Page 258 - Krugmans Economics for AP Text Book_Neat

long -run growth. Also, poorly timed policies can in- the case of lump-sum taxes, taxes reduce the size of the
crease economic instability. multiplier. Expansionary fiscal policy leads to an increase
15. Negative supply shocks pose a policy dilemma: a policy in real GDP, while contractionary fiscal policy leads to a
that counteracts the fall in aggregate output by increas- reduction in real GDP. Because part of any change in
ing aggregate demand will lead to higher inflation, but taxes or transfers is absorbed by savings in the first
a policy that counteracts inflation by reducing aggre- round of spending, changes in government purchases of
gate demand will deepen the output slump. goods and services have a more powerful effect on the
economy than equal-size changes in taxes or transfers.
16. The government plays a large role in the economy, col-
lecting a large share of GDP in taxes and spending a 19. An autonomous change in aggregate spending leads
large share both to purchase goods and services and to to a chain reaction in which the total change in real
make transfer payments, largely for social insurance. GDP is equal to the multiplier times the initial change
Fiscal policy is the use of taxes, government transfers, in aggregate spending. The size of the multiplier,
or government purchases of goods and services to shift 1/(1 − MPC), depends on the marginal propensity to
the aggregate demand curve. But many economists cau- consume, MPC, the fraction of an additional dollar of
tion that a very active fiscal policy may in fact make the disposable income spent on consumption. The larger
economy less stable due to time lags in policy formula- the MPC, the larger the multiplier and the larger the
tion and implementation. change in real GDP for any given autonomous change
in aggregate spending. The fraction of an additional
17. Government purchases of goods and services directly af-
dollar of disposable income that is saved is called the
fect aggregate demand, and changes in taxes and gov- marginal propensity to save, MPS.
ernment transfers affect aggregate demand indirectly by
changing households’ disposable income. Expansion- 20. Rules governing taxes—with the exception of lump-sum
ary fiscal policy shifts the aggregate demand curve taxes—and some transfers act as automatic stabilizers,
rightward; contractionary fiscal policy shifts the ag- reducing the size of the multiplier and automatically re-
gregate demand curve leftward. ducing the size of fluctuations in the business cycle. In
contrast, discretionary fiscal policy arises from delib-
18. Fiscal policy has a multiplier effect on the economy, the
erate actions by policy makers rather than from the
size of which depends upon the fiscal policy. Except in
business cycle.

Key Terms

Marginal propensity to consume (MPC), p. 159 Interest rate effect of a change in the aggregate Demand shock, p. 191
Marginal propensity to save (MPS), p. 159 price level, p. 174 Supply shock, p. 192
Autonomous change in aggregate spending, Fiscal policy, p. 176 Stagflation, p. 193
p. 160 Monetary policy, p. 177 Long -run macroeconomic equilibrium, p. 194
Multiplier, p. 160 Aggregate supply curve, p. 179 Recessionary gap, p. 195
Consumption function, p. 162 Nominal wage, p. 180 Inflationary gap, p. 196
Autonomous consumer spending, p. 162 Sticky wages, p. 180 Output gap, p. 196
Aggregate consumption function, p. 164 Short -run aggregate supply curve, p. 181 Self -correcting, p. 196
Planned investment spending, p. 166 Long -run aggregate supply curve, p. 184 Stabilization policy, p. 199
Inventories, p. 168 Potential output, p. 185 Social insurance, p. 204
Inventory investment, p. 168 AD–AS model, p. 190 Expansionary fiscal policy, p. 205
Unplanned inventory investment, p. 169 Short-run macroeconomic equilibrium, p. 190 Contractionary fiscal policy, p. 205
Actual investment spending, p. 169 Short -run equilibrium aggregate price level, Lump -sum taxes, p. 211
Aggregate demand curve, p. 172 p. 190 Automatic stabilizers, p. 212
Wealth effect of a change in the aggregate price Short -run equilibrium aggregate output, p. 190 Discretionary fiscal policy, p. 212
level, p. 174

Problems

1. A fall in the value of the dollar against other currencies makes ner says that this represents a movement down the aggregate de-
U.S. final goods and services cheaper to foreigners even though mand curve because foreigners are demanding more in response
the U.S. aggregate price level stays the same. As a result, foreign- to a lower price. You, however, insist that this represents a right-
ers demand more American aggregate output. Your study part- ward shift of the aggregate demand curve. Who is right? Explain.

216 section 4 National Income and Price Determination