1.

Why might economists be quite concerned if the annual interest payments on the
US public debt sharply increase as a percentage of GDP?

Burden of interest payment on public debt

A government borrows funds in exchange for some notes or bonds, or other government
securities.The cost of the public debt is the interest accumulating over the securities.A
government has to return the principal amount and the interest payment on that amount
to become debt-free.

Therefore, the interest payment adds to the burden of the public debt.
Explanation for the answer

Public debt as a percentage of GDP represents the payment capacity of the economy
depending on its GDP size.If interest payment increases sharply, it becomes an alarming
situation for the economy. Higher interest will weaken an economy and reduce the
possibility of repaying the debt because of an overvalued burden.

Therefore, the economists are more worried about significant hikes in the annual interest
payment on the public debt as a percentage of GDP.

2. Trace the cause-and-effect chain through which financing and refinancing of the
public debt might affect real interest rates, private investment, the capital stock, and
economic growth. How might investment in public capital and public-private
complementarities alter the outcome of the cause-effect chain?
01

Cause-and-effect chain of public debt

When the government falls short of the funds, it opts for debt. The public debt can be for
productive purposes or to settle the preceding debts.The increase in public debts raises the
interest rate, crowding out private investment.
A decline in private investment lowers the stock of capital and aggregate spending of the
economy. A smaller aggregate spending will hamper economic growth.
02

Alteration of the outcome of the cause-and-effect chain

Investment in public capital such as transportation, health, education, or any other physical
or social infrastructure creates excessive production capacity in the economy in the
future.It repairs the economic loss caused by the crowding-out effect.

Public-private complementarities can reduce the crowding-out impact of private

investment.If the public debt is used for productive purposes, increasing the demand for
private investment, the private and public investments will grow simultaneously, flourishing
the economic growth.

For instance, the government invests the public debt in setting up new hospitals in an
underdeveloped area. It will encourage private investment for setting up pathologies,
medical and other shops, hotels, and restaurants in the area.

Therefore, the public and private investments will complement each other, and the
economy will experience growth.

3. What do economists mean when they say Social Security and Medicare are
“pay-as-you-go” plans? What are the Social Security and Medicare trust funds, and
how long will they have money left in them? What is the key long-run problem of
both Social Security and Medicare? To fix the problem, do you favor increasing taxes
or do you prefer reducing benefits?

01

Meaning of social security and Medicare systems

Social Security and Medicare are “pay-as-you-go” plans.The term “pay-as-you-go”

indicates that the current revenues are used to pay the social security retirees.Social
Security and Medicare are the schemes of the U.S. government for providing funds to
retirees.

The Social Security system delivers funds to old citizens (aged 62 years) during retirement.
At the same time, Medicare is a health care program that provides funds to people aged 65
and above. These funds are derived from the current revenue from Social Security and
Medicare tax.
02

Social Security and Medicare trust funds and their exhaustion time

Social Security and Medicare trust funds collect revenues from social security’s tax used to
meet the deficit revenues.The annual budget for Social Security is $888 billion, which is
paid at a tax rate of 12.4% at a set income level.

If they exceed the expenditure, the Social Security funds are stocked and used when the
tax revenues fail to meet the payment in the future. Similarly, Medicare funds are reserved
for meeting the healthcare requirement of senior citizens. The annual cost for the
Medicare system is $510 billion, which is paid through the Medicare earnings tax.

The Social Security fund will deplete in 2033, a year earlier than what was projected in the
previous reports of the trust fund due to Covid. The Medicare trust fund will exhaust in
2024. After the exhaustion of the trust funds, the social security and medicare
requirements can only be met by the tax revenues up to some percent.
03

Basic problem for the social security and Medicare systems

The critical problem for the Social Security and Medicare trust funds is the growing
population of grey-hair citizens. As the grey-haired population expands, the number of
retirees will increase. Thus the present tax rates will not be sufficient to meet the annual
cost of Social Security and Medicare trust funds.
Therefore, either tax rates will have to be increased, or the benefits from the funds will
have to be reduced.
04

increase in taxes or decrease in benefits

The opinion for increasing taxes or decreasing the benefits may vary from person to person
as both the options have their advantages and disadvantages.

Increasing the taxes might discourage the youngsters from gaining higher education and
skills and advancing their careers. Or higher taxes might evoke anger in the higher-skilled
workers.

Reducing the benefits, such as increasing the retirement age or excluding wealthy people
from receiving the benefits of the funds, might instigate rebellion in the country, and the
political support might be pulled off.

4. What are the government’s fiscal policy options for ending severe demand-pull
inflation?

01

Effects of decreased government spending

Fiscal policy has two instruments that are government spending and taxes.A contractionary
budgetary policy of the government reduces government spending.Lower government
spending will directly shrink the aggregate expenditure of the economy.

As a result, a lower income will pull the demand down to a lower aggregate demand and
supply model equilibrium. Hence, prices will fall, and inflation will be controlled or halted.
02

Effects of high taxes

Another part of a contractionary fiscal policy is high taxes.As taxes rise, the disposable
income of consumers declines. Consequently, the consumption expenditure and saving in
the economy also contracts. Less amount of consumption reduces the aggregate
expenditure.

On the other hand, lower saving pulls down the gross investment as the economy is stable
when saving matches the investment. Therefore, the consumption and investment
expenditure falls, bringing the equilibrium GDP down. A lower GDP will reduce the
aggregate demand, and the prices will fall. Hence, higher taxes will regulate demand-pull
inflation.

5. Use the aggregate expenditures model to show how government fiscal policy could
eliminate either a recessionary expenditure gap or an inflationary expenditure gap
(Figure 11.7). Explain how equal-size increases in G and T could eliminate a
recessionary gap and how equal-size decreases in G and T could eliminate an
inflationary gap.

01
Government fiscal policy for recessionary and inflationary expenditure gap

When the economic output falls short of the potential GDP due to recession, it creates a
recessionary expenditure gap. A recessionary expenditure gap is a difference between the
real output or aggregate expenditure at full employment and the actual aggregate
expenditure.

In the above graph, AEf represents the full employment aggregate expenditure at potential
output Yf. AE is the actual aggregate expenditure, and Y is the real output.The vertical
distance between AEf and AE is the recessionary expenditure gap.An increase in
government spending and a decrease in taxes can increase the actual aggregate
expenditure and lead to potential output.

On the contrary, the inflationary expenditure gap occurs when the economic output
exceeds the potential GDP. Here, the aggregate output generates greater spending.
The above graph shows that the full employment level expenditure curve AEfresides below
the actual aggregate expenditure curve AE. The vertical distance between the two
expenditure curves is the inflationary expenditure curve. A decrease in government
spending and increased taxes can reduce the actual aggregate expenditure and lead to
potential output.

Fiscal policies can equate the aggregate expenditure to the potential output using the tools
and eliminate any recessionary or inflationary expenditure gap.
02

Elimination of recessionary expenditure gap

An increase in G directly increases the initial aggregate spending.The initial increase leads
to a larger shift because of the multiplier effect. The recessionary gap vanishes as the
aggregate expenditure increases. It becomes equal to the real domestic output.

In contrast, reducing taxes in equal amounts (to G) will not increase the spending equally.
The government multiplier effect produces a larger effect than taxes because the income
increased by a reduction in taxes is not entirely consumed, but some part is also saved.
03

Elimination of inflationary expenditure gap

A reduction in government spending contracts the aggregate expenditure. An initial shrink

in the spending results in a greater fall in the aggregate expenditure due to the multiplier
effect. As aggregate expenditure falls and becomes equal to the potential output,
eliminating the inflationary expenditure gap.

△𝐺=11-𝑀𝑃𝐶

On the other hand, an equal increase in taxes will reduce disposable income. However, the
consumption expenditure will not fall in by the exact amount as income decreases because
some decline will go to the saving side. It can be observed by the difference in the formulas
of government spending multiplier and tax multiplier. The following formula represents the
tax multiplier:

△𝑇=𝑀𝑃𝐶1-𝑀𝑃𝐶

Thus, an equal amount decrease in spending and increase in tax will not produce the same
effect in reducing the inflationary expenditure gap.

6. Some politicians have suggested that the United States enact a constitutional
amendment requiring that the federal government balance its budget annually.
Explain why such an amendment, if strictly enforced, would force the government
to enact a contractionary fiscal policy whenever the economy experiences a severe
recession.

01

Meaning of recession

A recession is a phase of the business cycle when economic activities take a downturn. The
economy experiences a slowdown in aggregate spending and output due to a decline in
aggregate demand. As a result of the recession, unemployment rises, and the recession
accelerates further.

An economy falls into recession after a continued slow growth or decline in the output over
several months, at least a quarter of the year. The government needs to push the aggregate
demand forward by increasing its expenditure to overcome this, leading to a budget deficit.
02

Reason for contractionary fiscal policy in a recession

A mandatory requirement to maintain the budget annually will stop the government from
pursuing an expansionary policy.The only option left to overcome recession is that the
government leaves more money in the people's hands to encourage consumption. This
requires a reduction in taxes and an increase in transfer payments, unemployment
allowances, and other spending to accelerate production and growth.

The federal government will have to alter its expansionary fiscal policy to maintain its
budget annually. Therefore, a contractionary fiscal policy becomes mandatory whenever
the economy faces a high recession; otherwise, there will be a budget deficit.

7. Explain how built-in (automatic) stabilizers work. What are the differences between
proportional, progressive, and regressive tax systems as they relate to an economy’s
built-in stability?

01

Concept of built-in stabilizers

Built-in stabilizers are instruments of fiscal policy which act on their own to maintain the
smooth running of the economy.Built-in stabilizers do not require any external push. These
include components like taxes and transfer payments. These stabilizers reduce the
multiplier effect, and hence, the impact on the final GDP is less than a situation with no
stabilizers.
During an economic boom, an increase in any of the aggregate expenditure components
results in multiple increases in the real GDP than the initial push. The multiplier does the
work.However, the automatic stabilizers suck some amount of money from the economic
system and reduce the multiplier effect.

During an economic crisis, the built-in stabilizers reduce the multiplier effect of a small
decline in any aggregate expenditure components by injecting the money into the
economy, reducing the effect of the fall in aggregate expenditure.

As an economy’s GDP increases, the quantity of built-in stabilizers increases.The amount of

automatic stabilizers refers to the net taxes. Net taxes are the total taxes minus the transfer
payments.
02

Tax system in the context of the economic stability

The progressive tax holds a constantly increasing average tax rate with increasing GDP. The
proportional tax rate maintains a constant average tax rate with an increase in the GDP.
While the regressive tax rate may increase, decrease, or keep constant the average tax rate
with change in the GDP.

The progressive tax rate corresponds the best to the changes in the GDP. If GDP increases,
the progressive tax rate also increases, thus increasing the average tax rate and vice-versa.
Therefore, a progressive tax system provides the best stabilizing effect in the economy
compared to the other two tax systems.

8. Label each of the following scenarios as an example of a recognition lag, administrative

lag, or operational lag.

01

Explanation for part (a)

The bill passed by Congress to increase spending will not create any immediate impact on
the price level and output. The action will take a minimum of two years to reflect the
impact on the recession.A delay in the operation of activities will cause a time lag to cure
the recession.

Therefore, the passing of a bill to increase the spending, which requires at least two years
per project to complete and begin a new one, is an operational lag.
02

Explanation for part (b)

Wars are as disastrous for economic loss as for social loss. A robust war leads to higher
consumer demands, exhaustion of resources, declined output, shortage of labor supply,
hoarding of products, increased imports, and other effects. All these factors raise prices,
and inflation rises.

However, it is not possible to identify inflation quickly in such situations. It requires

observation of a continuous increase in price level at least over a quarter of the year. The
time taken to recognize the inflation allows the inflation to keep rising for the time being. It
is an example of recognition lag.
03

Explanation for part (c)

The politicians did not take much time to recognize the recession. They were able to
identify it quickly, but they took time frame an action plan to combat the recession. The
time lag between identifying the recession and preparing and taking administrative action
to recover from the recession is referred to as administrative lag.
04

Explanation for part (d)

The president’s order to federal agencies for removing the petty regulations needs time for
execution. It requires proper planning and scheme for guidelines to be sustained and to be
removed.
The time of 1 year taken to frame the map for rules and regulations showcases an
operational log.

9. Define the cyclically adjusted budget, explain its significance, and state why it may differ
from the actual budget. Suppose the full-employment, noninflationary level of real output
is GDP3 (not GDP2) in the economy depicted in Figure 13.3. If the economy is operating at
GDP2 instead of GDP3, what is the status of its cyclically adjusted budget? The status of its
current fiscal policy? What change in fiscal policy would you recommend? How would you
accomplish that in terms of the G and T lines in the figure?

01

Meaning and significance of cyclically adjusted budget and reason for deviation from actual
budget

The cyclically adjusted budget is the estimate of the budget when the economy operates at
the full employment level. It is referred to as to cyclically adjusted budget because it
eliminates the impact of cyclical changes in the economy and measures the budget status
of what it should be in an ideal situation.

A cyclically adjusted budget compares the actual budget status with the full employment
situation. It helps to understand how far the actual budget stands from the ideal position
and what amount should be adjusted to reach the full employment level of the budget.

A cyclically adjusted budget differs from the actual budget because of the automatic
stabilizers. The automatic stabilizers increase the budget deficit in times of recession and
decrease the budget deficit during inflation. Therefore, as GDP fluctuates from the
equilibrium level, the budget also deviates in the same direction.
02

Status of the cyclically adjusted budget

The cyclically adjusted budget is the measure of the budget at the full employment level.

The full employment level of the real domestic output is GDP3. The tax revenue at GDP3 is
greater than the government spending, which is constant. Thus, the cyclically adjusted
budget is in surplus.
03

Status of current fiscal policy

If Taxes > Government Spending; Contractionary Fiscal Policy.

If Taxes< Government Spending; Expansionary Fiscal Policy.

Since the cyclically adjusted budget is in surplus, the taxes are higher than government
spending. Thus the current fiscal policy is contractionary.
04

Changes in fiscal policy

The actual budget at GDP2is balanced, and the economy is practicing a contractionary
fiscal policy. However, the cyclically adjusted budget is in surplus. The government must
adopt an expansionary fiscal policy to reach full employment, increasing the GDP and
reducing the budget surplus.

Therefore, the economy will be at full employment with a cyclically balanced budget.
05

Changes in spending and tax curves

To maintain a balanced budget, the government should either increase government

spending, decrease taxes, or apply both. The changes in government spending and tax
revenue should be such that the line government spending, G, and tax revenue, T, should
intersect at full employment, GDP3.

When tax revenue and government spending curve meet, the cyclical budget will be fully
balanced.

9. Briefly state and evaluate the problem of time lags in enacting and applying fiscal policy.
Explain the idea of a political business cycle. How might expectations of a near-term policy
reversal weaken fiscal policy based on changes in tax rates? What is the crowding-out
effect, and why might it be relevant to fiscal policy?

01

Types of time lag in enactment and application of fiscal policy

The problem of time lag in enacting and applying a fiscal policy arises due to three broad
reasons:

Recognition lag: It occurs due to the delay in identifying the problem and realizing the need
for change in fiscal policy.A recession or inflation takes months to be identified exactly
from the day it starts because the economic growth keeps fluctuating in normal
situations.Meanwhile, the problem becomes more severe.
For example, the global recession of 2007-2009 began in early 2007 but was declared
officially in December 2007 and lasted till 2009.

Administration lag: The delay in enacting the fiscal policy occurs due to planning and
preparing a framework for the fiscal policy. Though the global crisis of 2007-09 was
declared in December 2007, the Emergency Economic Stabilization Act of 2008 was first
enacted in October 2008 in the U.S., including government funds to stimulate economic
growth.

Operational lag: It is time lag in applying the fiscal policy from the day of enactment of the
policy. The result of any spending cannot provide an immediate impact on economic
growth. Government spending naturally takes some time to affect the output, income, and
employment. However, taxes may have a short-run and an immediate impact.

The global recession lasted for approx 18 months, and the policies gave the desired
outcome on income, output, and employment after 7-8 months in the U.S.
02

Meaning of political business cycles

The political business cycles are the artificially created business cycles derived by the
selfish motives of the politicians. The primary goal of the elected politicians is to get
reelected.The politicians need some propaganda to gain the vote bank. Thus, they
recommend an expansionary fiscal policy irrespective of economic rationality.

The politicians advocate increased government spending areas like farm subsidies,
education, healthcare, and infrastructure projects. At the same time, they reduce taxes and
increase transfer payments. In this way, the political parties completely take over the fiscal
policy formulation according to their interests, resulting in an economically inefficient
policy. It disturbs the aggregate demand and thereby disturbs the whole chain of economic
stability, causing political business cycles.
03

Impact of expectations of near-term policy reversal on fiscal policy

The near-term policy reversal means that the policy implemented is temporary and will be
reversed soon. It depends on the expectations of the people regarding the policy
implemented. If the households expect a change in taxes to be quickly altered, the fiscal
policy based on tax changes may fail to achieve its objective.

Due to their hypothetical assumptions, people behave opposite to what should be the ideal
change in their behavior in response to the change in taxes. When the government cut
down the taxes, people start saving more instead of increasing consumption because they
believe the tax rate will restore to previous levels, and these savings will help them in the
future.

Alternatively, with a sudden increase in taxes, people do not disturb the consumption level
and pattern because they expect the tax rate will sooner be cut down to initial levels. This
opposite behavior of individuals and households do not fulfill the objective of the tax cut.

Increased savings following tax cuts do not increase the aggregate expenditure, which
ultimately does not improve aggregate demand and output level. On the opposite side,
increasing a tax rate does not bring down aggregate consumption, so the aggregate
demand and output level remain unchanged. The fiscal policy fails to achieve the desired
goal.
04

Crowding-out effect and its relevance to fiscal policy

The crowding-out effect is the elimination of some private investment by an increase in

government expenditure.The government expenditure crowds out the private investment
by raising the cost of investment. An expansionary fiscal policy encourages the
crowding-out effect.

The government gathers their funds for spending through tax revenues. However, when
the government falls short of funds, it takes debt. Public debt in bulk increases the interest
rate on the investment funds. Therefore, due to high costs, private investment declines.
And government spending fills the gap.
10. How do economists distinguish between the absolute and relative sizes of the public
debt? Why is the distinction important? Distinguish between refinancing the debt and
retiring the debt. How does an internally held public debt differ from an externally held
public debt? Contrast the effects of retiring an internally held debt and retiring an
externally held debt.

01

Distinction between the absolute and relative size of the public debt

The absolute size of the public debt is the nominal amount that a country owes as the
debt.It is the total deficits accumulated over time minus the surpluses.The public debt's
relative size is expressed as the percentage of the economy's real GDP.

𝑅𝑒𝑙𝑎𝑡𝑖𝑣𝑒𝑠𝑖𝑧𝑒=𝑃𝑢𝑏𝑙𝑖𝑐𝐷𝑒𝑏𝑡𝑅𝑒𝑎𝑙𝐺𝐷𝑃×100
02

Need for the distinction

The distinction between the two methods for the measurement of public debt is
crucial.The latter informs about repaying capacity of the economy. Also, the relative size
gives a better international comparison. The total public debt's absolute size may
sometimes overstate the problem, but relative size gives a clear picture.

For example, a public debt of $10 trillion for the U.S. federal government might seem huge.
However, the total public debt relative to its GDP must be smaller than the other nations.
And the U.S. economy must be capable of repaying its debt.
03

Distinction between refinancing and retiring the debt

Refinancing the debt means selling new bonds despite the existing loans at better
terms.The funds from new bonds are used to pay off the previous debt. It is the
overstanding of debt over the debt. The country can refinance the debt if the relative size is
small, and the economy can repay further debts.

Retiring the debt is purchasing back the bonds by the federal government from those who
hold the bonds. It can also be understood as the settling of the debt at maturity.
04

Distinction between internally held public debt and externally held public debt

An internally held public debt is when the bondholders belong to the domestic country.
The bonds are transferred internally, and there is no foreign party involvement.

While the externally held public debt is when the debt process becomes overseas, the
borrowers and bondholders belong to different economies. In externally held public debt,
the exchange rate can vary due to the size of the debt.
05

Comparison between the effects of retiring an internal and an external public debt

Retiring an internally held public debt involves just purchasing back the bonds from the
bondholders.The drawback of retiring an internally held public debt is equal income
distribution.

The majority of the bondholders in an economy are the big business houses. Retiring of the
debt transfers majority of the economy's income from lower-income groups (in the form of
taxes) to the wealthier groups (repaying the debt). However, the money circulates inside the
domestic country only.

Retiring an externally held public debt involves the exchange of currencies. Sometimes the
foreign bondholders can ask for domestic products in exchange for the bonds.

Sometimes, the dollars gained in exchange for the bonds can be settled by the foreign
exchange, declining the foreign exchange reserves of the home country. A decline in
foreign exchange reserve can depreciate the domestic currenc
11. How are supply-side policies implemented and what types of supply-side policies are
used?

Supply-Side Fiscal Policy

Similarly to boost aggregate demand, the reduction of taxation levels can be used to
promote economic growth, however, the main objective in mind is to give consumers,
laborers more incentives to save, work more productively and invest more.

We differentiate between 2 types of policies on supply side,

Interventionist and

Non-Interventionist

12. What happens between the public and private sectors during a "crowding out" effect?

types of fiscal policy

it is not possible to utilize real resources in both the public and private sectors at the same
time. However, if the governments increasingly employ more factors of production into the
public sector, the output produced in the private sector must fall. The government incurs
an opportunity cost when utilising resources in the public sector when they could have
used them in the private sector

13. What happens to the taxation and government spending rates during an expansionary
fiscal policy?

The government reduces the level of taxation for its households and increases overall
government spending on aspects like infrastructure to promote economic activity and
growth.
14. What is the relationship between the multiplier and the AD component of government
spending?

ypes of fiscal policy

● The larger the government spending multiplier, the smaller the increase in
government spending is needed to achieve the desired increase in national income.
The same principle applies to the other components of aggregate demand.