chapter: 29 13 - cloud object storage | store & retrieve...

Solution

S-169

chapter:

Fiscal Policy

1. The accompanying diagram shows the current macroeconomic situation for the econ-omy of Albernia. You have been hired as an economic consultant to help the economymove to potential output, YP.

a. Is Albernia facing a recessionary or inflationary gap?

b. Which type of fiscal policy—expansionary or contractionary—would move theeconomy of Albernia to potential output, YP? What are some examples of suchpolicies?

c. Illustrate the macroeconomic situation in Albernia with a diagram after the suc-cessful fiscal policy has been implemented.

1. a. Albernia is facing a recessionary gap; Y1 is less than YP.

b. Albernia could use expansionary fiscal policies to move the economy to potentialoutput. Such policies include increasing government purchases of goods and ser-vices, increasing government transfers, and reducing taxes.

c.

AD1

SRAS

P1

P2

Real GDP Y1 YP

AD2

Aggregate price level

E1

E2

LRAS

Potential output

Recessionary gap

AD1

SRAS

P1

Real GDP Y1 YP


E1

LRAS

Potential output

29 13ECO

NO

MIC

S

MA

CRO

ECO

NO

MIC

S

S169-S182_Krug2e_Macro_PS_Ch13.qxp 2/25/09 8:02 PM Page S-169

Solution

S-170 M A C R O E C O N O M I C S , C H A P T E R 1 3

E C O N O M I C S , C H A P T E R 2 9

2. The accompanying diagram shows the current macroeconomic situation for the econ-omy of Brittania; real GDP is Y1, and the aggregate price level is P1. You have beenhired as an economic consultant to help the economy move to potential output, YP.

a. Is Brittania facing a recessionary or inflationary gap?

b. Which type of fiscal policy—expansionary or contractionary—would move the econ-omy of Brittania to potential output, YP? What are some examples of such policies?

c. Illustrate the macroeconomic situation in Brittania with a diagram after the suc-cessful fiscal policy has been implemented.

2. a. Brittania is facing an inflationary gap; Y1 is greater than YP.

b. Brittania could use contractionary fiscal policies to move the economy to potentialoutput. Such policies include reducing government purchases of goods and ser-vices, lowering government transfers, and raising taxes.

c.

3. An economy is in long-run macroeconomic equilibrium when each of the followingaggregate demand shocks occurs. What kind of gap—inflationary or recessionary—willthe economy face after the shock, and what type of fiscal policies would help movethe economy back to potential output? How would your recommended fiscal policyshift the aggregate demand curve?

a. A stock market boom increases the value of stocks held by households.

b. Firms come to believe that a recession in the near future is likely.

AD1

SRAS

P1

P2

Real GDP Y1 YP

AD2


E1 E2

LRAS

Potential output

Inflationary gap

AD1

SRAS

P1

Real GDP Y1 YP


E1

LRAS

Potential output


Solution

F I S C A L P O L I C Y S-171

c. Anticipating the possibility of war, the government increases its purchases of mili-tary equipment.

d. The quantity of money in the economy declines and interest rates increase.

3. a. As the stock market booms and the value of stocks held by households increases,there will be an increase in consumer spending; this will shift the aggregatedemand curve to the right. The economy will face an inflationary gap. Policy mak-ers could use contractionary fiscal policies to move the economy back to potentialoutput. This would shift the aggregate demand curve to the left.

b. If firms become concerned about a recession in the near future, they will decreaseinvestment spending and aggregate demand will shift to the left. The economy willface a recessionary gap. Policy makers could use expansionary fiscal policies tomove the economy back to potential output. This would shift the aggregate demandcurve to the right.

c. If the government increases its purchases of military equipment, the aggregatedemand curve will shift to the right. The economy will face an inflationary gap.Policy makers could use contractionary fiscal policies to move the economy back topotential output. The government would need to reduce its purchases of non-defense goods and services, raise taxes, or reduce transfers. This would shift theaggregate demand curve to the left.

d. As interest rates rise, investment spending will decrease and the aggregate demandcurve will shift to the left. The economy will face a recessionary gap. Policy makerscould use expansionary fiscal policies to move the economy back to potential output. This would shift the aggregate demand curve to the right.

4. During an interview on May 16, 2008, the German Finance Minister Peer Steinbruecksaid, “We have to watch out that in Europe and beyond, nothing like a combinationof downward economic [growth] and high inflation rates emerges—something thatexperts call stagflation.” Such a situation can be depicted by the movement of theshort-run aggregate supply curve from its original position SRAS1 to its new positionSRAS2, with the new equilibrium point E2 in the accompanying figure. In this ques-tion, we try to understand why stagflation is particularly hard to fix using fiscal policy.

AD1

SRAS2

SRAS1

P2

P1

Real GDPY2 YP


E2

E1

LRAS

Recessionary gap


Solution

a. What would be the appropriate fiscal policy response to this situation if the pri-mary concern of the government was to maintain economic growth? Illustrate theeffect of the policy on the equilibrium point and the aggregate price level using thediagram.

b. What would be the appropriate fiscal policy response to this situation if the pri-mary concern of the government was to maintain price stability? Illustrate theeffect of the policy on the equilibrium point and the aggregate price level using thediagram.

c. Discuss the effectiveness of the policies in parts a and b in fighting stagflation.

4. a. The government should adopt expansionary fiscal policy, such as lowering taxes orincreasing spending. This would shift the aggregate demand curve to the right,moving the equilibrium output back to YP but increasing the price to P3.

b. The government should adopt contractionary fiscal policy such as raising taxes orlowering government spending, causing the aggregate demand curve to shift left.The price level will decrease back to P1, but the recessionary gap will increase.

c. Although expansionary fiscal policy can help bring aggregate output back to potentialoutput, it also raises the aggregate price level. This makes the problem of inflationworse in a situation where low economic growth is coupled with higher-than-desiredinflation. Contractionary fiscal policy—reduced government purchases of goods andservices, an increase in taxes, or a reduction in government transfers—can help bringdown the price level. However, contractionary fiscal policy will further increase therecessionary gap.

AD3 AD1

SRAS2

LRAS

P1

P2

Real GDPY3 Y2 YP

Aggregatepricelevel

E2

E3

AD1

SRAS2

P2

P1

P3

Real GDP Y2 YP

AD2


E2E3

E1

LRAS




5. Show why a $10 billion reduction in government purchases of goods and serviceswill have a larger effect on real GDP than a $10 billion reduction in governmenttransfers by completing the accompanying table for an economy with a marginalpropensity to consume (MPC) of 0.6. The first and second rows of the table arefilled in for you: on the left side of the table, in the first row, the $10 billionreduction in government purchases decreases real GDP and disposable income,YD, by $10 billion, leading to a reduction in consumer spending of $6 billion(MPC × change in disposable income) in row 2. However, on the right side of thetable, the $10 billion reduction in transfers has no effect on real GDP in round 1but does lower YD by $10 billion, resulting in a decrease in consumer spending of$6 billion in round 2.

a. When government purchases decrease by $10 billion, what is the sum of thechanges in real GDP after the 10 rounds?

b. When the government reduces transfers by $10 billion, what is the sum of thechanges in real GDP after the 10 rounds?

c. Using the formula for the multiplier for changes in government purchases and forchanges in transfers, calculate the total change in real GDP due to the $10 billiondecrease in government purchases and the $10 billion reduction in transfers. Whatexplains the difference? (Hint: The multiplier for government purchases of goodsand services is 1/(1 – MPC). But since each $1 change in government transfersonly leads to an initial change in real GDP of MPC × $1, the multiplier for govern-ment transfers is MPC/(1 – MPC).)


Decrease in G = �$10 billion Decrease in TR = �$10 billion

Change Change in Change Change Change in Changein G or C real GDP in YD in TR or C real GDP in YDRounds

1 ΔG = −$10.00 −$10.00 −$10.00 ΔTR = −$10.00 $0.00 −$10.00

2 ΔC = −6.00 −6.00 −6.00 ΔC = −6.00 −6.00 −6.00

3 ΔC = ? ? ? ΔC = ? ? ?

4 ΔC = ? ? ? ΔC = ? ? ?

5 ΔC = ? ? ? ΔC = ? ? ?

6 ΔC = ? ? ? ΔC = ? ? ?

7 ΔC = ? ? ? ΔC = ? ? ?

8 ΔC = ? ? ? ΔC = ? ? ?

9 ΔC = ? ? ? ΔC = ? ? ?

10 ΔC = ? ? ? ΔC = ? ? ?

Billions of dollars Billions of dollars


Solution5. Here is the completed table:

a. When government purchases of goods and services decrease by $10 billion, thechange in real GDP is −$24.86 billion after 10 rounds.

b. When government transfers fall by $10 billion, the change in real GDP is −$14.86billion after 10 rounds.

c. When the government decreases purchases of goods and services by $10 billion,the total change in real GDP is −$25 billion [(1/(1 − 0.6)) × (−$10 billion)].When transfers fall by $10 billion, the total change in real GDP is −$15 billion[(0.6/(1 − 0.6)) × (−$10 billion)]. The difference is that the $10 billion decrease intransfers does not directly affect real GDP. All rounds except the first are the samein the table for a decrease in government purchases and reduction in transfers;however, in the first round, real GDP falls by the same amount that governmentpurchases declined but real GDP is initially unaffected when transfers decline bythat amount.

6. In each of the following cases, either a recessionary or inflationary gap exists. Assumethat the aggregate supply curve is horizontal, so that the change in real GDP arisingfrom a shift of the aggregate demand curve equals the size of the shift of the curve.Calculate both the change in government purchases of goods and services and thechange in government transfers necessary to close the gap.

a. Real GDP equals $100 billion, potential output equals $160 billion, and the marginal propensity to consume is 0.75.

b. Real GDP equals $250 billion, potential output equals $200 billion, and the marginal propensity to consume is 0.5.

c. Real GDP equals $180 billion, potential output equals $100 billion, and the marginal propensity to consume is 0.8.

(billions of dollars)(billions of dollars)

Rounds

1 �G = −$10.00 −$10.00 −$10.00 �TR = −$10.00 $0.00 −$10.00

2 �C = −6.00 −6.00 −6.00 �C = −6.00 −6.00 −6.00

3 �C = −3.60 −3.60 −3.60 �C = −3.60 −3.60 −3.60

4 �C = −2.16 −2.16 −2.16 �C = −2.16 −2.16 −2.16

5 �C = −1.30 −1.30 −1.30 �C = −1.30 −1.30 −1.30

6 �C = −0.78 −0.78 −0.78 �C = −0.78 −0.78 −0.78

7 �C = −0.47 −0.47 −0.47 �C = −0.47 −0.47 −0.47

8 �C = −0.28 −0.28 −0.28 �C = −0.28 −0.28 −0.28

9 �C = −0.17 −0.17 −0.17 �C = −0.17 −0.17 −0.17

10 �C = −0.10 −0.10 −0.10 �C = −0.10 −0.10 −0.10

. . . .

Sumfor 10rounds −$24.86 −$14.86

Change inreal GDP

Change inYD

Change inG or C

Change inreal GDP

Change inYD

Change inTR or C

Decrease in G = –$10 billion Decrease in TR = –$10 billion




Solution

Solution6. a. The economy is facing a recessionary gap; real GDP is less than potential output.Since the multiplier for a change in government purchases of goods and services is1/(1 − 0.75) = 4, an increase in government purchases of $15 billion will increasereal GDP by $60 billion and close the recessionary gap. Each dollar of a govern-ment transfer increase will increase real GDP by MPC/(1 − MPC) × $1, or 0.75/(1 − 0.75) × $1 = $3. Since real GDP needs to increase by $60 billion, thegovernment should increase transfers by $20 billion to close the recessionary gap.

b. The economy is facing an inflationary gap; real GDP is higher than potential out-put. Since the multiplier for a change in government purchases of goods and ser-vices is 1/(1 − 0.5) = 2, a decrease in government purchases of $25 billion willreduce real GDP by $50 billion and close the inflationary gap. Each dollar of a government transfer reduction will decrease real GDP by MPC/(1 − MPC) × $1, or0.5/(1 − 0.5) × $1 = $1. Since real GDP needs to decrease by $50 billion, the gov-ernment should decrease transfers by $50 billion to close the inflationary gap.

c. The economy is facing an inflationary gap; real GDP is higher than potential out-put. Since the multiplier for a change in government purchases of goods and servic-es is 1/(1 − 0.8) = 5, a decrease in government purchases of $16 billion will reducereal GDP by $80 billion and close the inflationary gap. Each dollar of a governmenttransfer reduction will reduce real GDP by MPC/(1 − MPC) × $1, or 0.8/(1 − 0.8) ×$1 = $4. Since real GDP needs to decrease by $80 billion, the government shouldreduce transfer payments by $20 billion to close the inflationary gap.

7. Most macroeconomists believe it is a good thing that taxes act as automatic stabilizersand lower the size of the multiplier. However, a smaller multiplier means that thechange in government purchases of goods and services, government transfers, or taxesnecessary to close an inflationary or recessionary gap is larger. How can you explainthis apparent inconsistency?

7. Automatic stabilizers, such as taxes, help to dampen the business cycle. As the economy expands, taxes increase; this increase acts as a contractionary fiscal policy.In this way, any autonomous change in aggregate spending will have a smaller effecton real GDP than it would in the absence of taxes and result in a smaller inflationaryor recessionary gap. Consequently, the need for discretionary fiscal policy is reduced.However, if a demand shock does occur and the government decides to use discre-tionary fiscal policy to help eliminate it, the smaller multiplier means that the changein government purchases of goods and services, government transfers, or taxes neces-sary to close the gap is larger.

8. The accompanying table shows how consumers’ marginal propensities to consume ina particular economy are related to their level of income.

a. Suppose the government engages in increased purchases of goods and services. Foreach of the income groups in the accompanying table, what is the value of the mul-tiplier—that is, what is the “bang for the buck” from each dollar the governmentspends on government purchases of goods and services in each income group?

b. If the government needed to close a recessionary or inflationary gap, at whichgroup should it primarily aim its fiscal policy of changes in government purchasesof goods and services?

Income range Marginal propensity to consume

$0–$20,000 0.9

$20,001–$40,000 0.8

$40,001–$60,000 0.7

$60,001–$80,000 0.6

Above $80,000 0.5



Solution

Solution

Solution8. a. The accompanying table shows the “bang for the buck” for an additional $1 of gov-ernment purchases of goods and services for a consumer in each income range. Itis calculated as 1/(1 − MPC).

b. Since the “bang for the buck” is highest for the lowest income group, fiscal policiesaimed at that income group would require the smallest change in government pur-chases of goods and services to close a recessionary or inflationary gap.

9. The government’s budget surplus in Macroland has risen consistently over the pastfive years. Two government policy makers disagree as to why this has happened. Oneargues that a rising budget surplus indicates a growing economy; the other argues thatit shows that the government is using contractionary fiscal policy. Can you determinewhich policy maker is correct? If not, why not?

9. It’s impossible to determine which policy maker is correct given the informationavailable. Everything else being equal, the government’s budget surplus will rise eitherif real GDP is growing or if Macroland is using contractionary fiscal policy. When theeconomy grows, tax revenue rises and government transfers fall, leading to anincrease in the government’s budget surplus. However, if the government uses con-tractionary fiscal policy, then the government purchases fewer goods and services,increases taxes, or reduces government transfers. Any of those three changes willresult in a temporary increase in the government’s budget surplus, although thereduction in real GDP will eventually cause tax revenue to fall and government trans-fers to rise, which will partly reduce the budget surplus.

10. Figure 29-10 shows the actual budget deficit and the cyclically adjusted budget deficitas a percentage of GDP in the United States since 1970. Assuming that potential out-put was unchanged, use this figure to determine in which years since 1990 the gov-ernment used expansionary fiscal policy and in which years it used contractionaryfiscal policy.

10. Since the cyclically adjusted budget balance is an estimate of what the budget balancewould be if real GDP were exactly equal to potential output, the effect of the businesscycle on the budget are eliminated. And since we have assumed that there are nochanges in potential output, any change in the cyclically adjusted budget balance rep-resents changes in fiscal policies. When the cyclically adjusted budget deficit falls, thegovernment must be engaging in contractionary fiscal policies: either governmentpurchases and transfer payments are decreasing or the government is raising taxes.When the cyclically adjusted budget deficit rises, the government must be engaging inexpansionary fiscal policies: either government purchases and transfer payments areincreasing or the government is lowering taxes. From Figure 29-10, we see that from1990 to 2000, the cyclically adjusted budget deficit was falling; this indicates that the

Marginal propensityIncome range to consume “Bang for the buck”

$0–$20,000 0.9 10

$20,001–$40,000 0.8 5

$40,001–$60,000 0.7 3.33

$60,001–$80,000 0.6 2.5

Above $80,000 0.5 2




Solution


government was pursuing contractionary fiscal policies during that period. From 2001to 2004, the cyclically adjusted budget deficit was rising; this indicates that the gov-ernment was pursuing expansionary fiscal policies during that period. From 2005 to2007, the cyclically adjusted budget deficit was again falling, indicating that duringthat time period, the government was again pursuing contractionary fiscal policies.

11. You are an economic adviser to a candidate for national office. She asks you for asummary of the economic consequences of a balanced-budget rule for the federal gov-ernment and for your recommendation on whether she should support such a rule.How do you respond?

11. You might respond that balanced-budget rules are usually proposed because the gov-ernment is running a budget deficit and many people think of deficits as bad. Whenthe government runs a budget deficit, it adds to the public debt. If the governmentpersists in running budget deficits, interest payments become an increasing part ofgovernment spending and the budget deficit itself. As a result, the debt–GDP ratiomay rise. However, budget deficits themselves are not the problem; the problem ariseswhen budget deficits become persistent. In the United States, there has been a strongrelationship between the federal government’s budget balance and the business cycle:when the economy expands, the budget moves toward surplus, and when the economy experiences a recession, the budget moves into deficit. The major disadvan-tage of a balanced-budget rule is that it would undermine the role of taxes and gov-ernment transfers as automatic stabilizers and force the government to respond to arecessionary gap with contractionary fiscal policies. You might recommend, as mosteconomists do, that rather than a balanced-budget rule, the government only balanceits budget on average; it should run budget deficits during recessions and budget sur-pluses during expansions.

12. In 2008, the policy makers of the economy of Eastlandia projected the debt–GDPratio and the ratio of the budget deficit to GDP for the economy for the next 10 yearsunder different scenarios for growth in the government’s deficit. Real GDP is current-ly $1,000 billion per year and is expected to grow by 3% per year, the public debt is$300 billion at the beginning of the year, and the deficit is $30 billion in 2008.

BudgetReal Budget Debt deficitGDP Debt deficit (percent (percent

(billions (billions (billions of ofof of of real real

Year dollars) dollars) dollars) GDP) GDP)

2008 $1,000 $300 $30

2009 $1,030

2010 $1,061

2011 $1,093

2012 $1,126

2013 $1,159

2014 $1,194

2015 $1,230

2016 $1,267

2017 $1,305

2018 $1,344

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?

?


Solution

a. Complete the accompanying table to show the debt–GDP ratio and the ratio of thebudget deficit to GDP for the economy if the government’s budget deficit remainsconstant at $30 billion over the next 10 years. (Remember that the government’sdebt will grow by the previous year’s deficit.)

b. Redo the table to show the debt–GDP ratio and the ratio of the budget deficit toGDP for the economy if the government’s budget deficit grows by 3% per year overthe next 10 years.

c. Redo the table again to show the debt–GDP ratio and the ratio of the budget deficitto GDP for the economy if the government’s budget deficit grows by 20% per yearover the next 10 years.

d. What happens to the debt–GDP ratio and the ratio of the budget deficit to GDP forthe economy over time under the three different scenarios?

12. a. Here is the completed table (numbers are rounded):

b. Here is the table redone (numbers are rounded):

Real GDP Debt Budget deficit Debt Budget deficit(billions (billions (billions of (percent of (percent of

Year of dollars) of dollars) dollars) real GDP) real GDP)

2008 $1,000 $300 $30 30.0% 3.0%

2009 1,030 330 31 32.0 3.0

2010 1,061 361 32 34.0 3.0

2011 1,093 393 33 35.9 3.0

2012 1,126 426 34 37.8 3.0

2013 1,159 459 35 39.6 3.0

2014 1,194 494 36 41.4 3.0

2015 1,230 530 37 43.1 3.0

2016 1,267 567 38 44.7 3.0

2017 1,305 605 39 46.3 3.0

2018 1,344 644 40 47.9 3.0



2008 $1,000 $300 $30 30.0% 3.0%

2009 1,030 330 30 32.0 2.9

2010 1,061 360 30 33.9 2.8

2011 1,093 390 30 35.7 2.7

2012 1,126 420 30 37.3 2.7

2013 1,159 450 30 38.8 2.6

2014 1,194 480 30 40.2 2.5

2015 1,230 510 30 41.5 2.4

2016 1,267 540 30 42.6 2.4

2017 1,305 570 30 43.7 2.3

2018 1,344 600 30 44.6 2.2




Solution


c. And here is the table again (numbers are rounded):

d. When the deficit remains constant at $30 billion, the ratio of the budget deficit toGDP declines but the debt–GDP ratio continues to increase because debt is risingfaster than GDP. When the deficit grows by 3% per year, the same rate at whichreal GDP grows, the ratio of the budget deficit to GDP remains constant at 3% andthe debt–GDP ratio continues to increase. When the deficit grows by 20% per year,the ratio of the budget deficit to GDP rises from 3.0% to 13.8% in 10 years and thedebt–GDP ratio more than doubles from 30% to more than 80%.

13. Your study partner argues that the distinction between the government’s budgetdeficit and debt is similar to the distinction between consumer savings and wealth. Healso argues that if you have large budget deficits, you must have a large debt. In whatways is your study partner correct and in what ways is he incorrect?

13. Your study partner is correct that the distinction between the government’s budgetdeficit and debt is similar to the distinction between consumer savings and wealth.Savings and deficits refer to actions that take place over time. When the governmentspends more than it receives in tax revenue in a particular time period, it is running abudget deficit. When consumers spend less than their disposable income in a particu-lar time period, they are saving. However, both debt and wealth are measured at onepoint in time. When the government runs a budget deficit, the deficit is almost alwaysfinanced by borrowing, which adds to its debt. Similarly, consumers accumulatewealth by saving. Your study partner is wrong in that the government can run a largebudget deficit and have a small debt if it hasn’t run large deficits in the past.

14. In which of the following cases does the size of the government’s debt and the size ofthe budget deficit indicate potential problems for the economy?

a. The government’s debt is relatively low, but the government is running a largebudget deficit as it builds a high-speed rail system to connect the major cities of the nation.

b. The government’s debt is relatively high due to a recently ended deficit-financedwar, but the government is now running only a small budget deficit.

c. The government’s debt is relatively low, but the government is running a budgetdeficit to finance the interest payments on the debt.



2008 $1,000 $300 $30 30.0% 3.0%

2009 1,030 330 36 32.0 3.5

2010 1,061 366 43 34.5 4.1

2011 1,093 409 52 37.4 4.7

2012 1,126 461 62 40.9 5.5

2013 1,159 523 75 45.1 6.4

2014 1,194 598 90 50.1 7.5

2015 1,230 687 107 55.9 8.7

2016 1,267 795 129 62.7 10.2

2017 1,305 924 155 70.8 11.9

2018 1,344 1,079 186 80.3 13.8


Solution

Solution14. a. If the government has relatively little debt but is running a large budget deficit as itbuilds a high-speed rail system, this should not indicate potential problems for theeconomy. Like funding a war effort, it is difficult, if not impossible, to financemajor improvements in a nation’s infrastructure without borrowing. As long as thebudget deficit ends with the building project, this should not create long-termproblems.

b. If the government’s debt is relatively high but the government has reduced its budgetdeficit, this should not indicate potential problems for the economy. However, thegovernment needs to be careful that the deficits do not become persistent.

c. Even if the government’s debt is relatively low, if it is running a budget deficit tofinance the interest payments on that debt, this portends potential problems forthe future. Without any changes, the government’s debt will grow over time andwith it the size of the government’s budget deficit because of increasing interestpayments. If GDP growth does not keep up with the growth in the government’sdebt, the debt–GDP ratio will rise.

15. How did or would the following affect the current public debt and implicit liabilitiesof the U.S. government?

a. In 2003, Congress passed and President Bush signed the Medicare ModernizationAct, which provides seniors and individuals with disabilities with a prescriptiondrug benefit. Some of the benefits under this law took effect immediately, but oth-ers will not begin until sometime in the future.

b. The age at which retired persons can receive full Social Security benefits is raised toage 70 for future retirees.

c. For future retirees, Social Security benefits are limited to those with low incomes.

d. Because the cost of health care is increasing faster than the overall inflation rate,annual increases in Social Security benefits are increased by the annual increase inhealth care costs rather than the overall inflation rate.

15. a. Because of its immediate impact on government spending, the MedicareModernization Act increased the current public debt; implicit liabilities also rosebecause the act commits the government to a higher level of spending in thefuture.

b. If the age at which future retirees can receive full Social Security benefits is raisedto age 70, implicit liabilities fall because government transfers will be lower in thefuture. There is no effect on the current public debt.

c. If Social Security benefits for future retirees are limited to those with low incomes,implicit liabilities fall because government transfers will be lower in the future.There is no effect on the current public debt because the change occurs in thefuture.

d. If annual increases in Social Security benefits are increased by the annual increasein health care costs rather than the overall inflation rate, implicit liabilities willrise. The current public debt will rise as soon as the rule is implemented.

16. Unlike households, governments are often able to sustain large debts. For example, inSeptember 2007, the U.S. government’s total debt reached $9 trillion, approximately64% of GDP. At the time, according to the U.S. Treasury, the average interest rate paidby the government on its debt was 5.0%. However, running budget deficits becomeshard when very large debts are outstanding.

a. Calculate the dollar cost of the annual interest on the government’s total debtassuming the interest rate and debt figures cited above.




Solution


b. If the government operates on a balanced budget before interest payments aretaken into account, at what rate must GDP grow in order for the debt–GDP ratioto remain unchanged?

c. Calculate the total increase in national debt if the government incurs a deficit of$200 billion in 2008. Assume that the only other change to the government’s totaldebt arises from interest payments on the current debt of $9 trillion.

d. At what rate must GDP grow in order for the debt–GDP ratio to remain unchangedwhen the deficit in 2008 is $200 billion?

e. Why is the debt–GDP ratio the preferred measure of a country’s debt rather thanthe dollar value of the debt? Why is it important for a government to keep thisnumber under control?

16. a. The annual interest on the debt is 5% of $9 trillion, or $450 billion.

b. U.S. GDP must grow at 5% so that the debt–GDP ratio remains unchanged. This isbecause the total debt and GDP would grow at the same rate.

c. The total debt increases by $650 billion, the $200 billion budget deficit plus the$450 billion interest payment.

d. $650 billion is 7.22% of the government’s total debt. So, in order for the debt–GDPratio to remain constant, GDP must also grow by 7.22%.

e. GDP measures the size of the economy, which determines the ability of the govern-ment to repay the debt through taxes. A falling debt–GDP ratio indicates a decreas-ing debt burden, and vice versa. To prevent the debt burden from becomingoverwhelming, a government should keep the debt–GDP ratio in check.


chapter: 29 13 - cloud object storage | store & retrieve...

Documents