Ch 16.1 16.2

Changes in taxes or government spending that increase aggregate demand without requiring policymakers to act when the economy goes into a recession are called

• automatic stabilizers.
• time lags.
• the crowding-out effect.
• stabilization policies.

Answer explanation

Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action. Stabilization policies are enacted by the government or the Bank of Canada and may result in time lags.

Temporary tax cuts shift the aggregate-demand curve

• not as far to the right as do permanent tax cuts.
• farther to the right than do permanent tax cuts.
• not as far to the left as do permanent tax cuts.
• farther to the left than do permanent tax cuts.

Answer explanation

If consumers believe a tax cut to be permanent, they will view the increased take-home pay as adding substantially to their financial resources and increase their spending by a large amount. By contrast, if households expect the tax change to be temporary, they will view it as adding only slightly to their financial resources and will increase their spending by only a small amount.

Which of the following statements about the multiplier effect is NOT true?

• Government purchases are said to have a multiplier effect on aggregate demand.
• The logic of the multiplier effect applies to any change in spending on any component of GDP.
• The multiplier effect states that there are additional shifts in aggregate demand from fiscal policy because this policy increases income and thereby increases consumer spending.
• Tax reductions are said to have a multiplier effect on aggregate supply.

Answer explanation

The multiplier effect is the additional shifts in aggregate demand that result when expansionary fiscal policy, such as increasing government purchases, increases income and thereby increases consumer spending. Additionally, the logic of the multiplier effect applies to any change in spending on any component of GDP.

Which of the following is an example of an increase in government purchases?

• The government builds new bridges.
• The Bank of Canada sells government bonds.
• The government increases corporate taxes.
• The government decreases CPP payments.

Answer explanation

Fiscal policy refers to the government's choices regarding the overall level of government purchases and taxes. When the government builds new bridges, this is an example of an increase in government purchases. However, when the Bank of Canada sells government bonds, this is an example of a monetary policy.

Which of the following illustrates how the investment accelerator works?

• An increase in government expenditures increases the interest rate so that Starshine Inc. decides to open new car washes in additional locations.
• An increase in government expenditures increases aggregate spending so that Starshine Inc. finds it profitable to update its car-wash equipment.
• An increase in government expenditures decreases the interest rate so that Starshine Inc. finds it profitable to update its car-wash equipment.
• An increase in government expenditures increases the interest rate so that the demand for stocks and bonds issued by Starshine Inc. rises.

Answer explanation

When higher government spending spurs higher demand for investment goods, this positive feedback from demand to investment is called the investment accelerator. In this case, an increase in government expenditures that increases aggregate spending and encourages Starshine Inc. to invest in newer car-wash equipment is an example of the investment accelerator.

If the multiplier is 5, then the MPC is

• 0.2
• 0.8
• 2
• 10

Answer explanation

The multiplier for changes in government spending is calculated as 1/(1 – MPC). Rearranging this equation yields MPC = 1 – (1/Multiplier). Therefore, if the multiplier is 5, then the MPC is 1 – (1/5) = 0.8.

The multiplier effect amplifies the effects of an increase in government expenditures, while the crowding-out effect diminishes the effect.

• True
• False

Answer explanation

The multiplier effect is the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending. The crowding-out effect is the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending. Therefore, the multiplier effect amplifies the effects of an increase in government expenditures, while the crowding-out effect diminishes the effect.

Which of the following is an example of an automatic stabilizer?

• the minimum wage
• Employment Insurance and social assistance
• an increase in money demand
• an increase in tax rates in response to an expansion

Answer explanation

Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action. Some examples of automatic stabilizers include Employment Insurance and social assistance.

Which of the following policy actions does NOT shift the aggregate-demand curve?

• open-market operations by the Bank of Canada
• a decrease in taxes
• an increase in governemnt spending
• a change in price level

Answer explanation

Fiscal policy such as a decrease in taxes or an increase in government spending shifts the aggregate-demand curve. Similarly, monetary policy such as the Bank of Canada conducting open-market operations also shifts the aggregate-demand curve. Because the aggregate-demand curve represents the relationship between the price level and the quantity of output, a change in the price level causes a movement along the aggregate-demand curve.

Refer to the scenario. Scenario 16-1. Take the following information as given for small, imaginary economy: When income is $10,000, consumption spending is $6,500. When income is $11,000, consumption spending is $7,250. For this economy, an initial increase of $200 in net exports translates into a(n) _________ increase in aggregate demand in the absence of the crowding-out effect.

• 500
• 1000
• 120
• 800

Answer explanation

The spending multiplier is calculated as 1/(1 – MPC). The marginal propensity to consume is the fraction of extra income that a household consumes rather than saves. In this case, an extra $1000 of income increases spending by $600, so the MPC = 0.60. This means the multiplier is 1/(1 – 0.60) = 1/(0.40) = 2.5. Therefore, a $200 increase in net exports translates into a $200 × 2.5 = $500 increase in aggregate demand in the absence of the crowding-out effect.