CBE Public Finance 3 — Questions and Answers
Question 1: In a federal system, 'fiscal federalism' is primarily concerned with:
- International trade agreements between federal states
- The optimal assignment of taxing and spending functions across levels of government (Correct answer)
- Federal oversight of state monetary policy
- Balancing federal and state judicial authority
Correct answer: The optimal assignment of taxing and spending functions across levels of government
Fiscal federalism studies which government functions and revenue sources should be centralized versus decentralized across federal, state, and local levels.
Question 2: The 'flypaper effect' in intergovernmental grants refers to the observation that:
- Grant funds tend to stick to the recipient government's budget rather than being passed to residents as tax cuts (Correct answer)
- Federal grants attract private investment to recipient localities
- Matching grants are more effective than lump-sum grants for stimulating spending
- State governments redirect federal grants to favored political districts
Correct answer: Grant funds tend to stick to the recipient government's budget rather than being passed to residents as tax cuts
The flypaper effect is the empirical finding that lump-sum grants increase government spending by more than an equivalent increase in private income would, as if money 'sticks where it lands.'
Question 3: A government runs a structural budget deficit of $200 billion at full employment. This means the deficit is primarily caused by:
- A recession reducing tax revenues
- Discretionary fiscal policy decisions, not the economic cycle (Correct answer)
- Automatic stabilizers responding to unemployment
- Temporary emergency spending
Correct answer: Discretionary fiscal policy decisions, not the economic cycle
A structural deficit persists even at full employment, indicating it results from deliberate policy choices rather than cyclical economic downturns.
Question 4: The Haavelmo theorem (balanced budget multiplier) states that equal increases in government spending and taxes result in:
- No change in GDP since the effects cancel out
- A GDP increase equal to the amount of the spending increase (Correct answer)
- A GDP decrease due to crowding out effects
- An increase in GDP greater than the spending increase
Correct answer: A GDP increase equal to the amount of the spending increase
The Haavelmo theorem shows that a balanced budget expansion increases GDP by exactly the amount of the spending increase because the tax multiplier is smaller in absolute value than the spending multiplier.
Question 5: Which type of government expenditure is most likely to have the highest fiscal multiplier during a recession?
- Tax cuts for high-income households
- Transfer payments to wealthy retirees
- Infrastructure investment in labor-intensive projects (Correct answer)
- Corporate tax holidays
Correct answer: Infrastructure investment in labor-intensive projects
Infrastructure investment in labor-intensive projects has high multipliers because it employs workers with high marginal propensities to consume and creates lasting productive capital.
Question 6: A country's debt-to-GDP ratio will stabilize when:
- The primary surplus equals zero
- The interest rate on debt equals the GDP growth rate times the existing debt ratio minus the primary balance
- The government balances its total budget including interest payments
- Nominal GDP growth exceeds the nominal interest rate on all outstanding debt (Correct answer)
Correct answer: Nominal GDP growth exceeds the nominal interest rate on all outstanding debt
The debt-to-GDP ratio stabilizes when nominal GDP growth (g + π) exceeds the nominal interest rate (i), or equivalently when the primary surplus offsets the excess of interest costs over growth.
Question 7: Ricardian equivalence suggests that deficit-financed tax cuts will:
- Stimulate consumer spending and boost GDP
- Leave consumer spending unchanged as households save to pay future taxes (Correct answer)
- Cause inflation due to increased money supply
- Lower interest rates by reducing government borrowing costs
Correct answer: Leave consumer spending unchanged as households save to pay future taxes
Ricardian equivalence holds that forward-looking households recognize that today's deficit implies future taxes, and thus save the tax cut rather than spending it, leaving aggregate demand unchanged.
CBE Public Finance 3
In a federal system, 'fiscal federalism' is primarily concerned with: