.
According to the aggregate demand/aggregate supply model, the
government expenditure multiplier exceeds the tax multiplier, so
government expenditure has a larger impact on real GDP. Some
economists, such as Robert Barro and Harald Uhlig disagree and
assert that the tax multiplier exceeds the government expenditure
multiplier because taxes affect aggregate demand and aggregate
supply. In this case the decrease in taxes has a larger impact on
real GDP.

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Answers to Additional Problems and Applications

22. 2012 Deficit: Smaller, But Still Big
The Congressional Budget Office said the budget deficit was about
$1.1 trillion in fiscal year 2012. That is about $200 billion
smaller than in 2011, but still ranks as the fourth-largest
deficit since World War II.
Source: The Congressional Budget Office, October 5, 2012
Of the components of government outlays and receipts, which have
changed most to contribute to the huge budget deficits in 2011
and 2012?
In general, since 2008 outlays have increased substantially while
receipts have risen slightly. The major factor leading to the
massive rise in the budget deficit is an increase in transfer
payments. An increase in government expenditure on goods and
services also has lead to increasing the budget deficit but the
effect from this factor is dwarfed by the rise in transfer payments.
Use the following information to work Problems 23 and 24.
Suppose that in the United States, investment is $1,600 billion,
saving is $1,400 billion, government expenditure on goods and
services is $1,500 billion, exports are $2,000 billion, and imports
are $2,500 billion.
23. What is the amount of tax revenue? What is the government budget
balance?
Tax revenue equals $1,200 billion. From the circular flow of
expenditure and income, we know that
I = S + T – G + M – X. Rearranging the equation gives T = I– S + G +
X – M, which equals $1,200 billion.
24. a. Is the government’s budget exerting a positive or negative
impact on investment?
The government has a budget deficit. It is exerting a negative
influence on investment by increasing the demand for loanable funds,
which increases the real interest rate and crowds out investment.
b. What fiscal policy action might increase investment and speed
economic growth? Explain how the policy action would work.
A decrease in the budget deficit by increasing taxes or decreasing
government expenditure decreases the demand for loanable funds,
which lowers the real interest rate and increases investment. The
increase in investment increases economic growth.
25. Suppose that capital income taxes are based (as they are in the
United States and most countries) on nominal interest rates. And
suppose that the inflation rate increases by 5 percent a year.
Use appropriate diagrams to explain and illustrate the effect
that this change would have on:
a. The tax rate on capital income.
The increase in the inflation rate increases the true tax rate on
capital income because the interest income that is received in
compensation for inflation is larger so that the tax paid on capital
income increases.

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b. The supply of loanable funds.

With a higher tax rate on capital
income, the supply of loanable
funds decreases and the after-tax
real interest rate falls. This
change is illustrated in Figure
13.5 by the leftward shift of the
supply of loanable funds curve
from the initial supply of
loanable funds curve SLF0 to the
new supply, SLF1, when the
inflation rate is higher.
c. The demand for loanable funds.
The demand for loanable funds
generally remains the same
because it depends in large part
on investment demand. Firms’
investment demand depends on how
productive capital is and the
productivity of capital does not change when the tax code changes.
d. Equilibrium investment.
As illustrated in Figure 13.5, when the supply of loanable funds
decreases, the supply of loanable funds curve shifts leftward from
SLF0 to SLF1. The real interest rate rises from 4 percent a year to 5
percent a year, and the equilibrium quantity of loanable funds
deceases from $2.5 trillion to $2.4 trillion. Investment decreases.
e. The equilibrium real interest rate.
The decrease in the supply of loanable funds leads to a higher
equilibrium real interest rate. In the figure the real interest rate
rises from 4 percent to 5 percent.
Use the following information to work Problems 26 and 27.
Policy Changes Scheduled to Take Effect in 2013
A host of significant provisions of the Job Creation Act of 2010 are
set to expire on January 1, 2013, including the emergency
unemployment benefits and a temporary reduction of 2 percentage
points in the Social Security payroll tax.
Source: The Congressional Budget Office, October 5, 2012
26. Explain the supply-side effects of allowing unemployment benefits
and the Social Security payroll tax cut to expire.
Allowing emergency unemployment benefits to expire decreases job
search by making unemployed workers more likely to accept employment
offers, thereby boosting employment. Allowing the Social Security
payroll tax cuts to expire increases the income tax on labor, which
decreases the supply of labor, thereby decreasing employment.
27. a. Explain the potential demand-side effects of extending
unemployment benefits and not increasing the Social Security
payroll tax.
Compared to the situation of allowing these policies to expire,
extending unemployment benefits will increase the income of

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unemployed workers who cannot find jobs. Extending the Social

Security payroll tax cut increases the income of employed workers.
The increase in income for both classes of workers boosts their
consumption expenditure higher than what it would be if the policies
expired, so aggregate demand increases from what it would be
otherwise.
b. Explain the potential supply-side effects of these fiscal policy
actions.
Compared to the situation of allowing these policies to expire,
extending emergency unemployment benefits increases job search by
making unemployed workers less likely to accept employment offers,
thereby reducing employment. Allowing the Social Security payroll
tax cuts to continue continues the decreases the income tax on labor,
which means that the supply of labor will not decrease and hence
employment will not decrease.
c. Draw a graph to illustrate the combined demand-side and supply-
side effect of these fiscal policy actions.
Figure 13.6 shows the combined
effects of these policies
compared to what the situation
would be if the policies were
allowed to expire. Aggregate
demand unambiguously increases,
so the aggregate demand curve
shifts rightward from AD0 to AD1.
The effect on aggregate supply is
ambiguous. Continuing the
unemployment benefits decreases
aggregate supply; continuing the
Social Security payroll tax cuts
increases aggregate supply.
Presuming that the effects from
extending the unemployment
benefits and Social Security
payroll tax cuts just offset each
other, aggregate supply does not
change so the aggregate supply curve does not shift. In Figure 13.6
the shift of the aggregate demand curve increases real GDP, in the
figure from $13.4 trillion to $13.8 trillion, and the price level
rises, in the figure from 122 to 126.

Use the following news clip to work Problems 28 and 29.

Paul Ryan’s Roadmap Business Tax
Paul Ryan has proposed replacing the corporate income tax, which is
among the highest in the industrialized world, with what he calls a
business consumption tax but what is in effect a tax of a firm’s
value added. He proposes that this tax be set at 8.5 percent, which
is half that of the value-added taxes in the rest of the
industrialized world.
Source: A Roadmap for America’s Future,
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 FISCAL POLICY 223

http://roadmap.republicans.budget.house.gov/
28. Explain the potential supply-side effects of Paul Ryan’s tax plan.
Mr. Ryan’s plan effectively lowers the tax on business income. By
decreasing the tax on profits, business’s demand for investment
increases, which increases the nation’s capital stock. Aggregate
supply and potential GDP both increase.
29. Where on the Laffer curve do you think Paul Ryan believes the U.S.
economy lies? Explain your answer.
Mr. Ryan probably believes that the tax rate U.S. economy lies
beyond the rate that maximizes U.S. tax revenue.
30. Mandatory Spending Is Hard to Contain
In Fiscal 2013, spending on the big three entitlement programs—Social
Security, Medicare, and Medicaid—was $2.1 trillion. The CBO baseline
projection sees this expenditure rising by 70 percent to $3.55
trillion by 2022. Over that same period, discretionary expenditure,
mainly national defense, is projected to grow by only 17 percent from
$1.2 trillion to $1.4 trillion. The deficit is projected to fall from
$1 trillion to $200 billion.
Source: Congressional Budget Office, 2013
If politicians continue to avoid debating the projected increases in
the three big entitlement programs, how do you think the fiscal
imbalance will change? If Congress introduced changes that slowed the
growth of expenditure on the three entitlement programs, who would
benefit and who would pay?
If politicians avoid tackling spending from the three big
entitlement programs, the fiscal imbalance will increase because
their scheduled spending will skyrocket. If Congress introduces
changes that slow the growth of expenditures on the three
entitlement programs, the current generation would pay because they
do not receive the benefit from any growth in the programs. The
future generation would benefit because they do not have to pay
higher taxes.
31. The economy is in a boom and the inflationary gap is large.
a. Describe the discretionary and automatic fiscal policy actions
that might occur.
Fiscal policy that decreases expenditure or increases taxes would
decrease aggregate demand. In terms of automatic fiscal policy,
need-tested spending decreases in expansions and tax revenue
increases. Congress might also use discretionary policy by cutting
spending programs or increasing tax rates.
b. Describe a discretionary fiscal restraint package that could be
used that would not produce serious negative supply-side effects.
A decrease in government expenditure with an offsetting decrease in
autonomous taxes would not bring a change in government saving and
so would not change investment and the growth of real GDP.
c. Explain the risks of discretionary fiscal policy in this
situation.
The risk of discretionary policy is that, because of time lags, it
takes effect too late and ends up moving the economy away from
potential GDP.

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32. The economy is growing slowly, the inflationary gap is large, and
there is a budget deficit.
a. Do we know whether the budget deficit is structural or cyclical?
Explain your answer.
The economy is at an above full-employment equilibrium because there
is an inflationary gap. Real GDP exceeds potential GDP. There is a
budget deficit, but with potential GDP greater than real GDP there
is a cyclical surplus. The structural deficit is larger than the
total budget deficit because the cyclical surplus offsets some of
structural deficit. So the budget deficit is composed of a
structural deficit and a cyclical surplus.
b. Do we know whether automatic stabilizers are increasing or
decreasing aggregate demand? Explain your answer.
We know that automatic stabilizers are decreasing aggregate demand
relative to what it would be otherwise in an inflationary gap.
c. If a discretionary decrease in government expenditure occurs,
what happens to the structural budget balance? Explain your
answer.
A discretionary decrease in government expenditure decreases the
structural deficit. Following the change in fiscal policy,
government outlays would be smaller even when the economy returned
to full employment.
Use the following news clip to work Problems 33 to 35.
Is Fiscal Stimulus Necessary?
China’s economy is slowing from its normal 9 percent or higher rate
to just below 9 percent. The source of the slowdown is the global
economic slowdown that is restricting exports growth and the
government’s deliberate decision to discourage unproductive
investment. The situation now is not like that in 2008 when real GDP
growth dropped from 9 percent to 6.8 percent and fiscal stimulus does
not appear to be urgently needed.
Source: China Daily, June 8, 2012
33. Explain why fiscal stimulus was needed in 2008 but not in 2012.
Fiscal stimulus was needed in 2008 because the growth rate of the
Chinese economy significantly slowed. The slowdown in the growth
rate in 2012 is much milder and hence fiscal stimulus is not needed.
34. Would you expect automatic stabilizers to be operating in 2012
and if so, what effects might they have?
China’s automatic stabilizers will operate in 2012. China has fewer
automatic stabilizers than the United States because China has fewer
unemployment benefit programs and fewer welfare programs. China’s
income tax, however, will operate as an automatic stabilizer as
fewer people rise into higher tax brackets and some fall into lower
tax brackets.
35. Why might stimulus come too late? What are the potential
consequences of stimulus coming too late?
Stimulus might come too late because forecasters’ predictions that
the slowdown in China’s growth will be slight might prove incorrect.
So stimulus might be delayed until the economy was actually in a

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 FISCAL POLICY 225

recession. If this outcome occurred, the unemployment rate would

already have risen and real GDP already have decreased because of
the delay in implementing the program. Additionally, if the program
is implemented too late, then GDP might already be rising and
unemployment falling when the program’s impacts occur, which could
result in a significantly higher price level.

Economics in the News

36. After you have studied Reading Between the Lines on pp. 340–341
(746–747 in Economics), answer the following questions.
a. What is the fiscal cliff?
The fiscal cliff is the simultaneous expiration of Bush-era tax cuts,
a temporary payroll tax cut, and the beginning of automatic spending
cuts to both defense and domestic budgets. All of these policies are
contractionary; that is, all would decrease real GDP and raise
unemployment.
b. Explain the effects of the fiscal cliff on the labor market tax
wedge and the level of employment and potential GDP.
Part of the fiscal cliff is the expiration of the Bush-era tax cuts
and the temporary payroll tax cut. If these tax cuts expire, the
labor market tax wedge increases. The increase in the labor market
tax wedge decreases the level of employment and thereby decreases
potential GDP.
c. Explain the effects of the fiscal cliff on aggregate demand and
aggregate supply.
The expiration of the Bush-era tax cuts and the temporary payroll
tax cut increase the labor market tax wedge. This increase decreases
potential GDP and short-run aggregate supply. The expiration of
Bush-era tax cuts, a temporary payroll tax cut, and the automatic
spending cuts to both defense and domestic spending all decrease
aggregate demand.

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d. Draw a graph to show how the fiscal cliff changes real GDP and
the output gap if the effect on aggregate demand is greater than
that on aggregate supply.
The labor market tax wedge
decreases potential GDP and
short-run aggregate supply. If
these effects are larger than
other effects that increases
potential GDP, then both
potential GDP and short-run
aggregate supply decrease.
Figure 13.7 shows the effect of
the decrease in potential GDP
and short-run aggregate supply.
In Figure 13.7, the long-run
aggregate supply curve shifts
from LAS0 to LAS1 and the short-
run aggregate supply curve
shifts from SAS0 to SAS1. In the
figure aggregate demand does not
change. Potential GDP decreases
from $13.0 trillion to $12.8
trillion and equilibrium real GDP decreases from $12.6 trillion to
$12.5 trillion. The recessionary gap—the difference between
potential GDP and real GDP—decreases from $0.4 trillion to $0.3
trillion.
37. More Fiscal Stimulus Needed?
In New York Times articles and in blogs, economists Paul Krugman and
Joseph Stiglitz say there is a need for more fiscal stimulus in both
the United States and Europe despite the large federal budget deficit
and large deficits in some European countries.
a. Do you agree with Krugman and Stiglitz? Why?
Students who agree with Mr. Krugman and Mr. Stiglitz likely believe
that the U.S. economy will not return to full employment rapidly
without further government stimulus. Students who disagree with Mr.
Krugman and Mr. Stiglitz likely believe that the U.S. economy is on
track to return to full employment.
b. What are the dangers of not engaging in further fiscal stimulus?
If the economy is not returning to full employment, fiscal stimulus
might be necessary. In this situation, if there is no fiscal
stimulus, the economy will remain mired in a recessionary gap and
unemployment will exceed natural unemployment.
c. What are the dangers of embarking on further fiscal stimulus
when the budget is in deficit?
The fiscal stimulus will further increase the budget deficit. The
rise in the deficit increases the government’s demand for loanable
funds and thereby raises the real interest rate. The higher real
interest rate decreases—crowds out—investment. The net effect on
aggregate demand is uncertain: The fiscal stimulus increases
aggregate demand; however, the decrease in investment expenditure
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 FISCAL POLICY 227

decreases aggregate demand. If aggregate demand does not change,

there is no immediate effect on real GDP. But the decrease in
investment lowers the future capital stock, which means that
aggregate supply does not increase as much as otherwise so that U.S.
economic growth will be slower.
38. Payroll Tax Cut Is Unlikely to Survive Into Next Year
The payroll tax holiday in 2012 reduced workers’ tax by $700 for an
income of $35,000 a year and by $2,202 for incomes of $110,100 and
over. If the tax holiday ends, the Economic Policy Institute
recommends replacing the payroll tax cut with infrastructure spending.
Source: The New York Times, September 30, 2012
a. Explain how a payroll tax affects the before-tax and after-tax
wage rate and employment and unemployment.
The payroll tax places a wedge between the before-tax wage rate and
the after-tax wage rate. The payroll tax raises the before-tax wage
rate (though by less than the amount of the tax) and lowers the
after-tax wage rate. Employment decreases and unemployment increases.
b. Explain the effects of an increase in infrastructure spending on
employment and unemployment.
In the short-run, an increase in infrastructure increases aggregate
demand, which increases real GDP and thereby increases employment
and decreases unemployment. In the longer-run, an increase in
infrastructure spending increases the nation’s productive resources,
which increases potential GDP and short-run aggregate supply. The
increase in short-run aggregate supply increases employment and
decreases unemployment.
c. Which fiscal policy action would have the bigger effect on
employment: continuing the payroll tax cut or new infrastructure
spending? Explain your answer.
The payroll tax cut has only an aggregate supply effect; the
infrastructure spending increases both aggregate supply and
aggregate demand. Because the increase in infrastructure spending
affects both aggregate demand and aggregate supply, it might have a
larger effect on employment.

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