Macro Unit 5 Application Activity

A. Fiscal Policy

Please use your textbook to decide whether each of the fiscal policy actions of the federal government that follow is expansionary or contractionary. Please make sure you explain the reason for your choice. Thank you.

1. The government cuts business and personal income taxes and increases its own spending.

2. The government increases business and personal income taxes and decreases its own spending.

3. The government increases the wages of federal employees while also reducing taxes on consumers and businesses.

Please complete the table by following the example provided in the first scenario and one column of the second scenario. Thank you.

XXXXXXXX	Objective for AD	Action for Taxes	Action for Government Spending	Effect on Federal Budget	Effect on National Debt
National unemployment rate rises to 11%	Increase	Decrease	Increase	Towards deficit	Increase
Inflation is strong at a rate of 8% per year				Toward surplus
Surveys show consumers are losing confidence in the economy, retail sales are weak, and business inventories are increasing
Business sales and investment are expanding rapidly, and economists think inflation lies in the near future

B. Discretionary Fiscal Policy and Automatic Stabilizers

The government has the economic policy goal of stabilizing the economy. This includes promoting full employment and stable prices. When the government passes a law or takes specific action itself to change taxes or its own spending, we call this policy discretionary fiscal policy because the action is at the government's discretion. If an effect happens automatically as the economy changes, we call this an automatic stabilizer. For example, if the economy is in a recession, some people will be laid off and become eligible for unemployment compensation. This government payment creates income which leads to spending. The result is AD is kept from falling as much as it would have. In this example, we call the unemployment compensation an automatic stabilizer because it helps stabilize the economy during a recession.

For each of the scenarios that follow, please indicate whether it represents an automatic stabilizer (A) or a discretionary fiscal policy (D). Then, please indicate if it is an example of expansionary (E) or contractionary (C) fiscal policy. The first two are done for you. Thank you.

Scenario	Automatic (A) or Discretionary (D)	Expansionary (E) or Contractionary (C)
Because of a recession, the amount of unemployment compensation increases	A	E
Government eliminates favorable tax treatment of long-term capital gains	D	C
Government reduces personal income tax rates
Because of a recession, more families qualify for food stamps and the earned income tax credit
Government eliminates the tax deduction of mortgage interest
Government raises Social Security taxes
Government launches a major new space exploration program
Government increases the Federal Minimum Wage

C. Policy Effects On Aggregate Supply (AS)

Both fiscal and monetary policies affect the economy through changes in aggregate demand (AD). There are also policies that affect both short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS). The determinants of SRAS include changes in input/commodity prices (e.g., wages and the price of oil) and productivity. The determinants of LRAS include the quantity and quality of available resources and level of technology.

Let's pretend the government grants businesses a large tax credit on physical capital investment. Determine what will happen (increase or decrease) to each of the following as a result of the tax credit:

1. The I in GDP

2. AD

3. The amount of capital available to labor

4. Productivity

5. Firms' unit cost of production (average cost)

6. SRAS

7. LRAS

8. Real GDP

9. Price Level