Exercises: Fiscal Policy and Automatic Stabilizers

Classify each action as expansionary or contractionary fiscal policy. (a) Congress cuts personal income taxes. (b) Congress reduces spending on infrastructure. (c) Congress raises corporate income taxes. (d) Congress extends unemployment benefits during a recession.

Define automatic stabilizers and give two examples. Explain in one sentence why they are called "automatic."

Decide whether each item is discretionary fiscal policy or an automatic stabilizer. (a) Congress passes and the President signs a one-time stimulus bill. (b) Unemployment insurance payments rise as layoffs increase. (c) Income tax revenue falls in a recession because incomes fall under a progressive tax system. (d) Congress passes a new highway construction program.

An economy has a recessionary gap of $\$200$ billion and an MPC of 0.75. (a) Compute the increase in government spending that would close the gap. (b) Compute the tax cut that would close the gap. (c) In which direction does each policy move the federal budget balance?

An economy has an inflationary gap of $\$120$ billion and an MPC of 0.6. (a) Compute the spending multiplier and the tax multiplier. (b) Compute the decrease in government spending that would close the gap. (c) Compute the tax increase that would close the gap. Which policy is the more powerful per dollar?

Explain how a progressive income tax system and unemployment insurance dampen the business cycle during a recession and during an expansion. Describe the effect of each on the federal budget deficit over the cycle.

An economy has a recessionary gap of $\$1{,}500$ billion and an MPC of 0.8. Congress passes a $\$600$ billion package made of $\$400$ billion in new government spending and $\$200$ billion in tax cuts. (a) Compute the total change in aggregate demand using the multiplier formulas, ignoring price-level changes. (b) Compare the result with the size of the gap, and say whether the policy closes it, falls short, or overshoots. (c) Explain two reasons the real-world effect could differ from your calculation, such as time lags and crowding out. (d) Explain the policy danger if the result overshoots.

Real GDP falls by $\$1{,}000$ billion in a recession. Suppose the income tax is proportional at 20% of income. (a) Compute the fall in tax revenue and the fall in disposable income, and compare with an economy where taxes are a fixed lump sum. (b) Explain why this makes the tax system an automatic stabilizer. (c) Evaluate automatic stabilizers against discretionary fiscal policy, using the recognition, legislative, and implementation lags. Which would you rely on for a mild recession, and which for a deep one? Justify your answer.