Deck 18: The Modern Fiscal Policy Dilemma

Question 1

What is the difference between demand side policies and supply side policies?

Answer 1

Demand side policies are short-term policies that attempt to stimulate the economy by managing the demand (expenditures)side of the economy.They are conducted by shifting the aggregate demand of the economy.Supply side policies are long-term policies that attempt to change the long-run aggregate supply and,thus,the potential output of the economy.When conducted,they shift the long-run aggregate supply of the economy.

Question 2

What is the difference between "sound finance" and "functional finance"? Why did the advocates of each view of public finance take such different positions?

Answer 2

Sound finance was a view of public finance and fiscal policy that the government budget should always be balanced except in wartime.Functional finance held that as a theoretical proposition,governments should make spending and taxing decisions on the basis of their effect on the economy.Under functional finance if spending in the economy was too low,the government should run a deficit; if spending was too high,the Government should run a surplus.Prior to the Great Depression economists favored sound finance primarily on political grounds.Economists at the time viewed government with suspicion,so any policy that would make it easier to increase government spending during peacetime was seen as undesirable.The advocates of functional finance were totally focused on the need for government to steer the economy.In their writings,there was no discussion of politics or whether the recession was a major one or a minor one.

Question 3

What is meant by "functional finance"?

Answer 3

Functional finance holds that as a theoretical proposition,governments should make spending and taxing decisions on the basis of their effect on the economy.Under functional finance if spending in the economy is too low,the government should run a deficit; if spending is too high,the government should run a surplus.

Question 4

List four assumptions underlying fiscal policy that may not hold in the real world.

Question 5

Why is unemployment insurance an automatic stabilizer and how does it work? How does the decline in the percentage of unemployed who receive unemployment insurance in the 2000s impact the effectiveness of unemployment insurance as an automatic stabilizer?

Question 6

What is meant by "sound finance"?

Question 7

What are some of the political and institutional limitations on fiscal policy in the U.S.?

Question 8

Why did proponents of sound finance oppose deficit spending?

Question 9

What is the Ricardian Equivalence Theorem? What is the significance of this theorem for government deficit financing?

Question 10

What is the Ricardian Equivalence Theorem and why is it important to debates about fiscal policy?

Question 11

Empirical evidence over the past two decades suggests that the percentage of unemployed who receive unemployment insurance has been declining: in the 2000s,less than two out of every five unemployed persons collected benefits.What does this decline do to the impact of unemployment insurance as an automatic stabilizer?

Question 12

What are automatic stabilizers? How do they work?

Question 13

What fiscal policy was implemented in response to the financial crisis of 2008? How does this fit into the broader discussion of sound versus functional finance?

Question 14

Consider the following quote from your text,"Some economists see the crowding out effect as relatively large,in many cases almost completely negating the effect of expansionary fiscal policy." Demonstrate graphically the case where the crowding out effect does "completely negate" the effect of expansionary fiscal policy.Explain your diagram,making sure to define the crowding out effect in your answer.

Question 15

Six key assumptions underlie models of fiscal policy.All of them are likely to be violated in the context of real world macroeconomic problems.Explain how any three of the following assumptions are likely to fail in the real world.
(a)Financing the deficit doesn't have any offsetting effects.
(b)The government knows what the current situation is.
(c)The government knows the economy's potential income level.
(d)The government has great flexibility in changing spending and taxes.
(e)The size of the government debt doesn't matter.
(f)Fiscal policy doesn't negatively affect other government goals.

Question 16

What are three advantages and disadvantages of expansionary fiscal policy?

Question 17

Many economists argue that certain rules must guide the use of economic policies.What are the benefits and costs of economic policies conducted by rules?

Question 18

What is the difference between a policy and a policy regime?

Question 19

Define the crowding out effect.At which output level does it intensify?

Question 20

What is the crowding out effect? Using the AS/AD model,demonstrate graphically and explain in words the impact of expansionary fiscal policy on the crowding out effect.