1. If an economy operates in the short run at point a, restrictive fiscal policy will a.increase AD and move the economy toward point c. b.decrease AD and move the economy toward point b. c.increase SRAS and move the economy toward point b. d.decrease SRAS and move the economy toward point c. 2. When the economy is operating at point a, reliance on the self-correcting mechanism will a.result in higher resource prices and a shift to the left in the SRAS curve. b.result in lower resource prices and a shift to the right in the SRAS curve. c.lead to lower interest rates and a shift to the right in the AD curve. d.lead to higher interest rates and a shift to the left in the AD curve. e.do both a and d. 3.Which of the following will a Keynesian most likely favor if the economy is operating at point a? a.a tax cut b.an increase in government expenditures c.restrictive fiscal policy d.an increase in the budget deficit

4. If the output of the economy is Y 1, which of the following would a Keynesian economist be most likely to favor? a.a reduction in government expenditures b.an increase in government expenditures c.an increase in taxes d.continuation of the current tax and expenditure policies 5. If the output of the economy is Y 1, which of the following would a new classical economist be most likely to favor? a.a reduction in government expenditures b.a reduction in taxes c.an increase in taxes d.continuation of the current tax and expenditure policies

6.When government expenditures exceed revenue from all sources, a.a budget deficit is present. b.the supply of money will increase. c.the government’s outstanding debt will decline. d.all of the above are true. 7.According to the Keynesian view, which of the following would most likely decrease aggregate demand? a.a decrease in tax rates b.a decrease in government expenditures c.an increase in transfer payments d.an increase in the budget deficit

Expenditures < Revenues Expenditures > Revenue Discretionary changes in taxes and/or spending affect the Budget

AD 1 Equilibrium below full employment. Two options Price Level LRAS Y F Y1Y1 P2P2 AD 2 Goods & Services (real GDP) directs the Economy to full-employment SRAS 1 P1P1 1. Wait for SRAS 1 to shift out to SRAS 2 SRAS 2 P3P3 market self- adjustment may be a lengthy process. e1e1 E2E2 2. Shift AD 1 out to AD 2 E3E3

AD 1 Equilibrium above full employment at Y 1. Price Level LRAS Y F Y1Y1 P3P3 AD 2 Goods & Services (real GDP) restrains demand and helps control inflation. SRAS 2 P1P1 1. Will lead to the long-run equilibrium E 3 at a higher price level as SRAS shifts to SRAS 2. or SRAS 1 P2P2 E3E3 2. Reduce demand to AD 2 and lead to equilibrium E 2. e1e1 E2E2

Increase in budget deficit Higher real interest rates Inflow of financial capital from abroad Decline in private investment Appreciation of the dollar Decline in net exports

AD 1 Price Level Y1Y1 Goods & Services (real GDP) SRAS 1 P1P1 Government deficit would shift AD 1 to AD 2. Household saving keeps demand unchanged at AD 1. AD 2 G G G G H H

Quantity of loanable funds Q1Q1 S1S1 Q2Q2 Loanable Funds Market Real interest rate r 1 S2S2 D 2 1. Government borrows from the loanable funds market, increasing the demand (to D 2 ). 2. People save for expected higher future taxes (raising the supply of loanable funds to S 2.) 3. Loans increase, but interest rate doesn’t. D 1 no effect on the interest rate, real GDP, and unemployment. e1e1 e2e2

AD 0 1. Equilibrium at E 0 Price Level LRAS Y0Y0 Y1Y1 AD 1 Goods & Services (real GDP) P0P0 SRAS 1 P1P1 E0E0 e1e1 2. AD decreases to AD 1 and output falls to Y 1

AD 0 3. While policy is being enacted, private investment has begun to recover. Price Level LRAS Y0Y0 Y1Y1 Goods & Services (real GDP) P0P0 SRAS 1 P1P1 AD 2 E0E0 e1e1 4. AD has begun shifting back to AD 0 on its own, the effects of fiscal policy over-shift AD to AD 2. AD 1

AD 0 The price level in the economy rises (from P 1 to P 2 ) as the economy is now overheating. Price Level LRAS Y 0 Y1Y1 P2P2 Goods & Services (real GDP) P0P0 SRAS 1 P1P1 AD 2 E0E0 e1e1 e2e2 Y2Y2 Unless the expansionary fiscal policy is reversed, wages and other resource prices will eventually increase, shifting SRAS back to SRAS 2 (driving the price level up to P 3 ). P3P3 SRAS 2 E3E3

AD 0 1. Demand shifts AD out to AD 2, and prices upward to P 2. Price Level LRAS Y0Y0 P2P2 Goods & Services (real GDP) P0P0 SRAS 1 E0E0 Y2Y2 2. Restrictive Fiscal Policy is considered AD 2 e2e2

AD 1 AD 0 2. The price level falls (from P 2 to P 1 ) as the economy is thrown into a recession. Price Level LRAS Y0Y0 Y1Y1 P2P2 Goods & Services (real GDP) P0P0 SRAS 1 P1P1 AD 2 E0E0 e1e1 e2e2 Y2Y2 3. With the timing lag, fiscal policy does not work instantaneously.

4. Investment returns to its normal rate (shifting AD 2 back to AD 0 ). Price Level LRAS Y0Y0 Goods & Services (real GDP) P0P0 SRAS 1 AD 2 5. The effects of fiscal policy over-shift AD to AD 1. P2P2 e2e2 Y2Y2 AD 1 Suppose that shifts in AD are difficult to forecast. E0E0 AD 0

AD 1 Price Level LRAS 1 Y F2 Y F1 AD 2 Goods & Services (real GDP) With time, lower tax rates promote more rapid growth (shifting LRAS and SRAS out to LRAS 2 and SRAS 2 ). SRAS 1 P 0 SRAS 2 E1E1 LRAS 2 E2E2 1. Lower marginal tax rates shifts AD 1 out to AD 2, and SRAS & LRAS shift to the right. 2. If the tax cuts are financed by budget deficits, AD may expand by more than supply, bringing an increase in the price level.

Their share of taxes paid has increased as the top tax rates have declined. This indicates that the supply side effects are strong for these taxpayers. Share of personal income taxes paid by top ½ % of earners Top rate cut from 91% to 70% 1981 Top rate cut from 70% to 50% 1986 Top rate cut from 50% to 30% Top rate raised from 30% to 39.6% 30 % 28 % 26 % 24 % 22 % 20 % 18 % % 14 % Capital gains tax rate cut Top rate cut from 39.6% to 35% 2005

“Soaking the Rich?” Since 1986 the top tax rate has been less than 40%. The top one-half percent of earners have paid more than 25% of the personal income tax every year since Well above the 14% to 19% from the 1960s and 1970s.

1. Generally small deficits except during recessions. 2. Budget deficits generally increased during recessions and shrank during expansions, (automatic stabilizers, not discretionary policy) 3. Reductions in income tax rates and sharp increases in defense expenditures led to large deficits during the 1980s. 4. The deficits replaced by surpluses in the 1990s. 5. Real economic growth was strong and the inflation rate low during 80s and 90s

6. The combination of: -the 2001 recession -the economy’s sluggish recovery -the Bush Administration’s tax cut, and -increases in defense spending quickly moved the budget from surplus to deficit at the beginning of the new century.

Federal Expenditures and Revenues Federal Government Expenditures and Revenues (as a share of GDP) 18% 20% 22% 24% Expenditures Revenues Deficits

Growth of Real Federal Government and Defense Expenditures During the 1980s, rapid growth of defense spending pushed federal spending upward and contributed substantially to the large deficits of the decade. During the 1990s, defense cuts retarded the growth of federal spending and thereby helped shift the budget to surplus. Defense Total 8 % 6 % 4 % 2 % 0 % - 2 % - 4 % Percent rate of change

Fiscal Policy & Economic Performance: In the 1960s, most economists believed fiscal policy was highly potent and could be used to smooth out the business cycle. Confidence in the ability of policy makers to implement countercyclical fiscal policy has waned. Most now believe that fiscal policy exerts only a modest impact on aggregate demand, much like the crowding-out and new classical models imply. Since 1980, real growth has been strong during periods of both expanding (1980s and ) and contracting (1990s) deficits.