1. In this problem, the multiplier is 1/.1 or 10 so, the increase in government spending = $10
billion. For tax cut question, initial spending of $10 billion is still required, but only .9 (= MPC) of
a tax cut will be spent. So .9 x tax cut = $10 billion or tax cut = $11.11 billion. Part of the tax
reduction ($1.11 billion) is saved, not spent.
2. Options are to reduce government spending, increase taxes, or some combination of both. If
the price level is flexible downward, it will fall. In the real world, the goal is to reduce inflation—
to keep prices from rising so rapidly—not to reduce the price level. A “conservative” economist
might favor cuts in government spending since this would reduce the size of government. A
“liberal” economist might favor a tax hike; it would preserve government spending programs.
3. It takes time to ascertain the direction in ...view middle of the document...
Before the election, they enact tax cuts and spending increases to
please voters even though this may fuel inflation. After the election, they apply the brakes to
restrain inflation; the economy will slow and unemployment will rise. In this view the political
process creates economic instability.
The disappointing report means that once again the Federal Reserve is unlikely to
consider tightening fiscal policy. That means interest rates will remain at historically low
levels and the Fed will continue its bond buying purchases for the foreseeable future.
The stock markets haven’t been affected recently by economic news, seemingly surging
to new records every day despite mixed data on housing, labor and retail. But the Dow
Jones industrial average was down more than 150 points in early trading Friday
following the release of the much‐worse‐than expected labor numbers.
Bernanke has essentially tied fiscal policy to the labor markets, and the disappointing
March numbers will certainly provide justification for continuing the Fed’s loose fiscal
4. While fiscal policy is useful in combating the extremes of severe recession with its
built‐in “safety nets” and stabilization tools, and while the built‐in stabilizers can also
dampen spending during inflationary periods, it is undoubtedly not possible to keep the
economy at its full‐employment, noninflationary level of real GDP indefinitely. There is
the problem of timing. Each period is different, and the impact of fiscal policy will affect
the economy differently depending on the timing of the policy and the severity of the
situation. Fiscal policy operates in a political environment in which the unpopularity of
higher taxes and specific cuts in spending may dictate that the most appropriate
economic policies are ignored for political reasons. Finally, there are offsetting decisions
which may be made at any time in the private and/or international sectors. For
example, efforts to revive the economy with more government spending could result in
reduced private investment or lower net export levels