BUSI 101 - Chapter 16

(a)2 Why does an increase in government purchases affect aggregate demand more directly than a tax cut does?

(a)3 A government increases purchases by $5 billion. Why might aggregate demand ultimately increase by either more or less than $5 billion?

(a)4 What is the multiplier effect, and what positive-feedback mechanism causes it?

(a)5 What is the investment accelerator, and how can it strengthen the multiplier effect?

(a)2 Government purchases are themselves a component of aggregate demand, so an increase directly raises spending on goods and services. A tax cut works indirectly by increasing disposable income and then relying on households to spend part of it.

(a)3 The multiplier effect can amplify the original $5 billion increase, while higher money demand and interest rates can crowd out private investment. In an open economy, exchange-rate changes can create additional crowding out through net exports.

(a)4 Government spending becomes income for workers and firms. They spend part of that additional income, creating income for others, who then spend part of theirs. This repeated income-spending process amplifies the initial change in expenditure.

(a)5 Higher demand can cause firms to expand their planned investment in equipment and productive capacity. This additional investment creates another source of expenditure and can amplify the original fiscal expansion.

(b)1 What is the marginal propensity to consume (MPC), and why does a larger MPC produce a larger spending multiplier?

(b)3 If the MPC is 0.75 and government purchases increase by $4 billion, calculate the closed-economy multiplier and the total increase in aggregate demand before considering crowding out.

(b)4 If households receive an additional $100 of income and the MPC is 0.80, how much do they initially consume and save, and why does only the consumption portion continue the multiplier process?

(b)1 MPC is the fraction of an additional dollar of income that households spend on consumption. A larger MPC means more of each new round of income is respent, so the feedback process dies out more slowly and the multiplier is larger.

(b)3 The multiplier is 1/(1−0.75)=41/(1-0.75)=4. Therefore a $4 billion increase generates 4×4=164\times4=\16 billion of aggregate demand before crowding out.

(b)4 They consume $80 and save $20. The $80 becomes spending and therefore income to someone else, allowing another round of expenditure; the saving does not directly create another round of consumption in the simple multiplier model.

(c)4 Suppose MPC = 0.75 and MPI = 0.25. Calculate the open-economy multiplier and compare it with the closed-economy multiplier for the same MPC.

(c)5 If government purchases rise by $10 billion, MPC = 0.75, and MPI = 0.25, what total increase in demand for Canadian-produced goods would the simple open-economy multiplier predict before crowding out?

(c)4 The open-economy multiplier is 1/(1−0.75+0.25)=21/(1-0.75+0.25)=2. The closed-economy multiplier is 1/(1−0.75)=41/(1-0.75)=4. Openness cuts the multiplier in half in this example.

(c)5 The multiplier is 2, so the predicted increase is 2×$10 billion=20 billion2\times \10\text{ billion}=\$20\text{ billion}.

(d)2 Why does the multiplier principle apply to changes in consumption, investment, and net exports as well as changes in government purchases

(d)5 Why can relatively small initial changes in private spending produce substantial fluctuations in output and employment?

(d)2 Any initial increase or decrease in spending changes someone else’s income, which changes that person’s consumption and starts the same feedback process.

(d)5 Initial changes in spending change income, which induces further spending changes. The economy therefore amplifies the original shock through successive rounds of expenditure.

(e)3 Why does higher government-induced income increase the demand for money?

(e)4 If the Bank of Canada keeps the money supply fixed while fiscal expansion shifts money demand to the right, what happens to the equilibrium interest rate and why?

(e)3 Higher incomes cause households and firms to undertake more transactions, so they want to hold larger money balances.

(e)4 The interest rate rises. With money supply unchanged, a higher rate is required to reduce money demanded enough to restore money-market equilibrium.

(f)1 Why can the final increase in aggregate demand following a rise in government purchases be either greater or smaller than the original increase in government spending?

(f)2 Distinguish clearly between the multiplier effect and the crowding-out effect on investment.

(f)4 Why does the strength of crowding out depend partly on how responsive investment is to interest rates?

(f)5 In a closed economy, give the complete causal chain from expansionary fiscal policy to its final effect on aggregate demand.

(f)1 The multiplier makes the effect larger than the initial spending increase, while crowding out makes it smaller. The net result depends on their relative strength.

(f)2 The multiplier is positive feedback from higher income to additional spending. Crowding out is negative feedback in which higher money demand raises interest rates and suppresses private investment.

(f)4 If firms and households greatly reduce investment when rates rise, a small interest-rate increase can offset a large portion of the fiscal stimulus.

(f)5 Government spending rises → direct AD increase → income rises → multiplier amplifies spending → money demand rises → interest rate rises → private investment falls → crowding out partially offsets the multiplier → AD still rises, but by the net amount.

(g)1 What additional restriction must be considered when analyzing fiscal policy in Canada as a small open economy with perfect capital mobility?

(g)1 Canada’s domestic interest rate must ultimately equal the world interest rate, ignoring differences in taxes and default risk.

(i)5 Why is fiscal policy effectiveness fundamentally dependent on the exchange-rate regime in this model?

(i)5 The exchange-rate regime determines whether international capital flows are absorbed through changes in the currency or through central-bank intervention and changes in the money supply.

(j)5 What is the overall effect of expansionary fiscal policy on aggregate demand under a fixed exchange rate compared with a flexible exchange rate?

(j)5 Under a fixed exchange rate the fiscal expansion produces a large lasting increase in AD because the required monetary expansion reinforces it. Under a flexible rate, currency appreciation crowds out NX and the model predicts no lasting AD effect.

(l)2 Why is the increase in aggregate demand from a tax cut not necessarily equal to the size of the tax cut itself?

(l)3 How do the multiplier effect and crowding-out effect apply to a tax cut?

(l)5 Why does a tax cut have a much larger and more lasting aggregate-demand effect when the exchange rate is fixed in this model?

(l)2 Households save part of the tax reduction rather than spending all of it. At the same time, multiplier and crowding-out effects alter the eventual change in aggregate demand.

(l)3 Additional consumption raises income and generates further spending through the multiplier. Higher income also increases money demand and interest rates, crowding out some investment.

(l)5 Defending the exchange rate requires monetary expansion, which lowers interest rates and prevents the investment and net-export crowding-out mechanisms from eliminating the stimulus.

(m)1 Although Chapter 16 focuses mainly on aggregate demand, how could lower tax rates also shift aggregate supply?

(m)2 Why are most economists skeptical of the strongest supply-side claim that cutting tax rates could necessarily increase total tax revenue?

(m)1 Lower taxes increase the after-tax reward from working and producing. If people respond by supplying more labour or productive effort, productive capacity rises and AS shifts right.

(m)2 Although lower rates improve incentives, most economists doubt behavioural responses are large enough for the resulting expansion of taxable activity always to offset the revenue lost from the lower tax rate.

(n)1 What is the main argument in favour of using active fiscal policy to stabilize economic fluctuations?

(n)1 Recessions waste productive resources through unemployment and idle capital. If fiscal policy can offset deficient aggregate demand, it can potentially reduce these losses.

(o)1 Why does inaccurate economic forecasting make discretionary fiscal stabilization especially difficult?

(o)2 Why might fiscal stimulus have a larger effect during a deep recession than when the economy is already near full employment?

(o)4 What characteristics of the Canadian economy tend to reduce the effectiveness of fiscal stimulus even during recessions?

(o)5 Why should expectations about the size of Canadian fiscal multipliers generally be modest according to the chapter?

(o)1 Because policy works with lags, policymakers need forecasts of future conditions. If those forecasts are wrong, the policy may have the wrong size, timing, or direction.

(o)2 Idle workers and machines can be brought back into production without strongly bidding up wages and other costs. Near full employment, additional government demand competes for already-employed resources.

(o)4 Canada has a relatively large MPI, causing expenditure leakage abroad, and normally operates with a flexible exchange rate, allowing fiscal expansion to appreciate the dollar and crowd out NX.

(o)5 These leakages and crowding-out mechanisms reduce the effect substantially. The chapter suggests that well-designed fiscal multipliers under favourable conditions are much closer to 1 than to very large values such as 2 or 3.

(p)5 Why does the chapter suggest that automatic stabilizers may help explain why Canadian business cycles have generally become less severe since World War II?

(p)5 Postwar tax and income-support systems respond much more automatically to recessions than earlier institutions did, helping stabilize household disposable income and aggregate demand.

(q)2 Why was the coordinated fiscal response during the 2008–09 recession potentially more effective than the simple flexible-exchange-rate model would suggest?

(q)5 Why was expanding Employment Insurance a useful component of the 2008–09 fiscal response?

(q)2 Governments in many countries expanded fiscal policy simultaneously, reducing the extent to which Canadian stimulus leaked away because foreign economies were also supporting demand.

(q)5 EI payments could be delivered quickly and directly to households suffering income losses, helping sustain consumption without waiting for new spending programs to be designed.