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Answers to Exercises

1. The GDP gap may be eliminated by increasing aggregate demand so that the AD curve intersects the AS curve at the potential level of real GDP. The steeper the slope of the AS curve, the greater the increase in AD required to move to the equilibrium level of real GDP.

2. The process begins with federal agencies preparing budget proposals. The Office of Management and Budget reviews agency budgets and assembles them into a unified budget. The Congress reviews the president's budget in House and Senate hearings. By April 15 the budget resolution is passed, and it is followed by the reconciliation process, whereby congressional committees make spending and tax decisions. Funds are appropriated and the process ends by June. There is an eighteen-month lag between the beginning of the budget process and the actual spending of the money.

3. Budget deficits are harmful to the economy if they cause interest rates to increase, thereby crowding out investment and/or net exports.

4. Automatic stabilizers are those elements of fiscal policy that change automatically in value when real GDP changes. A progressive tax system acts as an automatic stabilizer because as the economy expands and incomes rise, tax revenues increase, thereby moving the budget toward a surplus. Transfer payments also act as automatic stabilizers. When the economy expands, individuals who had been receiving social welfare benefits gain employment. Hence, government expenditures fall and the budget moves toward a surplus. Unemployment benefits also act as automatic stabilizers. When the economy expands, workers who had been unemployed find work. Because these workers no longer receive unemployment benefits, expenditures on unemployment benefits fall and the budget moves toward a surplus.

5. In the developing countries the government plays a larger role in investment spending than it does in the industrialized countries. Developing countries also spend less on social welfare and education than industrial countries do. On the tax side, developing countries tend to depend more on indirect taxes and developed countries, on income taxes.

6. Because government spending increases expenditures directly, but taxes decrease expenditures indirectly and by less than the change in taxes. The multiple by which real GDP increases (decreases) when both government spending and taxes are increased (decreased) by an equal amount is the balanced-budget multiplier. This value equals 1. The balanced-budget multiplier is derived from adding the spending multiplier to the tax multiplier.

Balanced-budget multiplier = - = = =1

7. A larger fiscal deficit causes domestic interest rates to rise, which attracts foreign investors, who exchange foreign money for domestic money to use to purchase domestic bonds, which causes the domestic currency to appreciate on the foreign exchange market and causes domestic goods to rise in price relative to foreign goods. This leads to a balance-of-trade deficit.

8. Deficits grow during recessions since transfer payments rise and tax revenues fall.

9. Progressive: The tax rate rises as income rises. Regressive: The tax rate falls as income rises. Proportional: The tax rate remains constant as income rises. Income taxes are generally structured as progressive taxes because that is considered the fairest system: The higher one's income, the more one can afford to pay taxes.

10. GDP gap = potential GDP - actual real GDP = $900 billion - $800 billion = $100 billion.

11. The recessionary gap is the amount that aggregate expenditures must change to close the GDP gap.

Multiplier = = = 1.66

Recessionary gap = = 60.

Government spending must increase by 60.

12. Taxes must fall by $75 to close the GDP gap because with an MPC of .8, an increase in disposable income of $75 (the result of a tax reduction) will increase consumption spending by $60, which is a sufficient increase in aggregate spending to close the recessionary gap.

13. If both government spending and taxes change by the same amount but in opposite directions, they must change by $100 because the balanced-budget multiplier equals 1.

14. The spending multiplier = = 5

The tax multiplier = -(.9 - .1) 5 = -4

If spending rises by $100 billion, the equilibrium level of real GDP increases by $500 billion. If taxes increase by $100 billion, equilibrium real GDP falls by -$400. The combined effect is an increase of $100 billion.

15. $1,625

16. $1,875

17. $1,725

Answers to Study Guide Homework

1. Changing government spending and taxes; the president (executive branch) and Congress (legislative branch)

2. Taxes, change in government debt, change in the stock of government-issued money

3. Increase government spending and decrease taxes

4. Increasing government spending increases aggregate demand directly; decreasing taxes increases consumption (and possibly investment)

5 a. Price level will increase; real GDP will be unchanged.

b. The deficit would increase interest rates, and investment would decrease.

Answers to Internet Exercise

This exercise will help students obtain an understanding of sources of government revenue for the U.S. It should stress the extreme importance of individual taxes to the government as a source of revenue. The exercise can be expanded to consider the expenditures by category for the U.S. government and to point out that for recent years, the expenditures have exceeded the sources. The exercise can also be used to generate a discussion of major market economies discussed in Chapter 5.

Solution: Based on 1995 data:

Individual income taxes39.9%
Social insurance taxes32.7%
Corporate income taxes10.6%
Sale of goods and services5.6%
Excise taxes3.9%
Customs duties1.3%
Estate and gift taxes1.0%

As students make comparisons to Figure 9, they should note the particularly higher percentages of revenue from individual income taxes, corporate income taxes, and social security for the U.S. as compared to all industrial countries. Likewise, the U.S. has a significantly smaller proportion of revenue from goods and services.

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