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Macro Economics- Chapter 12

Macroeconomics, Canadian Ed. (Hubbard et al.)
Chapter 12 Fiscal Policy

12.1 What is Fiscal Policy?

1) Canada’s Economic Action Plan is an example of ________ aimed at increasing real GDP and employment.
A) discretionary fiscal policy
B) an automatic stabilizer
C) contractionary fiscal policy
D) a transfer payment

A
2) If Parliament passed a one-time tax cut in order to stimulate the economy in 2014, and tax rate levels returned to their pre-2014 level in 2015, how should this tax cut affect the economy?
A) Households on average would save an amount greater than the tax cut.
B) The tax cut would stimulate spending by households.
C) The tax cut would shift the aggregate demand curve to the right.
D) The tax cut would raise the price level in 2014.
B
3) Fiscal policy refers to changes in
A) provincial and local taxes and purchases that are intended to achieve social policy objectives.
B) taxes and purchases that are intended to achieve macroeconomic policy objectives.
C) federal taxes and purchases that are intended to fund tighter airport security.
D) the money supply and interest rates that are intended to achieve macroeconomic policy objectives.
B
4) Which of the following would be classified as fiscal policy?
A) The federal government passes tax cuts to encourage firms to reduce air pollution.
B) The Bank of Canada cuts interest rates to stimulate the economy.
C) A provincial government cuts taxes to help the economy of the province.
D) The federal government cuts taxes to stimulate the economy.
E) Provinces increase taxes to fund education.
D
5) Which of the following is an objective of fiscal policy?
A) energy independence from Middle East oil
B) drug plan coverage for all Canadians
C) discovering a cure for AIDs
D) high rates of economic growth
E) winning hockey gold at the winter olympics
D
6) Automatic stabilizers refer to
A) the money supply and interest rates that automatically increase or decrease along with the business cycle.
B) government spending and taxes that automatically increase or decrease along with the business cycle.
C) changes in the money supply and interest rates that are intended to achieve macroeconomic policy objectives.
D) changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives.
B
7) The increase in the amount that the government collects in taxes when the economy expands and the decrease in the amount that the government collects in taxes when the economy goes into a recession is an example of
A) automatic stabilizers.
B) discretionary fiscal policy.
C) discretionary monetary policy.
D) automatic monetary policy.
A
8) The increase in government spending on Employment Insurance payments to workers who lose their jobs during a recession and the decrease in government spending on unemployment insurance payments to workers during an expansion is an example of
A) automatic stabilizers.
B) discretionary fiscal policy.
C) discretionary monetary policy.
D) automatic monetary policy.
A
9) Which of the following would not be considered an automatic stabilizer?
A) legislation increasing funding for job retraining passed during a recession
B) decreasing unemployment insurance payments due to decreased jobless during an expansion
C) rising income tax collections due to rising incomes during an expansion
D) declining food stamp payments due to more persons finding jobs during an expansion
A
10) In the 1960s and 1970s, the majority of government spending took place at the ________ and since the 1990s the majority of government spending took place at the ________.
A) provincial and local levels; federal level
B) local level; federal level
C) federal level; provincial and local levels
D) federal level; provincial level
C
11) Federal government purchases, as a percentage of GDP
A) have risen since the early 1960s.
B) have fallen since the early 1960s.
C) have remained roughly the same since the early 1960s.
D) rose from the early 1960s until the mid 1990s, and then fell.
D
12) Federal government expenditures, as a percentage of GDP
A) have risen since the early 1950s to the present.
B) have fallen since the early 1950s to the present.
C) rose from 1950 to 1991, fell from 1992 to 2001, and have risen from 2001 to the present.
D) rose from 1950 to 2001 and then fell from 2001 to the present.
E) rose from 1950 to 1980, fell from 1981 to 2001, and have risen from 2001 to the present.
C
13) Government spending on health care has been
A) shrinking as a share of government spending.
B) steady as a share of government spending.
C) falling than rising as a share of government spending.
D) rising as a share of government spending.
D
14) Three categories of federal government expenditures, in addition to government operations, are
A) debt charges, transfers to other levels of government, and transfer persons.
B) interest on provincial debt, defense spending, and transfer payments.
C) defense spending, budgets of federal agencies, and transfer payments.
D) defense spending, income tax, and transfers.
A
15) The largest source of federal government revenue in 2012 was
A) the Goods and Services Tax (GST).
B) corporate income taxes.
C) personal income taxes.
D) payroll taxes to fund Employment Insurance.
C
16) Government spending on heath care will
A) decrease as the population ages.
B) remain constant as the population ages.
C) increase as the population.
D) become unaffordable no matter what we do.
C
17) Which of the following is not an option for provincial governments facing rising health care costs?
A) printing more money
B) raising income and sales taxes
C) reducing funding to eduction and other programs
D) reducing the level of health care services provided
A
18) By the time you’re likely to start thinking about retirement
A) the cost of health care will still be growing at current rates.
B) the cost of health care will be falling.
C) the cost of health care be growing much more slowly than it is now.
D) the cost of health care will not be an issue for Canadians.
C
19) A decrease in the marginal income tax rate is a fiscal policy which will increase aggregate demand.
TRUE
20) The income tax system serves as an automatic stabilizer over the course of the business cycle.
TRUE
21) Provincial health care systems receive no support from the federal government.
FALSE
22) What is the difference between fiscal policy and monetary policy?
Fiscal policy involves changes in federal taxes and purchases and is implemented by Parliament. Monetary policy involves changes in the money supply and interest rates and is implemented by Bank of Canada. Both are intended to achieve macroeconomic objectives.
23) List the major categories of federal government expenditures.
1. Defense and public safety
2. Transfers to persons
3. Transfers to other levels of government
4. Debt charges
5. Government operations
12.2 The Effects of Fiscal Policy on Real GDP and the Price Level

1) Parliament carries out fiscal policy through changes in
A) interest rates and the money supply.
B) taxes and the interest rate.
C) government purchases and the money supply.
D) government purchases and taxes.

D
2) Fiscal policy is determined by
A) the Bank of Canada.
B) the Prime Minister and the Governor of the Bank of Canada.
C) Parliament and the Bank of Canada
D) Parliament
D
3) An increase in government purchases will increase aggregate demand because
A) government expenditures are a component of aggregate demand.
B) consumption expenditures are a component of aggregate demand.
C) the decline in the price level will increase demand.
D) the decline in the interest rate will increase demand.
A
4) Expansionary fiscal policy involves
A) increasing government purchases or decreasing taxes.
B) increasing taxes or decreasing government purchases.
C) increasing the money supply and decreasing interest rates.
D) decreasing the money supply and increasing interest rates.
A
Figure 12.1

5) Refer to Figure 12.1. An increase in taxes would be depicted as a movement from ________, using the static AD-AS model in the figure above.
A) E to B
B) B to C
C) A to B
D) B to A
E) C to D

D
6) Refer to Figure 12.1. Suppose the economy is in a recession and expansionary fiscal policy is pursued. Using the static AD-AS model in the figure above, this would be depicted as a movement from
A) A to B.
B) B to C.
C) C to B.
D) B to A.
E) A to E.
A
7) Refer to Figure 12.1. Suppose the economy is in short-run equilibrium below potential GDP and Parliament and the prime minister lower taxes to move the economy back to long-run equilibrium. Using the static AD-AS model in the figure above, this would be depicted as a movement from
A) A to B.
B) B to C.
C) C to B.
D) B to A.
E) A to E.
A
8) Refer to Figure 12.1. Suppose the economy is in short-run equilibrium below potential GDP and no fiscal or monetary policy is pursued. Using the static AD-AS model in the figure above, this would be depicted as a movement from
A) A to B.
B) B to C.
C) C to B.
D) B to A.
E) A to E.
E
9) Refer to Figure 12.1. Suppose the economy is in short-run equilibrium above potential GDP and automatic stabilizers move the economy back to long-run equilibrium. Using the static AD-AS model in the figure above, this would be depicted as a movement from
A) D to C.
B) A to E.
C) C to B.
D) B to A.
E) E to A.
C
10) Refer to Figure 12.1. Suppose the economy is in short-run equilibrium above potential GDP and no policy is pursued. Using the static AD-AS model in the figure above, this would be depicted as a movement from
A) D to C.
B) A to E.
C) C to D.
D) C to B.
E) E to A.
C
11) Refer to Figure 12.1. Suppose the economy is in short-run equilibrium above potential GDP and wages and prices are rising. If contractionary policy is used to move the economy back to long run equilibrium, this would be depicted as a movement from ________ using the static AD-AS model in the figure above.
A) D to C
B) C to B
C) A to E
D) B to A
E) E to A
B
12) An increase in individual income taxes ________ disposable income, which ________ consumption spending.
A) increases; increases
B) increases; decreases
C) decreases; increases
D) decreases; decreases
D
13) Tax cuts on business income increase aggregate demand by increasing
A) business investment spending.
B) consumption spending.
C) government spending.
D) wage rates.
A
14) Tax cuts on business income ________ aggregate demand.
A) would decrease
B) would increase
C) would not change
D) may increase or decrease
B
15) If the economy is falling below potential real GDP, which of the following would be an appropriate fiscal policy to bring the economy back to long-run aggregate supply? An increase in
A) the money supply and a decrease in interest rates.
B) government purchases.
C) oil prices.
D) taxes.
B
16) Which of the following is considered contractionary fiscal policy?
A) Parliament increases the income tax rate.
B) Parliament increases the Canada Health Transfer.
C) Legislation removes a college tuition deduction from federal income taxes.
D) The Ontario legislature cuts highway spending to balance its budget.
A
17) Expansionary fiscal policy to prevent real GDP from falling below potential real GDP would cause the inflation rate to be ________ and real GDP to be ________.
A) higher; higher
B) higher; lower
C) lower; higher
D) lower; lower
A
18) Expansionary fiscal policy involves increasing government purchases or increasing taxes.
FALSE
19) Contractionary fiscal policy is used to decrease aggregate demand in an attempt to fight rising inflation.
TRUE
20) Lowering the personal income tax will increase household disposable income and consumption spending.
TRUE
21) What is expansionary fiscal policy? What is contractionary fiscal policy?
An expansionary fiscal policy is a decrease in taxes or an increase in government purchases intended to increase aggregate demand. A contractionary fiscal policy is an increase in taxes or a decrease in government purchases intended to decrease aggregate demand.
22) Does expansionary fiscal policy directly increase the money supply? Isn’t it true that the federal government recessions by spending more money?
No, expansionary fiscal policy does not directly increase the money supply. Parliament fights recessions by increasing spending, not the money supply, by either increasing government spending or cutting taxes to increase household disposable income and, therefore, consumption spending.
23) The problem typically during a recession is not that there is too little money, but too little spending. If the problem was too little money, what would be its cause? If the problem was too little spending, what could be its cause?
Too little money would be caused by too small of a money supply by the Bank of Canada. Too little spending could be caused by a variety of reasons such as a decrease in consumption spending by households because they become pessimistic about the future, a decrease in investment spending by firms because they lower their estimates of the future profitability of new factories and machinery, or a decrease in Canadian exports because a major trading partner is in a recession.
12.3 Fiscal Policy in the Dynamic Aggregate Demand and Aggregate Supply Model

Figure 12.2

1) Refer to Figure 12.2. In the dynamic model of AD-AS in the figure above, if the economy is at point A in year 1 and is expected to go to point B in year 2, the federal government would most likely
A) decrease government spending.
B) increase government spending.
C) increase oil prices.
D) increase taxes.
E) lower interest rates.

B
2) Refer to Figure 12.2. In the dynamic model of AD-AS in the figure above, if the economy is at point A in year 1 and is expected to go to point B in year 2, and no fiscal or monetary policy is pursued, then at point B
A) the unemployment rate is very low.
B) firms are operating below capacity.
C) the economy is above full employment.
D) income and profits are rising.
E) there is pressure on wages and prices to rise.
B
3) Refer to Figure 12.2. In the dynamic model of AD-AS in the figure above, if the economy is at point A in year 1 and is expected to go to point B in year 2, the federal government would most likely pursue
A) expansionary fiscal policy.
B) contractionary fiscal policy.
C) expansionary monetary policy.
D) contractionary monetary policy.
E) contractionary automatic stabilizers.
A
4) From an initial long-run equilibrium, if aggregate demand grows more slowly than long-run and short-run aggregate supply, the federal government would most likely
A) increase the required reserve ratio and decrease government spending.
B) decrease government spending.
C) decrease oil prices.
D) decrease taxes.
E) lower interest rates.
D
5) Which of the following would be most likely to induce the federal government to conduct expansionary fiscal policy? A significant
A) decrease in investment spending.
B) decrease in oil prices.
C) increase in consumption spending.
D) increase in net exports.
A
6) If real GDP exceeded potential real GDP and inflation was increasing, which of the following would be an appropriate fiscal policy?
A) a decrease in the money supply and an increase in the interest rate
B) an increase in government spending
C) an increase in taxes
D) an increase in oil prices
C
7) From an initial long-run equilibrium, if aggregate demand grows faster than long-run and short-run aggregate supply, then the federal government would most likely
A) decrease the required reserve ratio.
B) decrease government spending.
C) decrease oil prices.
D) decrease tax rates.
B
8) Contractionary fiscal policy to prevent real GDP from rising above potential real GDP would cause the inflation rate to be ________ and real GDP to be ________.
A) higher; higher
B) higher; lower
C) lower; higher
D) lower; lower
D
Figure 12.3

9) Refer to Figure 12.3. In the dynamic model of AD-AS in the figure above, if the economy is at point A in year 1 and is expected to go to point B in year 2, the federal government would most likely
A) increase the money supply and decrease the interest rate.
B) increase taxes.
C) increase government spending.
D) increase oil prices.
E) raise interest rates.

B
10) Refer to Figure 12.3. In the dynamic model of AD-AS in the figure above, if the economy is at point A in year 1 and is expected to go to point B in year 2, and no fiscal or monetary policy is pursued, then at point B
A) the unemployment rate is very low.
B) firms are operating at below capacity.
C) the economy is below full employment.
D) income and profits are falling.
E) there is pressure on wages and prices to fall.
A
11) Refer to Figure 12.3. In the dynamic model of AD-AS in the figure above, if the economy is at point A in year 1 and is expected to go to point B in year 2, the federal government would most likely pursue
A) expansionary fiscal policy.
B) contractionary fiscal policy.
C) expansionary monetary policy.
D) contractionary monetary policy.
E) expansionary automatic stabilizers.
B
12) Which of the following would be most likely to induce the federal government to conduct contractionary fiscal policy? A significant
A) decrease in oil prices.
B) decrease in real GDP.
C) increase in inflation.
D) increase in labor productivity.
C
13) If the economy is slipping into a recession, which of the following would be an appropriate fiscal policy?
A) an increase in the money supply and a decrease in interest rates
B) a decrease in government purchases
C) a decrease in taxes
D) a decrease in oil prices
C
14) An appropriate fiscal policy response when aggregate demand is growing at a slower rate than aggregate supply is to cut taxes.
TRUE
15) If real equilibrium GDP is above potential GDP, expansionary fiscal policy should be pursued.
FALSE
16) What are the key differences between how we illustrate an expansionary fiscal policy in the basic aggregate demand and aggregate supply model and in the dynamic aggregate demand and aggregate supply model?
In the basic aggregate demand and aggregate supply model, expansionary fiscal policy is illustrated by a rightward shift of the aggregate demand curve, with the short-run aggregate supply curve and long-run aggregate supply curve remaining stationary. The dynamic aggregate demand and aggregate supply model takes into account the economy experiencing continuing inflation from year to year and the economy experiencing long-run growth. In the dynamic model, expansionary fiscal policy is illustrated by a rightward shift of the aggregate demand curve, a rightward shift of the short run aggregate supply curve, and a rightward shift of the long run aggregate supply curve.
17) Use the dynamic aggregate demand and aggregate supply model and start with Year 1 in a long-run macroeconomic equilibrium. For Year 2, graph aggregate demand, long-run aggregate supply, and short-run aggregate supply such that the condition of the economy will induce Parliament to conduct expansionary fiscal policy. Briefly explain the condition of the economy and what Parliament is attempting to do.
The Parliament conduct expansionary fiscal policy to increase real GDP to potential real GDP. In the graph below, the economy would move from point A in Year 1 to point B in Year 2 without any expansionary fiscal policy. At point B, real GDP is below potential real GDP. Parliament would increase government purchases or decrease taxes to stimulate aggregate demand, trying to push
the economy to potential.
Table 12.1
Year Potential Real GDP Real GDP Price Level
1 $11.0 trillion $11.0 trillion 100
2 11.5 trillion 11.7 trillion 109

18) Refer to Table 12.1. Suppose the economy is in the state described by the table above. What problem will occur in the economy if no policy is pursued? What fiscal policy tools could be used to combat the problem? Draw a dynamic aggregate demand and aggregate supply diagram to illustrate the appropriate fiscal policy to use in this situation.

The economy begins in equilibrium at point A, at potential real GDP of $11 trillion and a price level of 100. Without government policy, aggregate demand will shift from AD1 to AD2 (without policy). Because long-run aggregate supply shifted from LRAS1 to LRAS2, the economy is pushed above potential real GDP. The economy will be at a short-run equilibrium at point B, with real GDP of $11.7 trillion and a price level of 109.
The government should pursue contractionary fiscal policy by decreasing government purchases or raising taxes to shift aggregate demand to AD2 (without policy). The economy will be in equilibrium at point C with real GDP of $11.5 trillion and a price level of 105. The price level is lower than it would have been if expansionary fiscal policy had not been used.
12.4 The Government Purchases and Tax Multipliers

1) Economists refer to the series of induced increases in consumption spending that result from an initial increase in autonomous expenditures as the ________ effect.
A) multiplier
B) expenditure
C) consumption
D) aggregate demand

A
2) The multiplier effect refers to the series of
A) autonomous increases in consumption spending that result from an initial increase in induced expenditures.
B) induced increases in consumption spending that result from an initial increase in autonomous expenditures.
C) autonomous increases in investment spending that result from an initial increase in induced expenditures.
D) induced increases in investment spending that result from an initial increase in autonomous expenditures.
B
3) The aggregate demand curve will shift to the right ________ the initial increase in government purchases.
A) by less than
B) by more than
C) by the same amount as
D) sometimes by more than and other times by less than
B
4) The aggregate demand curve will shift to the left ________ the initial decrease in government purchases.
A) by less than
B) by more than
C) by the same amount as
D) sometimes by more than and other times by less than
B
5) The aggregate demand curve will shift to the right ________ the initial decrease in taxes.
A) by less than
B) by more than
C) by the same amount
D) sometimes by more than and other times by less than
B
Figure 12.4

6) Refer to Figure 12.4. In the graph above, the shift from AD1 to AD2 represents the total change in aggregate demand. If government purchases increased by $50 billion, then the distance from point A to point B ________ $50 billion.
A) would be equal to
B) would be greater than
C) would be less than
D) may be greater than or less than

B
7) A change in consumption spending caused by income changes is ________ change in spending, and a change in government spending that occurs to improve roads and bridges is ________ change in spending.
A) an induced; an autonomous
B) an expansionary; a contractionary
C) an autonomous; an induced
D) a contractionary; an expansionary
A
8) The government purchases multiplier equals the change in ________ divided by the change in ________.
A) government purchases; equilibrium real GDP
B) equilibrium real GDP; government purchases
C) government purchases; consumption spending
D) consumption spending; government purchases
B
9) The tax multiplier equals the change in ________ divided by the change in ________.
A) taxes; equilibrium real GDP
B) equilibrium real GDP; taxes
C) taxes; consumption spending
D) consumption spending; taxes
B
10) Which of the following would increase the size of the government purchases multiplier?
A) an increase in the tax rate
B) an increase in the quantity of imports purchased by households from an increase in income
C) a decrease in the amount of consumption spending by households from an increase in income
D) a decrease in the amount saved by households from an increase in income
D
11) If the tax multiplier is -1.5 and a $20 billion tax increase is implemented, what is the change in GDP, holding everything else constant? (Assume the price level stays constant.)
A) a $30 billion decrease in GDP
B) a $30 billion increase in GDP
C) a $300 billion increase in GDP
D) a $13.33 billion decrease in GDP
E) a $13.33 billion increase in GDP
A
12) Suppose the government spending multiplier is 2. The federal government cuts spending by $4 billion. What is the change in GDP if the price level is not held constant?
A) an increase of less than $8 billion
B) an increase equal to $8 billion
C) an increase of greater than $8 billion
D) a decrease of less than $8 billion
E) a decrease of more than $8 billion
D
13) The tax multiplier is smaller in absolute value than the government purchases multiplier because some portion of the
A) decrease in taxes will be saved by households and not spent, and some portion will be spent on imported goods.
B) decrease in taxes will be saved by households and not spent, and some portion will be spent on consumer durable goods.
C) increase in government purchases will be saved by households and not spent, and some portion will be spent on imported goods.
D) increase in government purchases will be saved by households and not spent, and some portion will be spent on consumer durable goods.
A
14) A decrease in the tax rate will ________ the disposable income of households and ________ the size of the multiplier effect.
A) increase; increase
B) decrease; increase
C) increase; decrease
D) decrease; decrease
E) increase; not change
A
15) Suppose the federal government increased spending by $10 billion and raised taxes by $10 billion to keep the budget balanced. What will happen to real equilibrium GDP?
A) Real equilibrium GDP will fall.
B) Real equilibrium GDP will rise.
C) There will be no change in real equilibrium GDP.
D) Real equilibrium GDP will initially rise, but then fall below its previous equilibrium value.
B
16) Suppose real GDP is $1.6 trillion and potential GDP is $1.4 trillion. To move the economy back to potential GDP, the federal government should
A) lower government purchases by an amount less than $200 billion.
B) lower government purchases by $200 billion.
C) raise taxes by $200 billion.
D) lower taxes by $200 billion.
E) raise taxes by an amount more than $200 billion.
A
17) Suppose real GDP is $1.4 trillion and potential GDP is $1.9 trillion. To move the economy back to potential GDP, the federal government should
A) lower taxes by an amount less than $500 billion.
B) raise government purchases by $500 billion.
C) raise government purchases by more than $500 billion.
D) lower taxes by $500 billion.
E) lower government purchases by $500 billion.
A
18) The multiplier effect following an increase in expenditure is generated by induced increases in consumption expenditure as income rises.
TRUE
19) In absolute value, the tax multiplier is greater than the government purchases multiplier.
FALSE
20) If government increases taxes by the same amount it increases government spending, there will be no effect on aggregate demand: the increase in government spending is offset by an equal decrease in consumption spending by households.
FALSE
21) Suppose Political Party A proposes a tax cut on business income to stimulate the economy. Political Party B opposes the tax cut on business income asserting that it would only help businesses, not the average working man and woman. If you were hired as an economist for Political Party A, explain how the tax cut on business income would help the average working man and woman.
The multiplier effect would spread the effect of the tax cut in business income across average working men and women. First, the business income tax cut would increase the after-tax expected profitability of capital investment, leading businesses to purchase more capital goods, like factories, computers and machine tools. These capital goods are produced by businesses that employ average working men and women. Second, the increase in income to the owners and workers of the businesses that produce the capital goods would lead to additional spending across many other businesses, increasing the income of these owners and workers. Their increase in income would lead to still more spending and the multiplier effect would spread across businesses and average working men and women.
22) If real GDP is $300 billion below potential GDP and the tax multiplier equals -1.5, then how much would the government need to change taxes to bring the economy to equilibrium at potential?
The government would need to cut taxes by $200 billion. Plugging the values into the tax multiplier equation yields: -1.5 = . The change in taxes equals , or -$200 billion.
23) Suppose real GDP is currently $1.25 trillion and potential real GDP is $1.3 trillion. If the federal government increased government purchases by $50 billion, what would be the result on the economy?
The economy would go from a short-run equilibrium below potential GDP to a short-run equilibrium above potential GDP. The increase in government purchases, which equals the shortfall in real GDP from potential real GDP, is too large. The increase in government purchases needs to be less than the shortfall in real GDP because of the multiplier effect.
24) Why would a higher tax rate lower the government purchases multiplier? What does the tax rate have to do with the government purchases multiplier?
The tax rate affects how much of the additional income that results from the initial increase in government purchases is available to be consumed. A higher tax rate decreases the amount of disposable income that can be consumed at each round of the multiplier process.
12.5 The Limits of Using Fiscal Policy to Stabilize the Economy

1) The Bank of Canada plays a larger role than Parliament and the Prime Minister in stabilizing the economy because
A) the Bank of Canada can more quickly change monetary policy than the Parliament can change fiscal policy.
B) the Bank of Canada can immediately recognize when real GDP is below or above potential GDP.
C) changes in interest rates have a considerably larger effect on the economy than changes in government purchases or taxes.
D) changes in interest rates have their full effect on the economy in a short period of time, whereas changes in government spending and taxes have their full effect over a long period of time.

A
2) The use of fiscal policy to stabilize the economy is limited because
A) changes in government spending and tax rates have a small effect on aggregate demand.
B) changes in government spending and tax rates have a small effect on interest rates.
C) the legislative process can be slow, which means that it is difficult to make fiscal policy actions in a timely way.
D) the Canada Revenue Agency (CRA) resists changes in tax rates because of all the changes they would have to make to the tax code.
C
3) Crowding out refers to a decline in ________ as a result of an increase in ________.
A) tax revenues; unemployment
B) government purchases; tax rates
C) government purchases; private expenditures
D) private expenditures; government purchases
D
4) The crowding out of private spending by government spending will be greater the
A) less sensitive consumption, investment, and net exports are to changes in interest rates.
B) more sensitive consumption, investment, and net exports are to changes in interest rates.
C) less sensitive consumption, investment, and net exports are to changes in the price level.
D) more sensitive consumption, investment, and net exports are to changes in the price level.
B
5) An increase in the sensitivity of private spending (consumption, investment, and net exports) to changes in the interest rate ________ the government purchases multiplier.
A) will decrease
B) will increase
C) will not change
D) may increase or may decrease
A
6) The impact of crowding out may be the least
A) during a deep recession.
B) when real GDP is above but close to potential GDP.
C) during an expansion.
D) when real GDP is below but close to potential GDP.
A
7) In the long run, most economists agree that a permanent increase in government spending leads to ________ crowding out of private spending.
A) no
B) partial
C) complete
D) more than complete
C
8) Expansionary fiscal policy
A) can be effective in the short run.
B) causes complete crowding out in the short run.
C) is never effective because of crowding out.
D) can be effective in the long run.
A
9) In the long run, most economists agree that a permanent increase in government spending leads to
A) no decrease in private spending.
B) a decrease in private spending by less than the amount that government spending increased.
C) a decrease in private spending by the same amount that government spending increased.
D) a decrease in private spending by more than the amount that government spending increased.
C
10) In 2008, the global recession increased the risk of prolonged recession in Canada. What fiscal policy action was taken by Parliament to counter these events?
A) The Bank of Canada cut its target for the target for the overnight rate.
B) There was an increase in government spending.
C) Provincial governments cut health care spending.
D) Income taxes were raised to reduce the federal budget deficit and reduce interest rates.
B
11) A temporary tax deduction, like those introduced in 2009, is likely to ________ consumption spending ________ than would a permanent tax cut.
A) increase; more
B) increase; less
C) decrease; more
D) decrease; less
B
12) In 2009, the federal government introduced Canada’s Economic Action Plan an expansionary fiscal policy to try to pull the economy out of the recession, which was
A) the largest fiscal policy action in Canadian history.
B) second in size only to the fiscal policy action taken during the Great Depression.
C) small in comparison to the actions taken during the recession of 1974-1975.
D) roughly equal to the spending increases and tax cuts implemented during the recession of 1981-1982.
A
13) Crowding out refers to a decrease in government purchases as a result of an increase in private expenditures.
FALSE
14) As spending on government purchases increases, income rises and money demand falls.
FALSE
15) Recessions are bad for all aspects of personal health
FALSE
16) Why will there be less crowding out of private spending by government spending the less sensitive consumption, investment, and net exports are to changes in interest rates?
Crowding out occurs when the increase in government spending increases real GDP and income which increases money demand, pushing up interest rates. The higher interest rates decrease (crowd out) private spending — consumption, investment, and net exports. The less sensitive consumption, investment, and net exports are to interest rates, the less they decrease as a result of the higher interest rates.
17) If the federal government pursues an expansionary fiscal policy at the same time as the Bank of Canada pursues an expansionary monetary policy, how might the expansionary monetary policy affect the extent of crowding out in the short run?
An expansionary fiscal policy will cause the equilibrium rate of interest to increase. An expansionary monetary policy will cause the equilibrium rate of interest to decrease. An expansionary monetary policy will therefore lessen the effect of crowding out in the short run.
12.6 Deficits, Surpluses, and Federal Government Debt

1) To evaluate the size of the federal budget deficit or surplus over time, it would be best to look at the
A) absolute size of the budget deficit or surplus.
B) budget deficit or surplus as a percentage of GDP.
C) budget deficit or surplus as a percentage of tax revenues.
D) budget deficit or surplus as a percentage of government spending.

B
2) The largest Canadian federal budget deficits as a percentage of GDP in the last 50 years occurred during
A) the mid 1980s.
B) the early 1970s.
C) the late 1990s.
D) the early 2000s.
E) the late 1960s.
A
3) During 1975-1995, the federal government was
A) in surplus every year.
B) balanced every year.
C) in deficit every year.
D) in deficit most of those years.
C
4) A recession tends to cause the federal budget deficit to ________ because tax revenues ________ and government spending on transfer payments ________.
A) increase; rise; falls
B) increase; fall; rises
C) decrease; rise; falls
D) decrease; fall; rises
B
5) An economic expansion tends to cause the federal budget deficit to ________ because tax revenues ________ and government spending on transfer payments ________.
A) increase; rise; falls
B) increase; fall; rises
C) decrease; rise; falls
D) decrease; fall; rises
C
6) The cyclically adjusted budget deficit or surplus measures what the deficit or surplus would be if the economy was
A) in a recession.
B) in an expansion.
C) at potential GDP.
D) at potential tax revenue.
C
7) Suppose the federal budget deficit for the year was $10 billion and the economy was in a recession. If the economy had been at potential GDP, it is estimated that tax revenues would have been $6 billion higher and government spending on transfer payments $5 billion lower. Using these estimates, the cyclically adjusted budget
A) deficit was $21 billion.
B) deficit was $11 billion.
C) surplus was $1 billion.
D) surplus was $11 billion.
C
8) The automatic budget surpluses and budget deficits that occur in the federal budget over the business cycle
A) destabilize the economy.
B) stabilize the economy.
C) decrease potential GDP.
D) increase potential GDP.
B
9) The austerity plan required of the Greek government is a(n) ________ policy, when normally a recession would suggest ________ policy.
A) expansionary; contractionary
B) contractionary; expansionary
C) contractionary; contractionary
D) contractionary; cyclically adjusted
B
10) The best time to correct a structural budget deficit is
A) during a boom.
B) during a recession.
C) during an election.
D) during a recovery from recession.
A
11) For the federal deficit to be lowered
A) the federal government must decrease its spending and increase net exports.
B) the federal government’s expenditures must be lower than its tax revenue.
C) the Bank of Canada must raise interest rates and lower the required reserve ratio.
D) the Bank of Canada must reduce the money supply.
B
12) The federal government debt equals
A) tax revenues minus government spending.
B) government spending minus tax revenues.
C) the accumulation of past budget deficits.
D) the total value of Canadian bonds outstanding.
D
13) The federal government debt fell during the period
A) 2008-2015.
B) 1980-1992.
C) during World War I and World War II.
D) 2000-2008.
E) the Great Depression.
D
14) Which of the following is a reason why we should consider the federal national debt a problem?
A) The federal government is in danger of defaulting on its debt.
B) If the debt drives up interest rates, crowding out will occur.
C) If the debt was incurred to finance improvements in infrastructure, crowding out will occur.
D) If the debt was incurred to finance research and development, crowding out will occur.
B
15) The budget deficit increases during wars and recessions.
TRUE
16) Increasing the federal budget deficit will contribute to increasing the federal government debt.
TRUE
17) If the federal budget goes from a budget deficit in Year 1 to a budget surplus in Year 2, does it follow that the federal government acted to raise taxes or cut government spending in Year 2?
No, the economy could have been in an expansion in Year 2 with GDP growing faster than anticipated. The faster growth in GDP would raise tax revenues and decrease government spending on transfer payments, decreasing the budget deficit (in this case, moving it to a budget surplus).
18) In Year 1 suppose the economy is at potential GDP and that the federal budget deficit equals $100 billion. In Year 2 the federal budget deficit rises to $150 billion, but the cyclically adjusted budget deficit falls to $75 billion. How can the actual budget deficit rise and the cyclically adjusted budget deficit fall?
The rise in the actual budget deficit with a decline in the cyclically adjusted budget deficit indicates that the economy grew less than anticipated in Year 2, perhaps falling into a recession. The decline in the cyclically adjusted budget deficit indicates that the budget deficit would have fallen if the economy had been at potential GDP in Year 2.
19) Assume a country is required by law to balance the budget every year. Suppose aggregate demand falls, causing a recession and a budget deficit. To balance the budget, what would the government need to do with the level of government spending and taxes? How would these changes in government spending and taxes affect aggregate demand and the economy?
To balance the budget, the government would need to lower government spending and raise taxes, both of which would decrease aggregate demand, making the recession worse.
12.7 The Effects of Fiscal Policy in the Long Run

1) Which of the following best describes supply-side economics?
A) Labor productivity affects aggregate supply.
B) Education affects labor productivity which affects aggregate supply.
C) Education affects the incentive to work, save, and invest and, therefore, aggregate supply.
D) Tax rates, particularly marginal tax rates, affect the incentive to work, save, and invest and, therefore, aggregate supply.

D
2) The tax wedge is the difference between the
A) amount of taxes needed to balance the federal budget and the actual amount of taxes.
B) amount of taxes needed to pay off the national debt and the actual amount of taxes.
C) pretax and posttax returns to an economic activity.
D) nominal and real interest rates.
C
3) A decrease in which of the following would decrease the tax wedge?
A) marginal tax rate
B) money supply
C) national debt
D) federal budget deficit
A
4) Economists who believe the supply-side effects of tax cuts are small essentially believe that
A) tax cuts mainly affect aggregate demand.
B) tax cuts mainly affect aggregate supply.
C) tax cuts will increase the quantity of labor supplied.
D) tax cuts will result in relatively small changes in the price level.
A
5) Compare the effect on the price level and real GDP of a decrease in tax rates assuming a supply-side effect versus no supply-side effect. Compared to no supply-side effect, including a supply-side effect for the decrease in tax rates will cause the price level to increase ________ and real GDP to increase ________.
A) less; less
B) less; more
C) more; less
D) more; more
B
6) A program of austerity designed to return the government’s budget to balance would involve
A) decreases in government spending and tax increases.
B) tax increases and increases in government spending.
C) decreases in government spending and a tax cuts.
D) increases in government spending and tax increases.
A
7) An austerity program would shift
A) the aggregate expenditure curve left.
B) the aggregate expenditure curve right.
C) the short run aggregate supply curve right.
D) the short run aggregate supply curve left.
A
8) An increase in the tax wedge associated with a given economic activity will decrease the level of that activity.
TRUE
9) The level of crowding out associated with a tax cut will be smaller if the tax change has a supply-side effect than it will be if it only has a demand-side effect.
TRUE
10) The double taxation problem occurs because households pay taxes on dividends and capital gains from stock and corporations pay taxes on corporate profits.
TRUE
11) What is the “tax wedge”?
The “tax wedge” is the difference between the pretax and posttax return to an economic activity.
12) How can tax simplification be beneficial to the economy?
Tax simplification would free up resources in the economy. The complexity of the tax code has created an entire industry to assist taxpayers in preparing their tax forms. If tax simplification reduces the need for tax preparation assistance, the resources used in this industry could be allocated to some other productive endeavor. This is beneficial, as it would reduce wasted resources.
Simplifying the tax code would increase economic efficiency by reducing the time and trouble firms and households spend solely to reduce their tax payments.
13) Show the impact of tax reduction and simplification using the dynamic aggregate demand and aggregate supply model. Clearly show and identify the impact of the tax change. Assume that aggregate demand and short-run aggregate supply shift as they typically do in the dynamic model. Show what happens to the price level and real GDP because of the tax change.
The economy’s initial equilibrium is at point A. The movement from point A to point B illustrates the new long-run equilibrium that would exist in the economy with no tax change. This is an illustration of the economy that we’d typically expect in the dynamic model if the economy and aggregate demand were growing. The long-run aggregate supply will shift to the right from LRAS1 to LRAS2. Aggregate demand shifts to the right from AD1 to AD2. SRAS also shifts to the right from SRAS1 to SRAS2. The new long-run equilibrium in the economy is point B with a higher price level at P2 and a greater level of GDP at Y2. (The graph shows the AD shift relatively larger than the LRAS shift so the price level rises. This is arbitrary. The student could show the AD shift to be smaller relative to LRAS. The focus in this analysis is the movement from B to C.)
With the tax change, LRAS will shift by an even greater amount from LRAS2 to LRAS3. This shift in LRAS assumes that the tax reduction is effective and the economy experiences increases in labor supply, saving, investment and the formation of new firms. Because of the tax change, the new equilibrium will be at point C rather than point B. The tax change lowers the price level from P2 to P3. This is a lower price level than what would have existed without the tax change. The tax change also increases output from Y2 to Y3.
12.8 Appendix: A Closer Look at the Multiplier

1) In an open economy, the government purchases multiplier will be smaller the
A) smaller the marginal propensity to import.
B) larger the tax rate.
C) larger the marginal propensity to consume.
D) All of the above are correct.

B
2) Assume a closed economy with fixed taxes and the marginal propensity to consume is equal to 0.9. What is the government spending multiplier?
A) 10
B) 9
C) 5
D) 1
A
3) Suppose that the federal government allocates $5 billion to an “energy-efficient appliance rebate” program. It also raises taxes by $5 billion to keep the deficit from growing. If the marginal propensity to consume is 0.8, what is the effect on equilibrium GDP?
A) GDP does not change.
B) GDP increases by $25 billion.
C) GDP increases by $4 billion.
D) GDP increases by $5 billion.
D
4) Suppose the federal government imposes a $10 billion tax increase. Assume that taxes are fixed, the economy is closed, and the marginal propensity to consume is 0.8. What happens to equilibrium GDP?
A) There is a $50 billion increase in equilibrium GDP.
B) There is a $50 billion decrease in equilibrium GDP.
C) There is a $40 billion increase in equilibrium GDP.
D) There is a $40 billion decrease in equilibrium GDP.
D
5) What is the government purchases multiplier if the tax rate is 0.2 and the marginal propensity to consume is 0.8? Assume the economy is closed.
A) 2.78
B) 5
C) 6.25
D) 100
A
6) In an open economy, the government purchases multiplier will be
A) larger as the marginal propensity to import decreases.
B) smaller as the marginal propensity to import decreases.
C) smaller as the marginal propensity to tax decreases.
D) larger as the marginal propensity to consume decreases.
A
7) Calculate the government purchases multiplier if the marginal propensity to consume equals 0.75, the tax rate is 0.2, and the marginal propensity to import equals 0.3.
A) 1.43
B) 1.6
C) 3.33
D) 4
A
8) The government purchases multiplier will be larger if the marginal income tax rate decreases.
TRUE
9) The larger the marginal propensity to import, the larger the government purchases multiplier.
FALSE
10) In a closed economy with fixed or autonomous (non-income dependent) taxes, the balanced budget government purchases multiplier is negative.
FALSE
11) Assuming a fixed amount of taxes and a closed economy, calculate the value of the government purchases multiplier, the tax multiplier, and the balanced budget multiplier if the marginal propensity to consume equals 0.5.
Government purchases multiplier = = 2
Tax multiplier = = ?1
Balanced budget multiplier = 1
12) Calculate the value of the government purchases multiplier if the marginal propensity to consume equals 0.9, the tax rate equals 0.25, and the marginal propensity to import equals 0.15.
Government purchases multiplier = 1 / 1 – (0.9(1 – 0.25) – 0.15) = 2.11

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