Review Questions

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Review Questions

  1. The major sources of government outlays are government purchases, transfer payments, and net interest payments. The major sources of government revenues are personal taxes, contributions for social insurance, indirect business taxes, and corporate taxes. The federal government’s outlays and revenues differ from those of state and local governments in that: (1) most spending on nondefense goods and services is done by state and local governments; (2) the federal government spends far more on transfers than on nonmilitary goods and services; (3) the federal government makes grants in aid to state and local governments; (4) the federal government is a large payer of net interest, while state and local governments are net recipients of interest payments; and (5) most of the federal government’s revenues come from personal taxes and contributions for social insurance, while state and local governments rely more heavily on indirect business taxes (sales taxes).

3. The government deficit is the change in the government debt. A large change in the debt-GDP ratio can be caused by: (1) a high deficit relative to GDP, and (2) a slow growth rate of nominal GDP.
4. Fiscal policy affects the macroeconomy in three ways: (1) aggregate demand effects, (2) government capital formation, and (3) incentive effects.

The aggregate demand channel affects the macroeconomy because expansionary fiscal policy shifts the IS curve up and to the right, causing the AD curve to shift up and to the right as well.

Both classicals and Keynesians agree that an increase in government spending shifts the IS and AD curves. There is disagreement about the effects of tax changes, however. Classicals generally believe in the Ricardian equivalence proposition, so that the IS and AD curves do not shift. Keynesians reject the Ricardian equivalence proposition and believe that the IS and AD curves do shift in response to tax changes.

The formation of government capital affects the macroeconomy. The quantity and quality of public infrastructure, such as roads, schools, sewer and water systems, and hospitals, are important determinants of the growth rate of the economy. In addition, human capital formation, especially through education programs, affects the productivity of the labor force in the future.

Fiscal policy also has incentive effects that influence the macroeconomy. Tax policies influence economic behavior. Capital income taxes affect people’s decisions to save and invest, while labor income taxes affect people’s labor-supply decisions.

5. A balanced-budget amendment might prove useful if the government otherwise had a tendency to run a perpetual budget deficit. The amendment would provide a mechanism for fiscal discipline, forcing policymakers to balance the budget. But there could be significant disadvantages, since fiscal policy wouldn’t be as flexible. In particular, automatic stabilizers kick in during a recession to increase spending and reduce taxes, creating a budget deficit but stimulating the economy; however, these effects would have to be offset if the budget were to be balanced. Also, instead of smoothing taxes over time, the government would have to raise taxes when times were bad and incomes were low and reduce taxes when times were good and incomes were high, thus creating distortions to the economy. Finally,

a balanced-budget amendment would fail to recognize that capital formation would help future generations, so deficit financing that’s paid off by taxes on future generations would be appropriate.

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