AP Macro Fiscal Policy 3 — Questions and Answers
Question 1: Which of the following would most likely cause the government spending multiplier to be smaller than predicted by simple Keynesian theory?
- An increase in the marginal propensity to consume
- A closed economy with no imports
- Significant crowding out of private investment (Correct answer)
- A balanced budget requirement being eliminated
Correct answer: Significant crowding out of private investment
Crowding out reduces private investment as interest rates rise, partially or fully offsetting the expansionary effect of government spending.
Question 2: In a recessionary gap, appropriate fiscal policy would involve:
- Raising taxes and cutting spending to balance the budget
- Cutting taxes and/or increasing government spending to boost AD (Correct answer)
- Reducing the money supply to lower inflation
- Selling government bonds to drain excess reserves
Correct answer: Cutting taxes and/or increasing government spending to boost AD
A recessionary gap means output is below potential, so expansionary fiscal policy is needed to shift AD rightward toward full employment.
Question 3: The balanced budget multiplier states that equal increases in government spending and taxes will result in:
- No change in GDP because the effects cancel out
- A decrease in GDP equal to the size of the tax increase
- An increase in GDP equal to the amount of the spending increase (Correct answer)
- An increase in GDP equal to 1/(MPS) times the spending increase
Correct answer: An increase in GDP equal to the amount of the spending increase
The balanced budget multiplier equals 1, so GDP rises by exactly the amount of the spending increase even when financed by an equal tax hike.
Question 4: Which of the following best describes the concept of Ricardian equivalence?
- Budget deficits always crowd out private investment completely
- Rational consumers save any tax cut because they anticipate future tax hikes to repay the debt (Correct answer)
- Government spending is always more effective than tax cuts as stimulus
- Trade deficits and budget deficits always move together
Correct answer: Rational consumers save any tax cut because they anticipate future tax hikes to repay the debt
Ricardian equivalence argues that rational households offset tax cuts by saving more, expecting taxes will eventually rise to pay off the resulting debt.
Question 5: Which of the following is NOT a recognized lag in the implementation of fiscal policy?
- Recognition lag — time to identify the economic problem
- Administrative lag — time for the Federal Reserve to act (Correct answer)
- Legislative lag — time for Congress to pass a law
- Impact lag — time for spending to affect the economy
Correct answer: Administrative lag — time for the Federal Reserve to act
The administrative lag in monetary policy refers to the Fed's decision-making process; fiscal policy has recognition, legislative, and impact lags — not an administrative Fed lag.
Question 6: If MPC = 0.75, what is the value of the tax multiplier?
- -4
- -3 (Correct answer)
- 3
- 4
Correct answer: -3
The tax multiplier = -MPC/(1-MPC) = -0.75/0.25 = -3, meaning a $1 tax increase reduces GDP by $3.
Question 7: Transfer payments such as Social Security benefits are considered part of fiscal policy because they:
- Are directly produced by the government and count in GDP
- Affect disposable income and thus consumer spending and aggregate demand (Correct answer)
- Expand the money supply when paid out by the Treasury
- Reduce the budget deficit by offsetting tax revenues
Correct answer: Affect disposable income and thus consumer spending and aggregate demand
Transfer payments increase household disposable income, which raises consumption spending and shifts the AD curve rightward.
AP Macro Fiscal Policy 3
Which of the following would most likely cause the government spending multiplier to be smaller than predicted by simple Keynesian theory?