Ricardian equivalence theorem

ch18

1. According to the Ricardian equivalence theorem, people increase savings when the government increases deficits because they recognize the link between government deficits and higher future taxes.

True    False

2. Sound finance holds that government spending should be directed toward sound investment.

True    False

3. During early 20^th century, economists who held that the Ricardian equivalence theorem was theoretically true could support either sound or functional finance.

True    False

4. Financing expansionary fiscal policy by increasing the deficit does not generally affect interest rates.

True    False

5. If the government knew the level of potential income and had sufficient information about the economy (i.e., the mpe, etc.), it could fine-tune the economy.

True    False

6. Crowding out is the offsetting effect on private expenditures caused by the government's sale of bonds to finance expansionary fiscal policy.

True    False

7. The elimination of automatic stabilizers would decrease the need for other fiscal policies.

True    False

8. Automatic stabilizers are government programs or policies that will counteract the business cycle without any new government action.

True    False

9. The 2008-2009 deficit stimulus spending by the federal government was an example of expansionary sound finance.

True    False

10. The application of Keynesian economics to public finance and fiscal policy by Abba Lerner, and its incorporation into Paul Samuelson's economic principles textbook, was known as procyclical finance.

True    False

11. The government's running of a deficit or a surplus with the objective of affecting the level of output in the economy is called:

1. public finance.
2. fiscal policy.
3. the Ricardian equivalence.
4. sound finance.

12. Which of the following best describes most economists' approach to economic stabilization until the 1930s?

1. Maintain a balanced budget at all times, under the principle of sound finance.
2. Use a sound finance approach during normal economic times, and a functional finance approach during a recession or a boom.

CRun larger deficits during recessions and smaller deficits during economic booms, counting on economic . growth to be high enough to keep the debt-to-GDP ratio low.

DEconomists were wholly concerned with microeconomics and had ignored problems of government . deficits, debt, recessions, and economic growth.

13. The concept of fiscal policy refers to the:

1. running of a deficit or surplus to affect the level of output in the economy.
2. changing of interest rates to affect the level of output in the economy.
3. management of exchange rates to affect the trade deficit in the economy.
4. setting of wage policies by institutions to affect spending in the economy.

14. The view that the government budget should always be balanced except in wartime refers to:

1. public finance.
2. fiscal policy.
3. the Ricardian equivalence.
4. sound finance.

15. The theoretical proposition that government deficits do not affect the level of output because individuals realize that they have to pay the deficits in the future and therefore increase their savings is called:

1. purchasing power parity.
2. functional finance.
3. the Ricardian equivalence theorem.
4. sound finance.

16. According to the Ricardian equivalence theorem, government deficits do not affect the level of output because people:

1. do not understand the relationship between deficits and aggregate demand.
2. know that current deficits must be paid in the future and therefore reduce savings today.
3. recognize that current deficits must be paid by future generations and therefore spend more today.
4. recognize that current deficits must be paid in the future and therefore increase savings today to pay higher future taxes.

17. According to the Ricardian equivalence theorem, people increase savings today when the government increases deficits because they recognize that:

1. government deficits imply higher future taxes.
2. government deficits imply lower future taxes.
3. consumption reduces future taxes.
4. consumption increases future taxes.

18. According to the Ricardian equivalence theorem, government deficits do not affect output because people:

1. save more when the government deficits decrease.
2. save more when the government deficits increase.
3. consume more when the government deficits increase.
4. do not change consumption nor savings.

19. The Ricardian equivalence theorem is correct if two assumptions are true. These assumptions are that people have:

1. access to savings instruments and recognize the link between deficits and future taxes.
2. no access to savings instruments and recognize the link between deficits and future taxes.
3. access to savings instruments but cannot recognize the link between deficits and future taxes.
4. no access to savings instruments and cannot recognize the link between deficits and taxes.

20. Economists who believe in sound finance would say that in a recession, the government should:

1. run a budget deficit because the Ricardian equivalence theorem is true both in theory and in practice.
2. run a budget deficit despite the truth of the Ricardian equivalence theorem.
3. maintain a balanced budget because the Ricardian equivalence theorem is true in practice.
4. maintain a balanced budget for political and moral reasons.

21. A key difference between functional finance and sound finance is that in the functional finance approach the government has the potential for:

1. a more active role in spending and taxing decisions.
2. a less active role in spending and taxing decisions.
3. no role since functional finance holds that on moral principle the budget should be balanced.
4. more active role in spending and taxing but only during depressions.

22. Which of the following is most representative of the functional finance view of the macroeconomy?

1. The economy is self-regulating and the best thing the government can do to enhance stability is to stay out of the way.
2. Budgets should be balanced. Doing otherwise is morally wrong.
3. The government should decide on tax and spending plans based on their effects on the economy.
4. Crowding out almost completely cancels out any deficit spending, so fiscal policy is likely to be ineffective.

23. An economist who follows a functional finance principle believes that the government should:

1. do nothing in response to a recession.
2. do nothing in response to a recession due to the Ricardian Equivalence Theorem.
3. run either a deficit or surplus depending on the state of the economy.
4. run a balanced budget.

24. When the economy is experiencing inflation, an economist who follows a functional finance principle is most likely to suggest that the government should:

1. do nothing.
2. run a deficit.
3. run a surplus.
4. run a balanced budget.

25. Functional finance:

1. is based on empirical evidence that fiscal policy can be effective in smoothing business cycles.
2. is based on the political realities of voters wanting their government to respond to recessions.
3. is a theoretical proposition, not a moral proposition.
4. is a proposition supported by public choice economists.

26. In the early 2000s, car sales in China slowed because the government had been restricting credit growth. This action is consistent with the effects of:

1. contractionary fiscal or monetary policy.
2. contractionary fiscal policy but not contractionary monetary policy.
3. contractionary monetary policy but not contractionary fiscal policy.
4. expansionary fiscal policy.

27. Even as the U.S. government ran large budget deficits in the early 2000s, the interest rate did not rise substantially. Which of the following is among the reasons that crowding out did not raise interest rates at that time?

1. Americans increased their willingness to save at the same time that the budget deficits appeared. B The government spent the borrowed money in such a way that productivity and therefore the availability . of savings dramatically increased.
2. The Federal Reserve decreased the money supply.
3. Foreigners were willing to finance the U.S. deficit with their abundant supply of savings.

28. Fiscal policy would be more effective if:

1. potential income was unknown.
2. the government could change taxes and expenditures rapidly.
3. the size of the government debt didn't matter.
4. crowding out occurred more often.

29. Using fiscal policy to stabilize the economy is difficult because:

1. potential income is known.
2. the effects of policy changes is known with certainty.
3. there are time lags involved in the use of fiscal policy.
4. the size of the government debt doesn't matter.

30. Fine tuning the economy with fiscal policy is:

1. relatively simple because the government has access to the best information available.
2. difficult because the government lacks important information about the economy.
3. relatively simple because the political process usually works smoothly and without significant lags.
4. difficult because economists have not developed any theoretical models of the macroeconomy.

31. According to most economists, fiscal policy is:

1. not an effective tool for fine tuning the economy.
2. least useful in a serious economic crisis.
3. always ineffective because of crowding out.
4. effective only when potential output is perfectly known.

32. Refer to the graph above. Expansionary fiscal policy is most likely to shift the aggregate demand curve from:

1. AD₀ to AD₂ if crowding out does not occur and from AD₀ to AD₁ if crowding out does occur.
2. AD₀ to AD₂ if crowding out does not occur and from AD₀ to AD₃ if crowding out does occur.
3. AD₂ to AD₀ if crowding out does not occur and from AD₁ to AD₂ if crowding out does occur.
4. AD₂ to AD₀ if crowding out does not occur and from AD₁ to AD₃ if crowding out does occur.

33. Refer to the graph above. Expansionary fiscal policy shifts the aggregate demand curve from:

1. AD₀ to AD₂ but then back to AD₁ if crowding out occurs.
2. AD₀ to AD₂ but then out to AD₃ if crowding out occurs.
3. AD₀ to AD₂ whether or not crowding out occurs.
4. AD₂ to AD₁ and then from AD₁ to AD₀ if crowding out occurs.

34. Refer to the graph above. Suppose the government borrows $50 million to finance an increase in its spending and that as a result, the level of investment is reduced by $50 million. In this case, the aggregate demand curve will:

1. shift from AD₀ to AD₂ but then back to AD₁.
2. shift from AD₀ to AD₂ but then out to AD₃.
3. shift from AD₀ to AD₂.
4. not shift.

35. If a government finances an increase in its expenditures by selling bonds to the public, then the aggregate demand curve will:

1. not shift.
2. shift out but not as much as it would if crowding out didn't occur.
3. shift out by the same amount regardless of whether crowding out occurs.
4. shift out more if crowding out occurs.

36. When the government runs a deficit, the interest rate tends to:

3. remain unchanged.
4. rise or fall, depending on how the deficit is financed.

37. Reducing the budget deficit by cutting government spending could conceivably:

1. increase income if interest rates fall enough and private investment is more productive than government spending.
2. increase income if interest rates rise enough and government spending is more productive than private investment.
3. decrease income if interest rates fall too much and private investment is more productive than government investment.
4. decrease income if interest rates rise enough and private investment is more productive than government investment.

38. Between 1999 and 2009, the U.S. federal budget deficit moved from a record surplus to a record deficit. Other things being equal, the most likely effect of this shift would be:

1. higher interest rates and increased investment.
2. higher interest rates and decreased investment.
3. lower interest rates and increased investment.
4. lower interest rates and decreased investment.

39. Although macroeconomics textbooks have taught the logic of fiscal policy for over half a century, actual use of discretionary fiscal policy has been rare. When President George W. Bush persuaded Congress to enact a large tax cut early in his presidency, it was the first time in several decades that the fiscal policy rationale was taken seriously. Why has fiscal policy been used so infrequently?

1. It has inherent conflicts with monetary policy.
2. Concern about exchange-rate stabilization has limited its effectiveness.
3. The political processes of democracy make timely fiscal policy difficult.
4. Fiscal policy has proven to be too strong a medicine for the small economic fluctuations we have had.

40. Crowding out would most likely occur when:

1. workers lose jobs as a result of anti-inflationary fiscal policies.
2. the federal government engages in bond sales to finance its budget deficit.
3. the Congress enacts budget cuts to balance the budget.
4. tax receipts rise more slowly than anticipated, resulting in the need to cut government spending.

41. Crowding out is associated with:

1. a reduction in business investment resulting from an increase in government borrowing and higher interest rates.
2. an increase in business investment resulting from an increase in government borrowing and higher interest rates.
3. an increase in private savings caused by higher future tax liabilities when government increases

borrowing.

1. a decrease in government spending caused by a shortage of available credit.

42. When the government runs a deficit it must:

1. buy bonds to finance the deficit.
2. sell bonds to finance the deficit.
3. decrease the money supply to finance the deficit.
4. raise taxes immediately.

43. When interest rates go up, it is:

1. more expensive for businesses to borrow, so investment falls.
2. more expensive for businesses to borrow, so investment increases.
3. cheaper for businesses to borrow, so investment falls.
4. cheaper for businesses to borrow, so investment increases.

44. If private investment is relatively sensitive to interest rates, then a fiscal expansion financed by government bond sales will:

1. have no effect on output.
2. raise output by a relatively small amount.
3. raise output by a relatively large amount.
4. have an ambiguous effect on output.

45. If a fiscal expansion financed by government bond sales does not affect interest rates, then:

1. no crowding out will occur.
2. crowding out will be relatively small.
3. crowding out will be relatively large.
4. crowding out will be so great that output will decline.

46. Suppose the government increases spending by $30 billion and raises taxes by $20 billion at the same time. Then:

1. interest rates will most likely stay the same.
2. interest rates will most likely increase.
3. business investment is not likely to change.
4. business investment is likely to increase due to crowding out.

47. If interest rates adjust to equate savings and investment, then an expansionary fiscal policy is:

1. more likely to increase interest rates and less likely to crowd out investment.
2. more likely to increase interest rates and more likely to crowd out investment.
3. less likely to increase interest rates and less likely to crowd out investment.
4. less likely to increase interest rates and more likely to crowd out investment.

48. Crowding out will be less likely to occur if:

1. interest rates rise when the budget deficit increases. B. interest rates fall when the budget deficit decreases.
2. business investment does not depend on interest rates.
3. business investment depends on interest rates.

49. Crowding out:

1. increases the multiplier effect, so that an increase in government spending raises income by more.
2. increases the multiplier effect, so that an increase in government spending raises income by less.
3. decreases the multiplier effect, so that an increase in government spending raises income by more.
4. decreases the multiplier effect, so that an increase in government spending raises income by less.

50. The crowding out effect:

1. increases the multiplier effect, so that an increase in taxes reduces income by more.
2. increases the multiplier effect, so that an increase in taxes reduces income by less.
3. decreases the multiplier effect, so that an increase in taxes reduces income by more.
4. decreases the multiplier effect, so that an increase in taxes reduces income by less.

51. Expansionary fiscal policy that raises the budget deficit may:

1. reduce business investment by increasing interest rates.
2. reduce business investment by reducing interest rates.
3. increase business investment by increasing interest rates.
4. increase business investment by reducing interest rates.

52. A decrease in the budget deficit will have a:

1. more negative effect on income when crowding out is strong.
2. more positive effect on income when crowding out is weak.
3. less negative effect on income when crowding out is strong.
4. less positive effect on income when crowding out is weak.

53. An increase in the budget deficit will have a:

1. more negative effect on income when crowding out is weak.
2. more positive effect on income when crowding out is strong.
3. less negative effect on income when crowding out is weak.
4. less positive effect on income when crowding out is strong.

54. Contractionary fiscal policy that reduces the budget deficit may:

1. reduce business investment by increasing interest rates.
2. reduce business investment by reducing interest rates.
3. increase business investment by increasing interest rates.
4. increase business investment by reducing interest rates.

55. If the government knew the precise values of the multiplier and potential income, fine-tuning the economy would:

1. be possible.
2. be much easier but mistakes would still occur occasionally.
3. still be very difficult.
4. be more difficult.

56. Suppose one economist believes that the target rate of unemployment is 4 percent while another believes that it is 6 percent. If GDP is $5 trillion and the unemployment rate is 6 percent, then Okun's rule of thumb implies that the target output levels for these two economists will differ by:

1. $100 billion.
2. $200 billion.
3. $300 billion.
4. $400 billion.

57. Suppose one economist believes that the target rate of unemployment is 4 percent while another believes that it is 6 percent. If GDP is $10 trillion and the unemployment rate is 6 percent, then Okun's rule of thumb implies that the target output levels for these two economists will differ by:

1. $100 billion.
2. $200 billion.
3. $300 billion.
4. $400 billion.

58. Suppose one economist believes that the target rate of unemployment is 5 percent while another believes that it is 6 percent. If GDP is $10 trillion and the unemployment rate is 6 percent, then Okun's rule of thumb implies that the target output levels for these two economists will differ by:

1. $100 billion.
2. $200 billion.
3. $500 billion.
4. $600 billion.

59. In practice, economists:

1. agree about what the level of potential output is but disagree about what policies are appropriate.
2. disagree about what the level of potential output is but agree about what policies are appropriate.
3. agree about what the level of potential output is and about what policies are appropriate.
4. disagree about what the level of potential output is and about what policies are appropriate.

60. Suppose most economists agree that the target rate of unemployment is between 4 and 7 percent. If the actual unemployment rate is 11 percent, then most economists would agree that:

1. both expansionary and contractionary policies are appropriate.
2. expansionary monetary and fiscal policies are appropriate.
3. contractionary monetary and fiscal policies are appropriate.
4. neither expansionary nor contractionary policies are appropriate.

61. Which of the following issues will economists likely agree about?

1. The long-run achievable target rate of unemployment.
2. Estimates of potential income.
3. The relationship between the level of economic activity and inflation.
4. Outside of some range, too much spending causes inflation and too little causes a recession.

62. Fiscal policy is typically:

1. extremely flexible because most government spending is discretionary.
2. extremely flexible provided policy lags are short.
3. extremely flexible despite the presence of implementation problems.
4. difficult to implement quickly.

63. Most of the government budget is mandatory spending through programs like Medicare and Social Security, and much of the rest is politically difficult to alter. Because of this:

1. fiscal policy is always undertaken only when there is a national crisis that motivates voters to seek change.
2. fiscal policy that involves raising taxes is more likely to be implemented than fiscal policy that involves borrowing money.
3. the amount of spending is unlikely to be implemented as economists suggest.

Dmost spending is geared to perform as an automatic stabilizer, so that Congress is in fact largely . irrelevant when it comes to providing a fiscal response to a recession.

64. Activist fiscal policies:

1. generally produce balanced budgets.
2. usually produce budget surpluses.
3. usually produce budget deficits.
4. do not have any systematic effect on budget surpluses or deficits.

65. Because reducing both unemployment and inflation simultaneously are conflicting goals:

1. there is a policy that will allow policymakers to achieve either objective.
2. aggregate demand policy will allow policymakers to achieve one of these objectives, but not both.
3. aggregate demand policy will allow policymakers to achieve both objectives, but only if it is

expansionary.

1. aggregate demand policy will allow policymakers to achieve both objectives, but only if it is

contractionary.

66. The crowding out effect would be higher if:

1. the government never ran budget deficits
2. foreigners wanted to buy more U.S. bonds.
3. the interest rate is greatly affected by shifts in the demand of loanable funds.
4. investment is not affected by changes in the interest rates.

67. The crowding out effect would be lower if:

1. consumption is sensitive to changes in prices.
2. the government always ran budget deficits.
3. the interest rate is greatly affected by shifts in the demand of loanable funds.
4. investment is not sensitive to changes in the interest rates.

68. Generally speaking, the government implements fiscal policy in a:

1. fast and accurate manner.
2. slow and inaccurate manner.
3. fast but inaccurate manner.
4. slow but accurate manner.

69. Because automatic stabilizers lower transfer payments and raise tax receipts as an economy recovers from a recession, they:

1. slow down the pace of an economic recovery.
2. increase the pace of an economic recovery.
3. do not affect the pace of an economic recovery.
4. accelerate the recovery from a recession until inflation starts to develop, at which point they slow the

recovery.

70. If the economy falls into a recession, automatic stabilizers will cause:

1. tax receipts to fall and government spending to rise.
2. tax receipts to rise and government spending to fall.
3. both tax receipts and government spending to rise.
4. both tax receipts and government spending to fall.

71. As the economy contracts, tax revenues:

1. fall and transfer payments rise, causing the economy to contract by less than it would in the absence of automatic stabilizers.
2. rise and transfer payments rise, causing the economy to contract by more than it would in the absence of automatic stabilizers.
3. fall and transfer payments fall, causing the economy to contract by more than it would in the absence of automatic stabilizers.
4. rise and transfer payments fall, causing the economy to contract by less than it would in the absence of automatic stabilizers.

72. As the economy expands, tax revenues:

1. fall and transfer payments rise, causing the economy to expand by less than it would in the absence of automatic stabilizers.
2. rise and transfer payments rise, causing the economy to expand by more than it would in the absence of automatic stabilizers.
3. fall and transfer payments fall, causing the economy to expand by more than it would in the absence of automatic stabilizers.
4. rise and transfer payments fall, causing the economy to expand by less than it would in the absence of automatic stabilizers.

73. Which of the following would not be considered an automatic stabilizer?

1. Welfare payments.
2. Unemployment compensation.
3. The income tax.
4. Defense spending.

74. Which of the following is an automatic stabilizer?

1. Military expenditures.
2. Social Security benefits.
3. Unemployment compensation.
4. Property taxes.

75. In terms of fiscal policy, which of the following is an example of a fiscal automatic stabilizer?

1. The reduction in the money supply that occurs as banks become less willing to make loans during a recession.
2. The reduction in wages that occurs as the economy goes into a recession.
3. The increase in government spending that occurs as the result of new spending bills passed by Congress.
4. The rise in tax revenue that occurs as a result of growth in real GDP.

76. Because automatic stabilizers increase government spending and decrease tax revenue during a recession and have the opposite effect during a recovery, they tend to create budget:

1. deficits throughout the business cycle.
2. surpluses throughout the business cycle.
3. deficits during the recovery phase of the business cycle and budget surpluses during the recession phase.
4. deficits during the recession phase of the business cycle and budget surpluses during the recovery phase.

77. Automatic stabilizers cause:

1. deeper recessions and more rapid expansions.
2. deeper recessions and slower expansions.
3. shallower recessions and slower expansions.
4. shallower recessions and more rapid expansions.

78. During an economic contraction, automatic stabilizers:

1. reduce both budget surpluses and deficits.
2. reduce a budget surplus or increase a deficit.
3. reduce a budget deficit or increase a surplus.
4. increase both budget surpluses and deficits.

79. During an economic expansion, automatic stabilizers:

1. reduce both budget surpluses and deficits.
2. reduce a budget surplus or increase a deficit.
3. reduce a budget deficit or increase a surplus.
4. increase both budget surpluses and deficits.

80. An example of a pro-cyclical fiscal policy is:

1. an income tax.
2. unemployment compensation.
3. a balanced budget policy.
4. welfare payments.

81. In 2009, output was beneath potential. At the same time, the budget deficit hit a record high of over $1 trillion. If President Obama were to pursue budget cuts, given the state of the economy, these spending cuts would:

1. be procyclical.
2. be countercyclical.
3. increase interest rates.
4. crowd out investment.

82. Pro-cyclical fiscal policies:

1. reduce cyclical fluctuations in the economy, but not as effectively as countercyclical fiscal policies.
2. reduce cyclical fluctuations in the economy more effectively than countercyclical fiscal policies.
3. reduce cyclical fluctuations in the economy about as effectively as countercyclical fiscal policies.
4. increase cyclical fluctuations in the economy.

83. If output is falling, a pro-cyclical fiscal policy will result in:

1. higher taxes and/or increased government spending.
2. higher taxes and/or decreased government spending.
3. lower taxes and/or increased government spending.
4. lower taxes and/or decreased government spending.

84. The introduction of "rainy-day funds" by states would:

1. decrease the pro-cyclical nature of current state budgeting procedures.
2. increase the pro-cyclical nature of current state budgeting procedures.
3. decrease the counter-cyclical nature of current state budgeting procedures.
4. increase the counter-cyclical nature of current state budgeting procedures.

85. Which of the following policies would reduce the pro-cyclical nature of fiscal policy at the state level?

1. The establishment of "rainy day funds".
2. The introduction of price controls.
3. The institution of balanced budget requirements.
4. The elimination of automatic stabilizers.

86. If state governments began using a five-year rolling-average budgeting procedure as opposed to the current practice of no rolling average, which would the likely result be?

1. State financing would become more procyclical.
2. Balanced-budget requirements in state constitutions would be much less procyclical.
3. The need for automatic stabilizers at the federal level would increase.
4. State governments would run a greater risk of running short of funds during recessions.

87. The income tax is:

1. an automatic stabilizer because income tax revenues rise as income increases, slowing an economic expansion.
2. an automatic stabilizer because income tax revenues rise as income increases, accelerating an economic expansion.
3. an automatic stabilizer because income tax revenues fall as income increases, accelerating an economic

expansion.

1. not an automatic stabilizer.

88. Unemployment compensation is:

1. an automatic stabilizer because it rises as income increases, slowing an economic expansion.
2. an automatic stabilizer because it falls as income increases, slowing an economic expansion.
3. an automatic stabilizer because it falls as income decreases, slowing an economic contraction.
4. not an automatic stabilizer.

89. If taxes and government expenses did not vary with income, then income would:

1. be more stable.
2. not be more or less stable.
3. be less stable.
4. be closer to potential income.

90. If income increases, a budget deficit will:

1. tend to increase.
2. tend to decrease.
3. change unpredictably.
4. not change.

91. Suppose the government never borrows, so that it always finances its expenditures with taxes. Suppose further that government spending does not depend on income. In this case:

1. both government spending and taxes are automatic stabilizers.
2. government spending is an automatic stabilizer but taxes are not.
3. taxes are an automatic stabilizer but government spending is not.
4. neither government spending nor taxes are automatic stabilizers.

92. Property taxes are:

1. not an automatic stabilizer because they do not vary with income.
2. not an automatic stabilizer because they vary with income.
3. an automatic stabilizer because they do not vary with income.
4. an automatic stabilizer because they vary with income.

93. The provisions in state constitutions requiring them to balance their budgets means that

1. state governments often behave procyclically because lower revenues during recessions mean lower state spending.
2. state government spending acts as an automatic stabilizer for the national economy.
3. state governments can follow a functional finance approach with greater consistency than the federal . government, which has no such requirement.
4. state governments can only use monetary policy to affect their economies.

94. As income increases during the recovery from a recession, automatic stabilizers will:

1. increase taxes and increase government spending, increasing the overall size of the government.
2. reduce taxes and increase government spending, accelerating the recovery.
3. increase taxes and decrease government spending, slowing the recovery.
4. reduce taxes on high-income individuals and raise taxes on the poor, increasing economic inequality.

95. When inflation and unemployment are both higher than desired, most economists believe that the government should:

1. adopt contractionary monetary policies that reduce both inflation and unemployment.
2. adopt expansionary fiscal policies that reduce both inflation and unemployment.

Cdetermine whether reducing inflation is more or less important than reducing unemployment and adopt a . policy that targets the more important goal.

1. not act as it is impossible to reduce either inflation or unemployment under these circumstances.

96. It is generally true that elected officials find it easier to:

1. cut taxes.
2. cut government spending.
3. raise taxes and cut government spending.
4. raise both taxes and government spending.

97. What did the sound-finance approach to fiscal policy use to support its view?

1. Keynesian economics.
2. A history of successful procyclical fiscal policy.
3. The functional finance view.
4. The Ricardian equivalence theorem.

98. In contrast to the functional finance view, Classical sound-finance macroeconomics assumes that individuals:

1. do not adjust their spending to account for future tax payments.
2. adjust their spending to account for future tax payments.
3. do not adjust their spending to account for future incomes.
4. adjust their spending to account for future incomes.

99. According to the Classical advocates of sound finance, if an economy is in a recession, the government should run:

1. a budget deficit and increase spending, which will increase output.
2. a budget surplus and decrease spending, which will increase output.
3. neither a surplus nor a deficit since changes in deficit spending do not affect output.
4. neither a surplus nor a deficit since changes in spending affect output.

100.According to a Classical, sound-finance perspective on macroeconomics, if an economy is on an inflationary path, the government should run:  

1. a budget deficit and increase spending, which will reduce output.
2. a budget surplus and decrease spending, which will reduce output.
3. neither a surplus nor a deficit since changes in deficit spending do not affect output.
4. neither a surplus nor a deficit since changes in spending affect output.

101.Refer to the graph above. Assume the economy is in short-run equilibrium at point A below potential output. The government opts for an expansionary fiscal policy in an attempt to pull the economy out of the recession. An economist with a Classical view holding the Ricardian Equivalence theorem to be practically true would conclude that the economy will most likely end up at point:  

1. A
2. B
3. C
4. D

102.Refer to the graph above. Assume the economy is in short-run equilibrium at point A below potential output. The government opts for an expansionary fiscal policy that shifts the AD curve from AD₀ to AD₁ in an attempt to pull the economy out of the recession. An economist with a functional finance view who also recognizes that there will be a certain degree of crowding out would conclude that the economy will likely end up at point:  

1. A
2. B
3. C
4. D

103.Refer to the graph above. Assume the economy is in short-run equilibrium at point A below potential output. The government opts for an expansionary fiscal policy in an attempt to pull the economy out of the recession. Not taking into account shifts in aggregate supply, an economist with a functional finance view who also believes in a full crowding out effect would conclude that the economy will end up at point:  

1. A
2. B
3. C
4. D

104.Refer to the graph above. Assume the economy is in short-run equilibrium at point A below potential output. The government opts for an expansionary fiscal policy that shifts the AD curve from AD₀ to AD₁ in an attempt to pull the economy out of the recession. Not taking into account shifts in aggregate supply, an economist with a functional finance view who believes there will be no crowding out effect would conclude that the economy will end up at point:  

1. A
2. B
3. C
4. D

105.If an economy is in a recession and the government opts for an expansionary fiscal policy to shift AD closer to the potential output, a sound-finance economist with a Classical view who holds the Ricardian Equivalence theorem to be practically true would conclude that AD:  

1. shifts to the right due to higher government spending.
2. shifts to the left due to higher government spending.
3. does not shift since the higher government spending is offset by higher private consumption.
4. does not shift since the higher government spending is offset by lower private consumption.

106.If an economy is above potential output and the government opts for a contractionary fiscal policy (running surpluses) to shift AD, an economist with a Classical view who holds the Ricardian Equivalence theorem to be practically true would conclude that AD:  

1. shifts to the right due to lower government spending.
2. shifts to the left due to lower government spending.
3. does not shift since the lower government spending is offset by higher private consumption.
4. does not shift since the lower government spending is offset by lower private consumption.

107.If an economy is in a recession and the government opts for an expansionary fiscal policy to shift AD closer to potential output, an economist with a typical functional finance view who acknowledges partial crowding out would conclude that the AD:  

1. shifts to the right due to higher government spending.
2. shifts to the left due to higher government spending.
3. does not shift since the higher government spending is offset by higher private consumption.
4. does not shift since the higher government spending is offset by lower private consumption.

108.According to Ricardian Equivalence advocates, if the government announces a plan to balance the budget by reducing its deficits to zero, then the private sector will:  

1. decrease consumption.
2. decrease savings.
3. decrease investment.
4. increase savings.

109.When the economy entered a serious recession in 2008, the response of the U.S. government was to institute a $700 billion bailout plan, pursue other heavy deficit spending, and take on unusually large liabilities through bond and money market fund guarantees. This is an example of:  

1. sound finance as fiscal policy.
2. functional finance and expansionary fiscal policy.
3. fiscal policy that employs automatic stabilizers as the primary means of economic stabilization.
4. procyclical fiscal policy.

ch18 Key

1. According to the Ricardian equivalence theorem, people increase savings when the government increases deficits because they recognize the link between government deficits and higher future taxes.

TRUE

According to the Ricardian equivalence theorem, people increase savings when the government increases deficits because they recognize that those deficits must be paid in the future with higher taxes.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #1

Difficulty: Medium

Learning Objective: 18-1

Topic: Ricardian Equivalence

2. Sound finance holds that government spending should be directed toward sound investment.

FALSE

Sound finance holds the moral stance that government should stay out of the economy, that is, its budget should always be balanced except in wartime.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Knowledge

Colander - Chapter 18 #2

Difficulty: Medium

Learning Objective: 18-1

Topic: Sound Finance

3. During early 20^th century, economists who held that the Ricardian equivalence theorem was theoretically true could support either sound or functional finance.

TRUE

Holding the Ricardian equivalence theorem to be theoretically true does not entail accepting that deficits do not affect output in the short run. Therefore, one was still free to support functional finance, which says that the government should make the decision whether to run a deficit based on its effect on the economy. In addition, sound finance is a moral position that was based primarily on political grounds. Therefore, supporting that view doesn't depend on whether one holds the Ricardian equivalence theory to be theoretically true or not.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Knowledge

Colander - Chapter 18 #3

Difficulty: Hard

Learning Objective: 18-2

Topic: Ricardian Equivalence

4. Financing expansionary fiscal policy by increasing the deficit does not generally affect interest rates.

FALSE

Financing a deficit normally raises interest rates because the government must issue additional bonds to finance the deficit. Higher interest rates have offsetting effects because they reduce business investment.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Knowledge

Colander - Chapter 18 #4

Difficulty: Medium

Learning Objective: 18-3

Topic: Crowding Out

5. If the government knew the level of potential income and had sufficient information about the economy (i.e., the mpe, etc.), it could fine-tune the economy.

FALSE

Even if the government had this information, it would still have to formulate and implement the appropriate fiscal policies, and this takes time and may be difficult in a politically charged environment.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #5

Difficulty: Hard

Learning Objective: 18-3

Topic: Functional Finance

6. Crowding out is the offsetting effect on private expenditures caused by the government's sale of bonds to finance expansionary fiscal policy.

TRUE

Crowding out refers to the increase in interest rates and subsequent reduction in private investment that result from expansionary fiscal policy.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Knowledge

Colander - Chapter 18 #6

Difficulty: Easy

Learning Objective: 18-3

Topic: Crowding Out

7. The elimination of automatic stabilizers would decrease the need for other fiscal policies.

FALSE

Without automatic stabilizers, equilibrium income would be subject to greater swings, increasing the need for other fiscal policies.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #7

Difficulty: Hard

Learning Objective: 18-4

Topic: Automatic Stabilizers

8. Automatic stabilizers are government programs or policies that will counteract the business cycle without any new government action.

TRUE

See the definition of an automatic stabilizer in the textbook.

AACSB: Analytic

BLOOMS TAXONOMY: Knowledge

Colander - Chapter 18 #8

Difficulty: Easy

Learning Objective: 18-4

Topic: Automatic Stabilizers

9. The 2008-2009 deficit stimulus spending by the federal government was an example of expansionary sound finance.

FALSE

Sound finance is the view that the government budget should always be balanced except in wartime.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Application

Colander - Chapter 18 #9

Difficulty: Easy

Learning Objective: 18-2

Topic: Sound Finance

10. The application of Keynesian economics to public finance and fiscal policy by Abba Lerner, and its incorporation into Paul Samuelson's economic principles textbook, was known as procyclical finance.

FALSE

Keynes's student Abba Lerner developed what he called a functional finance view of public finance and fiscal policy.

AACSB: Analytic

BLOOMS TAXONOMY: Knowledge

Colander - Chapter 18 #10

Difficulty: Easy

Learning Objective: 18-2

Topic: Functional Finance

11. The government's running of a deficit or a surplus with the objective of affecting the level of output in the economy is called:

1. public finance.
2. fiscal policy.
3. the Ricardian equivalence.
4. sound finance.

Fiscal policy is when the government changes taxes and spending to affect the level of output. See the definition in the text under "Ricardian Equivalence Theorem: Deficits Don't Matter."

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Knowledge

Colander - Chapter 18 #11

Difficulty: Easy

Learning Objective: 18-1

Topic: Functional Finance

12. Which of the following best describes most economists' approach to economic stabilization until the 1930s?

1. Maintain a balanced budget at all times, under the principle of sound finance.
2. Use a sound finance approach during normal economic times, and a functional finance approach during a recession or a boom.

CRun larger deficits during recessions and smaller deficits during economic booms, counting on . economic growth to be high enough to keep the debt-to-GDP ratio low.

DEconomists were wholly concerned with microeconomics and had ignored problems of government . deficits, debt, recessions, and economic growth.

See the discussion in the textbook under "Classical Economics and Sound Finance."

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Knowledge

Colander - Chapter 18 #12

Difficulty: Medium

Learning Objective: 18-2

Topic: Sound Finance

13. The concept of fiscal policy refers to the:

1. running of a deficit or surplus to affect the level of output in the economy.
2. changing of interest rates to affect the level of output in the economy.
3. management of exchange rates to affect the trade deficit in the economy.
4. setting of wage policies by institutions to affect spending in the economy.

Fiscal policy is when the government runs a deficit or surplus so as to affect the level of output. See definition in the text under "Ricardian Equivalence Theorem: Deficits Don't Matter."

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Knowledge

Colander - Chapter 18 #13

Difficulty: Easy

Learning Objective: 18-1

Topic: Functional Finance

14. The view that the government budget should always be balanced except in wartime refers to:

1. public finance.
2. fiscal policy.
3. the Ricardian equivalence.
4. sound finance.

See definition in the text.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Knowledge

Colander - Chapter 18 #14

Difficulty: Easy

Learning Objective: 18-1

Topic: Sound Finance

15. The theoretical proposition that government deficits do not affect the level of output because individuals realize that they have to pay the deficits in the future and therefore increase their savings is called:

1. purchasing power parity.
2. functional finance.
3. the Ricardian equivalence theorem.
4. sound finance.

According to the Ricardian equivalence theorem, people increase savings when the government increases deficits because they recognize that those deficits must be paid in the future with higher taxes.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Knowledge

Colander - Chapter 18 #15

Difficulty: Easy

Learning Objective: 18-1

Topic: Ricardian Equivalence

16. According to the Ricardian equivalence theorem, government deficits do not affect the level of output because people:

1. do not understand the relationship between deficits and aggregate demand.
2. know that current deficits must be paid in the future and therefore reduce savings today.
3. recognize that current deficits must be paid by future generations and therefore spend more today.
4. recognize that current deficits must be paid in the future and therefore increase savings today to pay higher future taxes.

According to the Ricardian equivalence theorem, people increase savings when the government increases deficits because they recognize that those deficits must be paid in the future with higher taxes.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Knowledge

Colander - Chapter 18 #16

Difficulty: Hard

Learning Objective: 18-1

Topic: Ricardian Equivalence

17. According to the Ricardian equivalence theorem, people increase savings today when the government increases deficits because they recognize that:

1. government deficits imply higher future taxes.
2. government deficits imply lower future taxes.
3. consumption reduces future taxes.
4. consumption increases future taxes.

According to the Ricardian equivalence theorem, people increase savings when the government increases deficits because they recognize that those deficits must be paid in the future with higher taxes.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #17

Difficulty: Hard

Learning Objective: 18-1

Topic: Ricardian Equivalence

18. According to the Ricardian equivalence theorem, government deficits do not affect output because people:

1. save more when the government deficits decrease.
2. save more when the government deficits increase.
3. consume more when the government deficits increase.
4. do not change consumption nor savings.

According to the Ricardian equivalence theorem, people increase savings when the government increases deficits because they recognize that those deficits must be paid in the future with higher taxes. The higher savings and the corresponding reduction in consumption cancels out the increase in demand the deficit is meant to create.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #18

Difficulty: Medium

Learning Objective: 18-1

Topic: Ricardian Equivalence

19. The Ricardian equivalence theorem is correct if two assumptions are true. These assumptions are that people have:

1. access to savings instruments and recognize the link between deficits and future taxes.
2. no access to savings instruments and recognize the link between deficits and future taxes.
3. access to savings instruments but cannot recognize the link between deficits and future taxes.
4. no access to savings instruments and cannot recognize the link between deficits and taxes.

According to the Ricardian equivalence theorem, people increase savings when the government increases deficits because they recognize the link between deficits and higher future taxes and they have access to savings instruments.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Knowledge

Colander - Chapter 18 #19

Difficulty: Hard

Learning Objective: 18-1

Topic: Ricardian Equivalence

20. Economists who believe in sound finance would say that in a recession, the government should:

1. run a budget deficit because the Ricardian equivalence theorem is true both in theory and in practice.
2. run a budget deficit despite the truth of the Ricardian equivalence theorem.
3. maintain a balanced budget because the Ricardian equivalence theorem is true in practice.
4. maintain a balanced budget for political and moral reasons.

Economists who subscribed to sound finance supported this position on moral grounds, not because of their views on the Ricardian equivalence theorem.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Analysis

Colander - Chapter 18 #20

Difficulty: Medium

Learning Objective: 18-1

Topic: Sound Finance

21. A key difference between functional finance and sound finance is that in the functional finance approach the government has the potential for:

1. a more active role in spending and taxing decisions.
2. a less active role in spending and taxing decisions.
3. no role since functional finance holds that on moral principle the budget should be balanced.
4. more active role in spending and taxing but only during depressions.

The functional finance principle states that the government should have a more active role in spending and taxing decisions in order to affect the level of output in the economy. This role is effective during major or minor recessions. In contrast, the sound finance promotes a less active role of the government based on moralistic and political principles.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #21

Difficulty: Medium

Learning Objective: 18-2

Topic: Functional Finance

22. Which of the following is most representative of the functional finance view of the macroeconomy?

1. The economy is self-regulating and the best thing the government can do to enhance stability is to stay out of the way.
2. Budgets should be balanced. Doing otherwise is morally wrong.
3. The government should decide on tax and spending plans based on their effects on the economy.
4. Crowding out almost completely cancels out any deficit spending, so fiscal policy is likely to be ineffective.

See the discussion under "Functional Finance" in the textbook.

AACSB: Analytic

BLOOMS TAXONOMY: Knowledge

Colander - Chapter 18 #22

Difficulty: Easy

Learning Objective: 18-2

Topic: Functional Finance

23. An economist who follows a functional finance principle believes that the government should:

1. do nothing in response to a recession.
2. do nothing in response to a recession due to the Ricardian Equivalence Theorem.
3. run either a deficit or surplus depending on the state of the economy.
4. run a balanced budget.

The functional finance principle states that the government should make spending decisions based on their effect on the economy. They can support either activist or laissez-faire policy.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #23

Difficulty: Medium

Learning Objective: 18-2

Topic: Functional Finance

24. When the economy is experiencing inflation, an economist who follows a functional finance principle is most likely to suggest that the government should:

1. do nothing.
2. run a deficit.
3. run a surplus.
4. run a balanced budget.

The functional finance principle states that the government should run a surplus if the economy is in an inflationary process.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #24

Difficulty: Medium

Learning Objective: 18-2

Topic: Functional Finance

25. Functional finance:

1. is based on empirical evidence that fiscal policy can be effective in smoothing business cycles.
2. is based on the political realities of voters wanting their government to respond to recessions.
3. is a theoretical proposition, not a moral proposition.
4. is a proposition supported by public choice economists.

Functional finance is based on the theoretical proposition that governments can affect the economy. It is not based on moralistic principles that budgets should be balanced.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Knowledge

Colander - Chapter 18 #25

Difficulty: Easy

Learning Objective: 18-3

Topic: Functional Finance

26. In the early 2000s, car sales in China slowed because the government had been restricting credit growth. This action is consistent with the effects of:  

1. contractionary fiscal or monetary policy.
2. contractionary fiscal policy but not contractionary monetary policy.
3. contractionary monetary policy but not contractionary fiscal policy.
4. expansionary fiscal policy.

The policy was contractionary because it tried to slow the economy. Contractionary monetary policy raises interest rates, all else held equal. Contractionary fiscal policy tends to lower interest rates, other things held equal.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #26

Difficulty: Medium

Learning Objective: 18-3

Topic: Functional Finance

27. Even as the U.S. government ran large budget deficits in the early 2000s, the interest rate did not rise substantially. Which of the following is among the reasons that crowding out did not raise interest rates at that time?

1. Americans increased their willingness to save at the same time that the budget deficits appeared.
2. The government spent the borrowed money in such a way that productivity and therefore the availability of savings dramatically increased.
3. The Federal Reserve decreased the money supply.
4. Foreigners were willing to finance the U.S. deficit with their abundant supply of savings.

See the discussion under "Functional Finance in Practice" in the textbook.

AACSB: Analytic

BLOOMS TAXONOMY: Application

Colander - Chapter 18 #27

Difficulty: Medium

Learning Objective: 18-3

Topic: Crowding Out

28. Fiscal policy would be more effective if:

1. potential income was unknown.
2. the government could change taxes and expenditures rapidly.
3. the size of the government debt didn't matter.
4. crowding out occurred more often.

The more rapidly the government can adjust taxes and spending, the sooner fiscal policy will take effect and hence, the more timely it will be.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #28

Difficulty: Easy

Learning Objective: 18-3

Topic: Functional Finance

29. Using fiscal policy to stabilize the economy is difficult because:

1. potential income is known.
2. the effects of policy changes is known with certainty.
3. there are time lags involved in the use of fiscal policy.
4. the size of the government debt doesn't matter.

Generally, setting fiscal policy in place takes time.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #29

Difficulty: Medium

Learning Objective: 18-3

Topic: Functional Finance

30. Fine tuning the economy with fiscal policy is:

1. relatively simple because the government has access to the best information available.
2. difficult because the government lacks important information about the economy.
3. relatively simple because the political process usually works smoothly and without significant lags.
4. difficult because economists have not developed any theoretical models of the macroeconomy.

Theoretical models of the macroeconomy like the multiplier model are well developed, but their practical reliability is limited because key information about the economy is either unavailable or cannot be obtained in a timely fashion.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #30

Difficulty: Medium

Learning Objective: 18-3

Topic: Functional Finance

31. According to most economists, fiscal policy is:

1. not an effective tool for fine tuning the economy.
2. least useful in a serious economic crisis.
3. always ineffective because of crowding out.
4. effective only when potential output is perfectly known.

Fiscal policy is a "sledgehammer" that is best used to deal with major economic problems and not small deviations from potential output.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #31

Difficulty: Medium

Learning Objective: 18-3

Topic: Functional Finance

Colander - Chapter 18

32. Refer to the graph above. Expansionary fiscal policy is most likely to shift the aggregate demand curve from:

1. AD₀ to AD₂ if crowding out does not occur and from AD₀ to AD₁ if crowding out does occur. AD₀ to AD₂ if crowding out does not occur and from AD₀ to AD₃ if crowding out does occur. C. AD₂ to AD₀ if crowding out does not occur and from AD₁ to AD₂ if crowding out does occur.
2. AD₂ to AD₀ if crowding out does not occur and from AD₁ to AD₃ if crowding out does occur.

Because crowding out raises interest rates and reduces private investment, it causes the aggregate demand curve to shift out less than would ordinarily be the case when an expansionary fiscal policy is implemented.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #32

Difficulty: Easy

Learning Objective: 18-3

Topic: Crowding Out

33. Refer to the graph above. Expansionary fiscal policy shifts the aggregate demand curve from:

1. AD₀ to AD₂ but then back to AD₁ if crowding out occurs.
2. AD₀ to AD₂ but then out to AD₃ if crowding out occurs.
3. AD₀ to AD₂ whether or not crowding out occurs.
4. AD₂ to AD₁ and then from AD₁ to AD₀ if crowding out occurs.

Because crowding out raises interest rates and reduces private investment, it causes the aggregate demand curve to shift back after the initial outward shift resulting from an expansionary fiscal policy.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #33

Difficulty: Easy

Learning Objective: 18-3

Topic: Crowding Out

34. Refer to the graph above. Suppose the government borrows $50 million to finance an increase in its spending and that as a result, the level of investment is reduced by $50 million. In this case, the aggregate demand curve will:

1. shift from AD₀ to AD₂ but then back to AD₁.
2. shift from AD₀ to AD₂ but then out to AD₃.
3. shift from AD₀ to AD₂.
4. not shift.

If the level of investment falls by the full amount of the increase in government spending, the expansionary effect of the fiscal policy will be fully offset.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #34

Difficulty: Hard

Learning Objective: 18-3

Topic: Crowding Out

35. If a government finances an increase in its expenditures by selling bonds to the public, then the aggregate demand curve will:

1. not shift.
2. shift out but not as much as it would if crowding out didn't occur.
3. shift out by the same amount regardless of whether crowding out occurs.
4. shift out more if crowding out occurs.

Because crowding out raises interest rates and reduces private investment, expansionary fiscal policy will increase aggregate demand less than otherwise, causing the aggregate demand curve to shift out by less.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #35

Difficulty: Medium

Learning Objective: 18-3

Topic: Crowding Out

36. When the government runs a deficit, the interest rate tends to:

3. remain unchanged.
4. rise or fall, depending on how the deficit is financed.

When the government runs a deficit, it does so through selling bonds. To get people to buy these bonds, both government and private bond sellers must offer higher interest rates on them.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #36

Difficulty: Easy

Learning Objective: 18-3

Topic: Crowding Out

37. Reducing the budget deficit by cutting government spending could conceivably:

1. increase income if interest rates fall enough and private investment is more productive than government spending.
2. increase income if interest rates rise enough and government spending is more productive than private investment.
3. decrease income if interest rates fall too much and private investment is more productive than government investment.
4. decrease income if interest rates rise enough and private investment is more productive than government investment.

Lowering the budget deficit reduces both government borrowing and government bond sales. The result is a drop in interest rates and an increase in private investment. If private investment is more productive than government spending, income could grow if the increase in private investment is significant enough.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #37

Difficulty: Hard

Learning Objective: 18-3

Topic: Crowding Out

38. Between 1999 and 2009, the U.S. federal budget deficit moved from a record surplus to a record deficit. Other things being equal, the most likely effect of this shift would be:

1. higher interest rates and increased investment.
2. higher interest rates and decreased investment.
3. lower interest rates and increased investment.
4. lower interest rates and decreased investment.

Financing the budget deficit often has offsetting effects on investment (crowding out). This reduces the expansionary effect of fiscal policy.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #38

Difficulty: Medium

Learning Objective: 18-3

Topic: Crowding Out

39. Although macroeconomics textbooks have taught the logic of fiscal policy for over half a century, actual use of discretionary fiscal policy has been rare. When President George W. Bush persuaded Congress to enact a large tax cut early in his presidency, it was the first time in several decades that the fiscal policy rationale was taken seriously. Why has fiscal policy been used so infrequently?

1. It has inherent conflicts with monetary policy.
2. Concern about exchange-rate stabilization has limited its effectiveness.
3. The political processes of democracy make timely fiscal policy difficult.
4. Fiscal policy has proven to be too strong a medicine for the small economic fluctuations we have had.

Good economics does not necessarily make good politics. Decision making in legislatures, where tax and spend decisions are typically made in democracies, often take a great deal of time. In contrast, decisions about monetary policy in the U.S. have been designed to avoid political pressures and to be speedy. As a result, virtually all discretionary policy is monetary.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #39

Difficulty: Medium

Learning Objective: 18-3

Topic: Functional Finance

40. Crowding out would most likely occur when:

1. workers lose jobs as a result of anti-inflationary fiscal policies.
2. the federal government engages in bond sales to finance its budget deficit.
3. the Congress enacts budget cuts to balance the budget.
4. tax receipts rise more slowly than anticipated, resulting in the need to cut government spending.

Crowding out occurs when government bond sales drive up interest rates and reduce business investment.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #40

Difficulty: Medium

Learning Objective: 18-3

Topic: Crowding Out

41. Crowding out is associated with:

1. a reduction in business investment resulting from an increase in government borrowing and higher interest rates.
2. an increase in business investment resulting from an increase in government borrowing and higher interest rates.
3. an increase in private savings caused by higher future tax liabilities when government increases borrowing.
4. a decrease in government spending caused by a shortage of available credit.

Crowding out occurs when government bond sales drive up interest rates and depress business investment.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #41

Difficulty: Medium

Learning Objective: 18-3

Topic: Crowding Out

42. When the government runs a deficit it must:

1. buy bonds to finance the deficit.
2. sell bonds to finance the deficit.
3. decrease the money supply to finance the deficit.
4. raise taxes immediately.

Bond sales provide the funds the government needs to cover the budget deficit.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #42

Difficulty: Medium

Learning Objective: 18-3

Topic: Crowding Out

43. When interest rates go up, it is:

1. more expensive for businesses to borrow, so investment falls.
2. more expensive for businesses to borrow, so investment increases.
3. cheaper for businesses to borrow, so investment falls.
4. cheaper for businesses to borrow, so investment increases.

Higher interest rates increase the cost of obtaining loans, so businesses borrow and invest less.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #43

Difficulty: Easy

Learning Objective: 18-3

Topic: Crowding Out

44. If private investment is relatively sensitive to interest rates, then a fiscal expansion financed by government bond sales will:

1. have no effect on output.
2. raise output by a relatively small amount.
3. raise output by a relatively large amount.
4. have an ambiguous effect on output.

If business investment is sensitive to interest rates, then the increase in interest rates resulting from deficit financing will affect investment greatly, so that there will be significant crowding out.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #44

Difficulty: Medium

Learning Objective: 18-3

Topic: Crowding Out

45. If a fiscal expansion financed by government bond sales does not affect interest rates, then:

1. no crowding out will occur.
2. crowding out will be relatively small.
3. crowding out will be relatively large.
4. crowding out will be so great that output will decline.

If deficit financing has no effect on interest rates, then business investment will be unaffected, so there will be no crowding out.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #45

Difficulty: Medium

Learning Objective: 18-3

Topic: Crowding Out

46. Suppose the government increases spending by $30 billion and raises taxes by $20 billion at the same time. Then:

1. interest rates will most likely stay the same.
2. interest rates will most likely increase.
3. business investment is not likely to change.
4. business investment is likely to increase due to crowding out.

Crowding out is likely to occur in this case because the government is borrowing to finance the increase in its expenditures.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #46

Difficulty: Hard

Learning Objective: 18-3

Topic: Crowding Out

47. If interest rates adjust to equate savings and investment, then an expansionary fiscal policy is:

1. more likely to increase interest rates and less likely to crowd out investment.
2. more likely to increase interest rates and more likely to crowd out investment.
3. less likely to increase interest rates and less likely to crowd out investment.
4. less likely to increase interest rates and more likely to crowd out investment.

Since government borrowing increases the demand for savings, and since interest rates adjust to equate savings and investment, interest rates will rise here, making it more likely that investment will decline in response to an expansionary fiscal policy.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #47

Difficulty: Medium

Learning Objective: 18-3

Topic: Crowding Out

48. Crowding out will be less likely to occur if:

1. interest rates rise when the budget deficit increases.
2. interest rates fall when the budget deficit decreases.
3. business investment does not depend on interest rates.
4. business investment depends on interest rates.

If business investment doesn't depend on interest rates, then changes in the budget deficit, even if they do affect interest rates, will not affect business investment.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #48

Difficulty: Medium

Learning Objective: 18-3

Topic: Crowding Out

49. Crowding out:

1. increases the multiplier effect, so that an increase in government spending raises income by more.
2. increases the multiplier effect, so that an increase in government spending raises income by less.
3. decreases the multiplier effect, so that an increase in government spending raises income by more.
4. decreases the multiplier effect, so that an increase in government spending raises income by less.

Crowding out occurs when investment falls due to higher interest rates, reducing the expansionary effect of an increase in government spending.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #49

Difficulty: Medium

Learning Objective: 18-3

Topic: Crowding Out

50. The crowding out effect:

1. increases the multiplier effect, so that an increase in taxes reduces income by more.
2. increases the multiplier effect, so that an increase in taxes reduces income by less.
3. decreases the multiplier effect, so that an increase in taxes reduces income by more.
4. decreases the multiplier effect, so that an increase in taxes reduces income by less.

An increase in taxes allows the government to buy back some of its outstanding bonds, which has a tendency to reduce interest rates. The crowding out effect works in reverse here, where investment increases because of lower interest rates. Therefore, the contractionary effect of a tax increase is reduced; the multiplier effect of a change in fiscal policy has decreased.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #50

Difficulty: Medium

Learning Objective: 18-3

Topic: Crowding Out

51. Expansionary fiscal policy that raises the budget deficit may:

1. reduce business investment by increasing interest rates.
2. reduce business investment by reducing interest rates.
3. increase business investment by increasing interest rates.
4. increase business investment by reducing interest rates.

Expansionary fiscal policy raises interest rates if it is financed by increased government bond sales. Higher interest rates reduce business investment by increasing the cost of borrowing.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #51

Difficulty: Medium

Learning Objective: 18-3

Topic: Crowding Out

52. A decrease in the budget deficit will have a:

1. more negative effect on income when crowding out is strong.
2. more positive effect on income when crowding out is weak.
3. less negative effect on income when crowding out is strong.
4. less positive effect on income when crowding out is weak.

If crowding out is significant, then reducing the budget deficit will reduce interest rates and stimulate business investment to an extent that will significantly offset the reduction in income associated with a fiscal contraction.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #52

Difficulty: Medium

Learning Objective: 18-3

Topic: Crowding Out

53. An increase in the budget deficit will have a:

1. more negative effect on income when crowding out is weak.
2. more positive effect on income when crowding out is strong.
3. less negative effect on income when crowding out is weak.
4. less positive effect on income when crowding out is strong.

If crowding out is significant, then increasing the budget deficit will raise interest rates and reduce business investment to an extent that will significantly offset the increase in income associated with a fiscal expansion.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #53

Difficulty: Medium

Learning Objective: 18-3

Topic: Crowding Out

54. Contractionary fiscal policy that reduces the budget deficit may:

1. reduce business investment by increasing interest rates.
2. reduce business investment by reducing interest rates.
3. increase business investment by increasing interest rates.
4. increase business investment by reducing interest rates.

Contractionary fiscal policy reduces interest rates by reducing government borrowing and bond sales. Lower interest rates stimulate business investment.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #54

Difficulty: Medium

Learning Objective: 18-3

Topic: Crowding Out

55. If the government knew the precise values of the multiplier and potential income, fine-tuning the economy would:

1. be possible.
2. be much easier but mistakes would still occur occasionally.
3. still be very difficult.
4. be more difficult.

Problems such as lags, crowding out, policy conflicts, and political resistance would still make finetuning difficult.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #55

Difficulty: Medium

Learning Objective: 18-3

Topic: Functional Finance

56. Suppose one economist believes that the target rate of unemployment is 4 percent while another believes that it is 6 percent. If GDP is $5 trillion and the unemployment rate is 6 percent, then Okun's rule of thumb implies that the target output levels for these two economists will differ by:

1. $100 billion. $200 billion. C. $300 billion.
2. $400 billion.

Okun's rule of thumb states that every one percentage point drop in unemployment increases output by two percentage points. This means that reducing unemployment from 6 percent to 4 percent will increase output by 4 percent, or $200 billion in this case.

AACSB: Analytic

BLOOMS TAXONOMY: Evaluation

Colander - Chapter 18 #56

Difficulty: Hard

Learning Objective: 18-3

Topic: Functional Finance

57. Suppose one economist believes that the target rate of unemployment is 4 percent while another believes that it is 6 percent. If GDP is $10 trillion and the unemployment rate is 6 percent, then Okun's rule of thumb implies that the target output levels for these two economists will differ by:

1. $100 billion. $200 billion. C. $300 billion.
2. $400 billion.

Okun's rule of thumb states that every one percentage point drop in unemployment increases output by two percentage points. This means that reducing unemployment from 6 percent to 4 percent will increase output by 4 percent, or $400 billion in this case.

AACSB: Analytic

BLOOMS TAXONOMY: Evaluation

Colander - Chapter 18 #57

Difficulty: Hard

Learning Objective: 18-3

Topic: Functional Finance

58. Suppose one economist believes that the target rate of unemployment is 5 percent while another believes that it is 6 percent. If GDP is $10 trillion and the unemployment rate is 6 percent, then Okun's rule of thumb implies that the target output levels for these two economists will differ by:

1. $100 billion. $200 billion. C. $500 billion.
2. $600 billion.

Okun's rule of thumb states that every one percentage point drop in unemployment increases output by two percentage points. This means that reducing unemployment from 6 percent to 5 percent will increase output by 2 percent, or $200 billion in this case.

AACSB: Analytic

BLOOMS TAXONOMY: Evaluation

Colander - Chapter 18 #58

Difficulty: Hard

Learning Objective: 18-3

Topic: Functional Finance

59. In practice, economists:

1. agree about what the level of potential output is but disagree about what policies are appropriate.
2. disagree about what the level of potential output is but agree about what policies are appropriate.
3. agree about what the level of potential output is and about what policies are appropriate.
4. disagree about what the level of potential output is and about what policies are appropriate.

Estimates of potential output differ significantly, giving rise to a wide range of policy recommendations.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #59

Difficulty: Easy

Learning Objective: 18-3

Topic: Functional Finance

60. Suppose most economists agree that the target rate of unemployment is between 4 and 7 percent. If the actual unemployment rate is 11 percent, then most economists would agree that:

1. both expansionary and contractionary policies are appropriate.
2. expansionary monetary and fiscal policies are appropriate.
3. contractionary monetary and fiscal policies are appropriate.
4. neither expansionary nor contractionary policies are appropriate.

An activist policy is advisable only when the economy is generally agreed to be outside the range of potential output. Since that is the case here, and because unemployment is too high, most economists would regard expansionary policies as appropriate.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #60

Difficulty: Medium

Learning Objective: 18-3

Topic: Functional Finance

61. Which of the following issues will economists likely agree about?

1. The long-run achievable target rate of unemployment.
2. Estimates of potential income.
3. The relationship between the level of economic activity and inflation.
4. Outside of some range, too much spending causes inflation and too little causes a recession.

See the discussion under #3 in "Functional Finance in Practice" in the textbook.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Knowledge

Colander - Chapter 18 #61

Difficulty: Medium

Learning Objective: 18-3

Topic: Functional Finance

62. Fiscal policy is typically:

1. extremely flexible because most government spending is discretionary.
2. extremely flexible provided policy lags are short.
3. extremely flexible despite the presence of implementation problems.
4. difficult to implement quickly.

Fiscal policy takes time to formulate and is often limited by mandated programs like Social Security. As a result, it is difficult to change fiscal policy quickly.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #62

Difficulty: Medium

Learning Objective: 18-3

Topic: Functional Finance

63. Most of the government budget is mandatory spending through programs like Medicare and Social Security, and much of the rest is politically difficult to alter. Because of this:

1. fiscal policy is always undertaken only when there is a national crisis that motivates voters to seek change.
2. fiscal policy that involves raising taxes is more likely to be implemented than fiscal policy that involves borrowing money.
3. the amount of spending is unlikely to be implemented as economists suggest.

Dmost spending is geared to perform as an automatic stabilizer, so that Congress is in fact largely . irrelevant when it comes to providing a fiscal response to a recession.

See the discussion in the textbook under the heading "The Government Has Flexibility in Changing Spending and Taxes."

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #63

Difficulty: Hard

Learning Objective: 18-3

Topic: Functional Finance

64. Activist fiscal policies:

1. generally produce balanced budgets.
2. usually produce budget surpluses.
3. usually produce budget deficits.
4. do not have any systematic effect on budget surpluses or deficits.

Because it is politically easier for governments to run budget deficits, activist fiscal policies tend to produce deficits.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #64

Difficulty: Easy

Learning Objective: 18-3

Topic: Functional Finance

65. Because reducing both unemployment and inflation simultaneously are conflicting goals:

1. there is a policy that will allow policymakers to achieve either objective.
2. aggregate demand policy will allow policymakers to achieve one of these objectives, but not both.
3. aggregate demand policy will allow policymakers to achieve both objectives, but only if it is expansionary.
4. aggregate demand policy will allow policymakers to achieve both objectives, but only if it is contractionary.

The AS/AD model demonstrates that expansionary aggregate demand policies reduce unemployment but increase inflation and that contractionary fiscal policies do the reverse.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #65

Difficulty: Easy

Learning Objective: 18-3

Topic: Functional Finance

66. The crowding out effect would be higher if:

1. the government never ran budget deficits
2. foreigners wanted to buy more U.S. bonds.
3. the interest rate is greatly affected by shifts in the demand of loanable funds.
4. investment is not affected by changes in the interest rates.

The crowding out effect would be higher if the interest rate is greatly affected by the demand of loanable funds.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #66

Difficulty: Medium

Learning Objective: 18-3

Topic: Crowding Out

67. The crowding out effect would be lower if:

1. consumption is sensitive to changes in prices.
2. the government always ran budget deficits.
3. the interest rate is greatly affected by shifts in the demand of loanable funds.
4. investment is not sensitive to changes in the interest rates.

The crowding out effect would be lower if investment is not sensitive to changes in the interest rate.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #67

Difficulty: Medium

Learning Objective: 18-3

Topic: Crowding Out

68. Generally speaking, the government implements fiscal policy in a:

1. fast and accurate manner.
2. slow and inaccurate manner.
3. fast but inaccurate manner.
4. slow but accurate manner.

Fiscal policy takes time to formulate and implement, and its precise effects are often difficult to predict.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #68

Difficulty: Medium

Learning Objective: 18-3

Topic: Functional Finance

69. Because automatic stabilizers lower transfer payments and raise tax receipts as an economy recovers from a recession, they:

1. slow down the pace of an economic recovery.
2. increase the pace of an economic recovery.
3. do not affect the pace of an economic recovery.
4. accelerate the recovery from a recession until inflation starts to develop, at which point they slow the recovery.

As the economy grows and income increases, tax receipts rise while government spending declines. These changes slow the economic recovery.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #69

Difficulty: Hard

Learning Objective: 18-4

Topic: Automatic Stabilizers

70. If the economy falls into a recession, automatic stabilizers will cause:

1. tax receipts to fall and government spending to rise.
2. tax receipts to rise and government spending to fall.
3. both tax receipts and government spending to rise.
4. both tax receipts and government spending to fall.

Automatic stabilizers produce countercyclical changes in tax receipts and government spending.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #70

Difficulty: Medium

Learning Objective: 18-4

Topic: Automatic Stabilizers

71. As the economy contracts, tax revenues:

1. fall and transfer payments rise, causing the economy to contract by less than it would in the absence of automatic stabilizers.
2. rise and transfer payments rise, causing the economy to contract by more than it would in the absence of automatic stabilizers.
3. fall and transfer payments fall, causing the economy to contract by more than it would in the absence of automatic stabilizers.
4. rise and transfer payments fall, causing the economy to contract by less than it would in the absence of automatic stabilizers.

Lower income and higher unemployment reduce tax revenues and increase transfer payments, helping to maintain consumption and reduce the size of the recession.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #71

Difficulty: Medium

Learning Objective: 18-4

Topic: Automatic Stabilizers

72. As the economy expands, tax revenues:

1. fall and transfer payments rise, causing the economy to expand by less than it would in the absence of automatic stabilizers.
2. rise and transfer payments rise, causing the economy to expand by more than it would in the absence of automatic stabilizers.
3. fall and transfer payments fall, causing the economy to expand by more than it would in the absence of automatic stabilizers.
4. rise and transfer payments fall, causing the economy to expand by less than it would in the absence of automatic stabilizers.

Higher income and lower unemployment raise tax revenues and reduce transfer payments. These changes moderate any increase in consumption and slow the rate of expansion.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #72

Difficulty: Medium

Learning Objective: 18-4

Topic: Automatic Stabilizers

73. Which of the following would not be considered an automatic stabilizer?

1. Welfare payments.
2. Unemployment compensation.
3. The income tax.
4. Defense spending.

Defense spending does not vary countercyclically.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #73

Difficulty: Medium

Learning Objective: 18-4

Topic: Automatic Stabilizers

74. Which of the following is an automatic stabilizer?

1. Military expenditures.
2. Social Security benefits.
3. Unemployment compensation.
4. Property taxes.

Only unemployment compensation varies countercyclically with income.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #74

Difficulty: Easy

Learning Objective: 18-4

Topic: Automatic Stabilizers

75. In terms of fiscal policy, which of the following is an example of a fiscal automatic stabilizer?

1. The reduction in the money supply that occurs as banks become less willing to make loans during a recession.
2. The reduction in wages that occurs as the economy goes into a recession.
3. The increase in government spending that occurs as the result of new spending bills passed by Congress.
4. The rise in tax revenue that occurs as a result of growth in real GDP.

An automatic stabilizer is a fiscal policy that produces countercyclical movements in aggregate demand without any need for discretionary fiscal policy.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #75

Difficulty: Medium

Learning Objective: 18-4

Topic: Automatic Stabilizers

76. Because automatic stabilizers increase government spending and decrease tax revenue during a recession and have the opposite effect during a recovery, they tend to create budget:

1. deficits throughout the business cycle.
2. surpluses throughout the business cycle.
3. deficits during the recovery phase of the business cycle and budget surpluses during the recession phase.
4. deficits during the recession phase of the business cycle and budget surpluses during the recovery phase.

The presence of automatic stabilizers reduces tax revenues and increases transfer payments during an economic contraction and therefore increases the budget deficit. The reverse is true during an economic recovery or expansion.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #76

Difficulty: Medium

Learning Objective: 18-4

Topic: Automatic Stabilizers

77. Automatic stabilizers cause:

1. deeper recessions and more rapid expansions.
2. deeper recessions and slower expansions.
3. shallower recessions and slower expansions.
4. shallower recessions and more rapid expansions.

Automatic stabilizers reduce economic fluctuations by causing countercyclical changes in taxes and transfer payments.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #77

Difficulty: Medium

Learning Objective: 18-4

Topic: Automatic Stabilizers

78. During an economic contraction, automatic stabilizers:

1. reduce both budget surpluses and deficits.
2. reduce a budget surplus or increase a deficit.
3. reduce a budget deficit or increase a surplus.
4. increase both budget surpluses and deficits.

Automatic stabilizers are countercyclical fiscal policies so as income falls, taxes fall and spending increases. Both changes increase a budget deficit or reduce a surplus.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #78

Difficulty: Hard

Learning Objective: 18-4

Topic: Automatic Stabilizers

79. During an economic expansion, automatic stabilizers:

1. reduce both budget surpluses and deficits.
2. reduce a budget surplus or increase a deficit.
3. reduce a budget deficit or increase a surplus.
4. increase both budget surpluses and deficits.

Automatic stabilizers are countercyclical fiscal policies so as income rises, taxes increase and spending decreases. Both changes reduce a deficit or increase a surplus.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #79

Difficulty: Hard

Learning Objective: 18-4

Topic: Automatic Stabilizers

80. An example of a pro-cyclical fiscal policy is:

1. an income tax.
2. unemployment compensation.
3. a balanced budget policy.
4. welfare payments.

Pro-cyclical fiscal policies increase cyclical fluctuations in the economy because they are contractionary when output is falling and expansionary when output is rising.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #80

Difficulty: Easy

Learning Objective: 18-4

Topic: Procyclical Fiscal Policies

81. In 2009, output was beneath potential. At the same time, the budget deficit hit a record high of over $1 trillion. If President Obama were to pursue budget cuts, given the state of the economy, these spending cuts would:

1. be procyclical.
2. be countercyclical.
3. increase interest rates.
4. crowd out investment.

Because the spending cuts would reduce output even further beneath potential output, they would increase the downtrend of the cycle and is hence a procyclical policy.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #81

Difficulty: Medium

Learning Objective: 18-4

Topic: Procyclical Fiscal Policies

82. Pro-cyclical fiscal policies:

1. reduce cyclical fluctuations in the economy, but not as effectively as countercyclical fiscal policies.
2. reduce cyclical fluctuations in the economy more effectively than countercyclical fiscal policies.
3. reduce cyclical fluctuations in the economy about as effectively as countercyclical fiscal policies.
4. increase cyclical fluctuations in the economy.

Pro-cyclical fiscal policies increase cyclical fluctuations in the economy because they are contractionary when output is falling and expansionary when output is rising.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #82

Difficulty: Medium

Learning Objective: 18-4

Topic: Procyclical Fiscal Policies

83. If output is falling, a pro-cyclical fiscal policy will result in:

1. higher taxes and/or increased government spending.
2. higher taxes and/or decreased government spending.
3. lower taxes and/or increased government spending.
4. lower taxes and/or decreased government spending.

Pro-cyclical fiscal policies are contractionary when output is falling because they increase, rather than decrease, cyclical fluctuations.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #83

Difficulty: Hard

Learning Objective: 18-4

Topic: Procyclical Fiscal Policies

84. The introduction of "rainy-day funds" by states would:

1. decrease the pro-cyclical nature of current state budgeting procedures.
2. increase the pro-cyclical nature of current state budgeting procedures.
3. decrease the counter-cyclical nature of current state budgeting procedures.
4. increase the counter-cyclical nature of current state budgeting procedures.

Rainy-day funds would set aside budget surpluses in good years to offset budget deficits in bad years. States currently must balance their budgets.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #84

Difficulty: Medium

Learning Objective: 18-4

Topic: Procyclical Fiscal Policies

85. Which of the following policies would reduce the pro-cyclical nature of fiscal policy at the state level?

1. The establishment of "rainy day funds".
2. The introduction of price controls.
3. The institution of balanced budget requirements.
4. The elimination of automatic stabilizers.

Automatic stabilizers are counter-cyclical fiscal policies. Eliminating them would make fiscal policy more pro-cyclical, not less.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #85

Difficulty: Medium

Learning Objective: 18-4

Topic: Procyclical Fiscal Policies

86. If state governments began using a five-year rolling-average budgeting procedure as opposed to the current practice of no rolling average, which would the likely result be?

1. State financing would become more procyclical.
2. Balanced-budget requirements in state constitutions would be much less procyclical.
3. The need for automatic stabilizers at the federal level would increase.
4. State governments would run a greater risk of running short of funds during recessions.

See the discussion under the heading "State Government Finance and Procyclical Fiscal Policy" in the textbook.

AACSB: Analytic

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #86

Difficulty: Medium

Learning Objective: 18-4

Topic: Procyclical Fiscal Policies

87. The income tax is:

1. an automatic stabilizer because income tax revenues rise as income increases, slowing an economic expansion.
2. an automatic stabilizer because income tax revenues rise as income increases, accelerating an economic expansion.
3. an automatic stabilizer because income tax revenues fall as income increases, accelerating an economic expansion.
4. not an automatic stabilizer.

Higher income generates higher income tax revenues, which cause aggregate demand to increase less rapidly than it otherwise would.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #87

Difficulty: Medium

Learning Objective: 18-4

Topic: Automatic Stabilizers

88. Unemployment compensation is:

1. an automatic stabilizer because it rises as income increases, slowing an economic expansion.
2. an automatic stabilizer because it falls as income increases, slowing an economic expansion.
3. an automatic stabilizer because it falls as income decreases, slowing an economic contraction.
4. not an automatic stabilizer.

Higher income generates higher employment and thus lower unemployment compensation, so aggregate demand does not increase as rapidly as it otherwise would.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #88

Difficulty: Easy

Learning Objective: 18-4

Topic: Automatic Stabilizers

89. If taxes and government expenses did not vary with income, then income would:

1. be more stable.
2. not be more or less stable.
3. be less stable.
4. be closer to potential income.

The presence of automatic stabilizers like the income tax, welfare payments, and unemployment insurance help to stabilize output because these variables behave countercyclically.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #89

Difficulty: Medium

Learning Objective: 18-4

Topic: Automatic Stabilizers

90. If income increases, a budget deficit will:

1. tend to increase.
2. tend to decrease.
3. change unpredictably.
4. not change.

Increases in income increase income tax revenues and reduce transfer payments, causing the budget deficit to decline.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #90

Difficulty: Easy

Learning Objective: 18-4

Topic: Automatic Stabilizers

91. Suppose the government never borrows, so that it always finances its expenditures with taxes. Suppose further that government spending does not depend on income. In this case:

1. both government spending and taxes are automatic stabilizers.
2. government spending is an automatic stabilizer but taxes are not.
3. taxes are an automatic stabilizer but government spending is not.
4. neither government spending nor taxes are automatic stabilizers.

Since government spending does not vary with income, it cannot be an automatic stabilizer. Since taxes must always equal government spending, they cannot vary with income either and therefore cannot be automatic stabilizers.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #91

Difficulty: Hard

Learning Objective: 18-4

Topic: Automatic Stabilizers

92. Property taxes are:

1. not an automatic stabilizer because they do not vary with income.
2. not an automatic stabilizer because they vary with income.
3. an automatic stabilizer because they do not vary with income.
4. an automatic stabilizer because they vary with income.

Property taxes are based on the value of a piece of property and do not vary with income, so they cannot be an automatic stabilizer.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #92

Difficulty: Hard

Learning Objective: 18-4

Topic: Automatic Stabilizers

93. The provisions in state constitutions requiring them to balance their budgets means that

1. state governments often behave procyclically because lower revenues during recessions mean lower state spending.
2. state government spending acts as an automatic stabilizer for the national economy.
3. state governments can follow a functional finance approach with greater consistency than the federal . government, which has no such requirement.
4. state governments can only use monetary policy to affect their economies.

See the discussion under "State Government Finance and Procyclical Fiscal Policy."

AACSB: Analytic

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #93

Difficulty: Medium

Learning Objective: 18-4

Topic: Procyclical Fiscal Policies

94. As income increases during the recovery from a recession, automatic stabilizers will:

1. increase taxes and increase government spending, increasing the overall size of the government.
2. reduce taxes and increase government spending, accelerating the recovery.
3. increase taxes and decrease government spending, slowing the recovery.
4. reduce taxes on high-income individuals and raise taxes on the poor, increasing economic inequality.

See the discussion under "The Negative Side of Automatic Stabilizers" in the textbook.

AACSB: Analytic

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #94

Difficulty: Medium

Learning Objective: 18-4

Topic: Automatic Stabilizers

95. When inflation and unemployment are both higher than desired, most economists believe that the government should:

1. adopt contractionary monetary policies that reduce both inflation and unemployment.
2. adopt expansionary fiscal policies that reduce both inflation and unemployment.

Cdetermine whether reducing inflation is more or less important than reducing unemployment and . adopt a policy that targets the more important goal.

1. not act as it is impossible to reduce either inflation or unemployment under these circumstances.

Because the goals of lower inflation and lower unemployment conflict, policy makers must choose which goal is more important and trade off improvements in one area for improvements in the other.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #95

Difficulty: Hard

Learning Objective: 18-3

Topic: Functional Finance

96. It is generally true that elected officials find it easier to:

1. cut taxes.
2. cut government spending.
3. raise taxes and cut government spending.
4. raise both taxes and government spending.

Most voters prefer lower taxes.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Knowledge

Colander - Chapter 18 #96

Difficulty: Easy

Learning Objective: 18-3

Topic: Functional Finance

97. What did the sound-finance approach to fiscal policy use to support its view?

1. Keynesian economics.
2. A history of successful procyclical fiscal policy.
3. The functional finance view.
4. The Ricardian equivalence theorem.

The Classical, sound-finance macroeconomic tradition looks back to the Ricardian equivalence theorem.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Knowledge

Colander - Chapter 18 #97

Difficulty: Medium

Learning Objective: 18-1

Topic: Sound Finance

98. In contrast to the functional finance view, Classical sound-finance macroeconomics assumes that individuals:

1. do not adjust their spending to account for future tax payments.
2. adjust their spending to account for future tax payments.
3. do not adjust their spending to account for future incomes.
4. adjust their spending to account for future incomes.

The Classical, sound-finance macroeconomics states that individuals will adjust their spending to account for future tax payments and therefore, it is irrelevant whether the government runs a deficit or not or how it finances the deficits.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #98

Difficulty: Medium

Learning Objective: 18-1

Topic: Ricardian Equivalence

99. According to the Classical advocates of sound finance, if an economy is in a recession, the government should run:

1. a budget deficit and increase spending, which will increase output.
2. a budget surplus and decrease spending, which will increase output.
3. neither a surplus nor a deficit since changes in deficit spending do not affect output.
4. neither a surplus nor a deficit since changes in spending affect output.

An economist with a Classical, sound-finance point of view would recommend running neither a surplus nor a deficit since such changes do not affect output.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #99

Difficulty: Medium

Learning Objective: 18-2

Topic: Ricardian Equivalence

100. According to a Classical, sound-finance perspective on macroeconomics, if an economy is on an inflationary path, the government should run:

1. a budget deficit and increase spending, which will reduce output.
2. a budget surplus and decrease spending, which will reduce output.
3. neither a surplus nor a deficit since changes in deficit spending do not affect output.
4. neither a surplus nor a deficit since changes in spending affect output.

An economist with a Classical, sound-finance macroeconomic perspective would not recommend running a surplus or a deficit, since such changes do not affect output.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #100

Difficulty: Medium

Learning Objective: 18-2

Topic: Ricardian Equivalence

Colander - Chapter 18

101. Refer to the graph above. Assume the economy is in short-run equilibrium at point A below potential

output. The government opts for an expansionary fiscal policy in an attempt to pull the economy out of the recession. An economist with a Classical view holding the Ricardian Equivalence theorem to be practically true would conclude that the economy will most likely end up at point:  

1. A
2. B
3. C
4. D

An economist with a Classical view holding the Ricardian Equivalence theorem to be practically true would conclude that taxpayers will reduce their spending by the same amount as the deficit spending, which will bring back AD to the original position at point A.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #101

Difficulty: Hard

Learning Objective: 18-1

Topic: Ricardian Equivalence

102. Refer to the graph above. Assume the economy is in short-run equilibrium at point A below potential

output. The government opts for an expansionary fiscal policy that shifts the AD curve from AD₀ to AD₁ in an attempt to pull the economy out of the recession. An economist with a functional finance view who also recognizes that there will be a certain degree of crowding out would conclude that the economy will likely end up at point:  

1. A
2. B
3. C
4. D

An economist with a functional finance view who acknowledges partial crowding out would conclude that government spending will shift AD from AD₀ to AD₁, but the AD curve will shift back to the left to AD₂ if the government spending partially crowds out private investment.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #102

Difficulty: Hard

Learning Objective: 18-3

Topic: Crowding Out

103. Refer to the graph above. Assume the economy is in short-run equilibrium at point A below potential output. The government opts for an expansionary fiscal policy in an attempt to pull the economy out of the recession. Not taking into account shifts in aggregate supply, an economist with a functional finance view who also believes in a full crowding out effect would conclude that the economy will end up at point:

1. A
2. B
3. C
4. D

An economist with a typical functional finance view would conclude that government spending will shift AD from AD₀ to AD₁, but the AD will shift back to the left to AD₀ if government spending entirely crowds out private investment.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #103

Difficulty: Medium

Learning Objective: 18-3

Topic: Crowding Out

104. Refer to the graph above. Assume the economy is in short-run equilibrium at point A below potential

output. The government opts for an expansionary fiscal policy that shifts the AD curve from AD₀ to AD₁ in an attempt to pull the economy out of the recession. Not taking into account shifts in aggregate supply, an economist with a functional finance view who believes there will be no crowding out effect would conclude that the economy will end up at point:  

1. A
2. B
3. C
4. D

An economist with a typical functional finance view would conclude that government spending will shift AD from AD₀ to AD₁. With no crowding out effect, investment would not change and AD will not shift back to the left.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #104

Difficulty: Medium

Learning Objective: 18-3

Topic: Crowding Out

105. If an economy is in a recession and the government opts for an expansionary fiscal policy to shift AD closer to the potential output, a sound-finance economist with a Classical view who holds the Ricardian Equivalence theorem to be practically true would conclude that AD:

1. shifts to the right due to higher government spending.
2. shifts to the left due to higher government spending.
3. does not shift since the higher government spending is offset by higher private consumption.
4. does not shift since the higher government spending is offset by lower private consumption.

The Classical, Ricardian Equivalence perspective on macroeconomics states that individuals will adjust their spending to account for future tax payments and therefore, it is irrelevant whether the government runs a deficit or not or how it finances the deficits. The deficits do not shift the AD curve.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #105

Difficulty: Hard

Learning Objective: 18-1

Topic: Ricardian Equivalence

106. If an economy is above potential output and the government opts for a contractionary fiscal policy (running surpluses) to shift AD, an economist with a Classical view who holds the Ricardian Equivalence theorem to be practically true would conclude that AD:

1. shifts to the right due to lower government spending.
2. shifts to the left due to lower government spending.
3. does not shift since the lower government spending is offset by higher private consumption.
4. does not shift since the lower government spending is offset by lower private consumption.

The Ricardian Equivalence theorem states that individuals will adjust their spending to account for future tax payments and therefore, it is irrelevant whether the government runs a deficit or not or how it finances the deficits. The reduction in deficits due to a contractionary fiscal policy does not shift the AD, since individuals will expect lower tax rates in the future and increase current consumption by the same amount.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #106

Difficulty: Hard

Learning Objective: 18-1

Topic: Ricardian Equivalence

107. If an economy is in a recession and the government opts for an expansionary fiscal policy to shift AD closer to potential output, an economist with a typical functional finance view who acknowledges partial crowding out would conclude that the AD:

1. shifts to the right due to higher government spending.
2. shifts to the left due to higher government spending.
3. does not shift since the higher government spending is offset by higher private consumption.
4. does not shift since the higher government spending is offset by lower private consumption.

An economist with a functional finance view would conclude that government spending will shift AD to the right. Even with a partial crowding out effect, the net outcome is a shift to the right of the original AD curve.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #107

Difficulty: Hard

Learning Objective: 18-3

Topic: Crowding Out

108. According to Ricardian Equivalence advocates, if the government announces a plan to balance the budget by reducing its deficits to zero, then the private sector will:

1. decrease consumption.
2. decrease savings.
3. decrease investment.
4. increase savings.

A Ricardian Equivalence advocate would conclude that the private sector will increase their spending, and therefore reduce savings, by the same amount as the reduction in deficit spending.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Comprehension

Colander - Chapter 18 #108

Difficulty: Medium

Learning Objective: 18-1

Topic: Ricardian Equivalence

109. When the economy entered a serious recession in 2008, the response of the U.S. government was to institute a $700 billion bailout plan, pursue other heavy deficit spending, and take on unusually large liabilities through bond and money market fund guarantees. This is an example of:

1. sound finance as fiscal policy.
2. functional finance and expansionary fiscal policy.
3. fiscal policy that employs automatic stabilizers as the primary means of economic stabilization.
4. procyclical fiscal policy.

Unusual deficit spending of this nature is an example of functional finance.

AACSB: Reflective Thinking

BLOOMS TAXONOMY: Application

Colander - Chapter 18 #109

Difficulty: Medium

Learning Objective: 18-2

Topic: Functional Finance

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