Spring Term
(Last Updated May 21, 2010)
Study Guide for Exam 2
NOTE: This study guide is intended to only be a general outline of the material to be tested in this exam. It is not a full account of all the material or issues covered. It should not be considered the sole resource for preparation for the exam. KEYNESIAN THEORY & FISCAL POLICY A. Definitions:
Fiscal Policy, expansionary policy, contractionary policy Discretionary
spending versus automatic spending (stabilizers)
B.
According
to Keynesian theory when should the government:
- raise taxes? - reduce taxes? - increase government spending? - decrease government spending? - run a surplus? - run a deficit? - expand the national debt? - pay-off or pay-down the national debt? C. Be
able to explain (both verbally and graphically) the full sequence of
reasoning behind
Keynesian expansionary fiscal
policy and contractionary policy.
D. Be able to explain (both verbally and graphically) the derivation of the Aggregate Demand curve and its relationship to the Keynesian Expenditure Function. E. Be able to explain (both verbally and graphically) the derivation of the Aggregate Supply curve and its relationship to the Classical long run and short-run Supply curves, and the "Keynesian" supply curve. F. Why is the "Keynesian" supply curve depicted as horizontal? Why is the Classical long run supply curve vertical? Why is the Classical short run supply curve convex? A.
Definitions:
Deficit, Surplus, Debt
Deficit spending = government borrowing through the
sales of government bonds
Cyclical deficit versus Structural deficit
Crowding In versus Crowding Out
B.
Issues of debate re: government deficits & debt
1.
History/sources of U.S. deficits.
a. Wars are the primary cause of
deficits (All wars generate gov’t. deficit spending.)
b. Recessions and depressions are
the next most common cause.
(All
recessions generate gov’t. deficits.)
c. Discretionary expansionary
fiscal policy
intentionally generates deficits in order to
stimulate the economy.
d. The two periods with the
largest growth in both the debt and deficit caused by
discretionary
spending occured in the 1980s (Reagan/Bush I) and in the 2000s Bush
II/Obama).
Both of these record deficits were generated by broad-based,
Supply-side
tax cuts matched with increases in military spending. As the text
states: in 2000 the total debt was $5.6 Trillion. By January 2009, due
to "the Bush tax cuts and the defense build-up" the debt had increased
to over $10 Trillion before
the Obama stimulus plan was enacted. As of May 21, 2010 the Obama
budget, including the 2009 stimilus have added another $2.5 Trillion to
the debt.
2.
Government deficit spending is NOT the same as household deficit
spending, since:
- the government can raise its income
by raising taxes;
- the government can allow inflation to
increase tax revenue and reduce debt
repayment;
The
U.S. government deficit and debt are in the moderately high range for
developed nations. However, the US is the the world's safest and most
desired borrower as evidnced by the US government paying the lowest
interest rates in the world on its Treasury bonds.
3.
The proper way to evaluate deficits/debt:
- assets versus
liabilities: Are assets large enough to payoff the debt?
- Marginal Cost =
Marginal Benefit analysis: Is the benefit of the program that the money is
spent on worth the cost of paying off the debt?
- Opportunity Cost: Are the programs funded by the deficit (or debt) foregoing the next best alternative programs? 4.
Who owns the debt? Approximately 50% by US government agencies, 5% by
the U.S.
Federal Reserve Bank,
17% by
private U.S. corporations
and
individuals, and approximately 28% by foreign entities (governments,
corporations, and individuals).
5. It is appropriate for the future generation to pay the debt if the taxpayers in the future directly benefitted
from the program that the debt paid for. E.g. education, child health,
infrastructure, etc.
Additionally, as the textbook points out, the future generation does
not onlly inherit the debt, they also inherit the debt payments. They
are not only future taxpayers, but future bondholders.
6.
Government
deficit spending absorbs financial capital from the
private sector, thereby
"crowding-out private investment by:
(i) reducing the investable funds available for
private sector investment;
(ii) raising interest rates, thereby discouraging further
private investment.
7. The federal deficit is partly due to the federal government subsidy of state budgets. 8.
Debt/Deficit ceilings have been ineffective & would remove an
economic policy tool
if they were effective.
SUPPLY-SIDE
THEORY
& FISCAL POLICY
A.
Definitions;
Supply-side fiscal policy, stagflation, capital-gains B. Theory: 1. S.S. theory was a response to stagflation in the late 1970s & early 1980s; since standard Keynesian Demand-Side fiscal policy could only reduce inflation by causing an increase in already high UN, and expand employment by generating higher inflation. 2. The goals of S.S. theory were to reduce taxes, reduce the size of the government, and eliminate the deficit, stimulate output, and lower prices.
3. S.S. theory proposed to reduce inflation and
simultaneously stimulate production and
employment by increasing AS via tax cuts to
producers.
C.
S.S.
Fiscal Policy: Tax Cuts
A.S. should be stimulated by cutting the following taxes to "producers". 1. Cut Income taxes on all wages and salaries. These cuts are focused on the average working household and are claimed to stimulate worker effort, worker hours, worker productivity, and the labor supply by attracting more workers into the labor force. Generally, these tax cuts have failed to create the forecasted stimulus in A.S. since income tax cuts are not stimulated worker productivity nor increase in the labor supply, and since a decrease in taxes stimulates consumer spending, not additional work effort. 2. Tax cuts on Capital Gains (income from the sale of assets, and from inheritance). These cuts were claimed to be focussed on the "middle class" but really only affected large institutional investors and very wealthy individuals, since 98%of households are already exempted from capital-gains taxes on inheritance up to $2 million and the sale of a residential house. 3. Corporate profit tax cuts were intended to stimulate expansion of re-investment. However such cuts do not ensure re-investment. Thus, much of these tax cuts were siphoned off into increases in executive compensation, retained earnings, corporate consumption, and speculative hostile take-overs and mergers.
4. In general, each of these tax cuts fail to
significantly stimulate AS becasue they are all
"broad-based", i.e. going to everyone, with no focus on stimulating production. Consequently, they end-up having a larger stimulating effect on AD than AS, thus devolving into standard Keynesian demand-side fiscal policy. D. Other S.S. Policies 1. Human Capital Investment Expenditures or tax cuts which fund the improvement in a population's education, knowledge, skills, abilities, and health improve productivity and raise the economy's AS capacity. 2. Infrastructure Investment Expenditures or tax cuts which fund the expnasion or repair of the economy's basic productive infrastructure increase productivity and lower costs thereby stimulating AS. Productive instructural investments that governments historically produce or fund include: transportation (roadways, highways, bridges, airports, seaports); electrical grid (dams, power lines, etc.); telecommunications (phone lan lines, satellites, fiber optics network, the internet). 3. De-Regulation Regulations restrict private sector decision-making and raises costs of compliance. Thus, Supply-siders often conclude, removing regulation stimulates private sector decision-making and lowers costs. The problem with this reasoning is that regulation is enacted to address social goals (i.e. crime prevention, public safety, basic equity) and to address market failures (i.e. externalities, public goods, and market power). Thus, de-regulation is not always in the public interest. De-Regulation should be based upon determining whether a government program is: - effective (Is it acheiving its goals? Has it already acheived its goals?) - efficient (Can the the goals be acheived more cheaply? Are the costs appropriate to the level of success for the program?) 4. Expand Free Trade Free trade allows production to occur at the lowest cost free of costly trade restrictions. |
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Possible ESSAY QUESTIONS - EXAM 2 Some of the answers to these questions are addressed in the study guide and in the text. 1. Be
able to explain Keynesian fiscal policy,
including all options
for expansionary and contractionary policy, and their influence on the
federal deficit.
2.
Explain the Keynesian prediction of the impact
of cutting
taxes for all income earners. Include all the steps in the reasoning.
3.
According to the original proponents of
Supply-Side theory, why is
a reduction of taxes expected to stimulate Aggregate Supply?
4. What is the most likely (i.e "actual") impact of broadbased Supply side tax cuts? 5.
a. Explain why broad-based tax cuts may not be an
effective way to stimulate AS.
b. Propose a better method to stimulate AS.
6. Is it
possible to implement a tax cut that limits
the demand side impact and expands the supply side impact? How?
7.
Explain what is wrong with the following
statement:
Government spending should meet the same
conditions as household spending.
Since households cannot spend more than they earn, the government should not be allowed to spend more than it earns. 8.
Explain 2 different ways that are appropriate
to evaluate deficit spending.
9. When
is it appropriate for future taxpayers to
pay off government debt accumulated in the past?
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