Problem Set 4

Chapter 4: Fiscal Policy

1. Suppose an economy has constant prices, interest rates, and exchange rates. The
economy has following functions:
C = 0.8Yd + 1,000 T = 0.25Y + 500 G = 1,500
M = 0.1Y + 1,000 X = 400 I = 500
a. Calculate equilibrium income. Government budget surplus or deficit?
b. Use the multiplier to recalculate equilibrium income when government spending
increases by 100. Any comments on the government budget?
c. To achieve equilibrium income as in b, but not by increasing government spending
but by reducing autonomous taxes, by how much must net taxes be reduced.
d. Starting from a situation like a, if the government simultaneously increases public
spending and increases taxes by the same amount of 100, what is the equilibrium
income?
e. Of the types of fiscal policy mentioned above, which one do you favor? Why?
2. Suppose an economy has following information: (Unit: billion USD)
C = 100 + 0.8Yd I = 300 G = 250
X = 300 M = 50 + 0.12Y T = 0.1Y
Yp = 2500
a. Calculate the equilibrium output.
b. Comments on the state of the budget and the balance of trade.
c. For the budget to be in equilibrium, what would be the actual output?
d. If exports increase by 20, is the balance of trade in balance? Explain.
e. For Yt = Yp, how should the government conduct fiscal policy? Quantitative for
fiscal policy in this case (all 3 cases: change only G, change only T, change both G
and T simultaneously).
3. An economy has following functions:
C = 170 + 0.75Yd I = 220 + 0.15Y
T = 40 + 0.2Y Yp = 8800
a. Calculate the output at which the budget is balanced? What is the equilibrium
budget?
b. If household consumption increases by 20, investment increases by 30, the
government cuts spending by 10, calculate the new equilibrium output.

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 c. To bring the equilibrium output from b to potential output, by how much should
the government increase spending on goods and services?
4. Consider an open economy with exports of 5 billion VND and marginal propensity to
import 0.14. Autonomous consumption is 10 billion, the marginal propensity to
consume is 0.8. Domestic investment by the private sector is 5 billion VND. The
government spends 40 billion dong and levies taxes equal to 20% of national income.
a. Determine the level of autonomous expenditure of the economy.
b. Build the total expenditure function and display it on the graph.
c. Determine the equilibrium level of output.
Now, suppose the government increases expenditure on goods and services by 20
billion. Let's:
d. Determine the new equilibrium level of output and plot it.
e. Calculate the change in autonomous expenditure, the part of which depends on
income, consumption, imports, and investment.
5. Figure 4.1 depicts the aggregate expenditure curves of an economy with and without
international trade.
a. Which curve is the aggregate expenditure curve with and without international
trade?
b. Determine the equilibrium level of output in the absence of international trade.
c. Determine the equilibrium level of output in the presence of international trade.
Then the trade balance deficit or surplus?
d. What level of output ensures a balanced trade balance?
AE

B
D
C Figure 4.1

A
O 45o Y

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 G H I
6. Figure 4.2 shows the aggregate expenditure function of an open economy, where
taxes are proportional to income.
a. Explain what causes the aggregate expenditure curve to shift from AE 0 to AE1.
b. Explain what causes the aggregate expenditure curve to shift from AE1 to AE2.
c. Is the expenditure multiplier corresponding to curve AE2 greater or smaller than the
multiplier corresponding to curve AE1? Why?
d. What macroeconomic policies can be used to increase output from Y0 to Y1 and
from Y1 to Y2?
AE
AE2

AE1
Figure 4.2
AE0

O 45o Y
Y0 Y1 Y2

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 MULTIPLE CHOICES
1. The economy of Maxistan before and after a shock. Which of the following would be
the most appropriate discretionary fiscal policy action to restore Maxistan to full
employment output?
a. Allow automatic stabilizers to work
b. Increase taxes
c. Increase government spending
d. Increase the money supply
e. Sell government bonds
2. The government hires 2000 workers for new infrastructure projects. Over half of the
newly hired construction workers, however, were employed in other sectors of the
economy and quit their jobs to take this better paying opportunity.
a. Expansionary fiscal policy.
b. Contractionary fiscal policy. e. a & c
c. Crowding out. f. a & d
d. Fiscal multiplier.
3. The government increases taxes on corporations.
a. Expansionary fiscal policy.
b. Contractionary fiscal policy. e. a & c
c. Crowding out. f. a & d
d. Fiscal multiplier.
4. During a recession, the government increases spending by $300B, which in turn
increases GDP by $350B
a. Expansionary fiscal policy.
b. Contractionary fiscal policy. e. a & c
c. Crowding out. f. a & d
d. Fiscal multiplier.
6. During a recession, the government sends $500 checks to every American family.
70% of American families save the money or use it to pay off their debt. 
a. Expansionary fiscal policy.
b. Contractionary fiscal policy. e. a & c
c. Crowding out. f. a & d
d. Fiscal multiplier.
7. The purpose of fiscal policy is to
a. Alter the direction of the economy
b. Change people's attitudes toward government
c. Educate people as to the importance of economics
d. Offer insight into the way things work

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8. Fiscal policy is purposeful movements in ____________ designed to direct an
economy.
a. Interest rates
b. Legal structures
c. Government regulations
d. Government spending and taxes
9. Discretionary Fiscal Policy differs from Nondiscretionary Fiscal Policy in that
a. The former deals with interest rates and the latter deals with tax policy
b. The former is built into the system whereas the latter requires timely decisions
c. The former requires timely decisions whereas the latter is built into the system
d. The former deals with tax policy and the latter deals with interest rates
10. Discretionary Fiscal Policy differs from Nondiscretionary Fiscal Policy in that
a. The former deals with government spending and the latter deals with tax policy
b. The former is chosen by Congress while the latter is chosen by the President
c. The former is always stabilizing, while the latter is never stabilizing
d. The former often takes years to enact, while the latter takes effect automatically
11. Replacement of a progressive income tax system with a single income tax rate would
be an example of
a. Nondiscretionary fiscal policy
b. Discretionary fiscal policy
c. Mandatory spending policy
d. Interest rate policy
12. An example of discretionary fiscal policy would be
a. The operation of the welfare state
b. The operation of the progressive federal income tax
c. A tax cut adopted to stimulate consumption
d. An interest rate cut implemented to stimulate consumption
13. An example of discretionary fiscal policy would be
a. The operation of the welfare state
b. The operation of the progressive federal income tax
c. A tax increase adopted to control inflationary pressures
d. An interest rate increase implemented to control inflationary pressures
14. An example of discretionary fiscal policy would be
a. The existence of the welfare state
b. The existence of the progressive federal income tax
c. A federal jobs program adopted to stimulate consumption
d. an interest rate cut implemented to stimulate consumption
15. An example of nondiscretionary fiscal policy would be
a. The operation of the welfare state
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 b. A federal jobs program adopted to stimulate consumption
c. A tax cut adopted to stimulate consumption
d. An interest rate cut implemented to stimulate consumption
16. If you were to use an Aggregate Supply Aggregate Demand diagram to model
nondiscretionary and discretionary fiscal policy in reaction to a negative aggregate
demand shock, you would see
a. The aggregate demand curve move to the right as a result of the shock
b. The aggregate demand curve move to the left as a result of the shock
c. The aggregate demand curve move back toward its pre-shock position as a result of
these policies
d. B and C
17. The tax cuts of 2001 and 2003 that came in the form of tax rebate checks are good
examples of
a. Fiscal policy
b. Monetary policy
c. The fallacy of composition
d. The fallacy that causation and correlation are the same
18. Using the aggregate supply - aggregate demand model, the tax cuts of 2001 and 2003
that came in the form of tax rebate checks would cause
a. Aggregate demand to shift to the right
b. Aggregate supply to shift to the right
c. Aggregate demand to shift to the left
d. Aggregate supply to shift to the left
19. Short-run expansionary Fiscal Policy would result in
a. Aggregate demand moving to the right
b. Aggregate supply moving to the right
c. Aggregate demand moving to the left
d. Aggregate supply moving to the left
20. Which of the following would qualify as an aggregate supply shock?
a. An unexpected increase in oil prices
b. seasonally expected increase in oil prices
c. An unexpected reduction in consumer confidence
d. An anticipated tax cut
21. Which of the following would qualify as an aggregate demand shock?
a. An unexpected increase in oil prices
b. A seasonally expected increase in oil prices
c. An unexpected reduction in consumer confidence
d. An anticipated tax cut