Demand management: fiscal policy practice questions.

If the marginal propensity to consume is 0.75, the value of the Keynesian multiplier is

• 1.33
• 2.5
• 4
• 7.5

Answer: 4

k = 1 / (1 − MPC) = 1 / (1 − 0.75) = 1 / 0.25 = 4.

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

• Unemployment benefits that rise in a recession automatically
• A one-off stimulus package approved by parliament during a downturn
• A cut in the central bank's policy interest rate
• A newly legislated motorway construction programme

Answer: Unemployment benefits that rise in a recession automatically

Automatic stabilizers, such as unemployment benefits and progressive taxes, dampen the business cycle automatically, without discretionary policy decisions; the other options are discretionary fiscal or monetary actions.

According to the crowding-out argument, an increase in government spending financed by borrowing may

• lower interest rates and therefore stimulate private investment
• cause the currency to depreciate, automatically raising net exports
• push up interest rates and thereby reduce private-sector investment
• automatically reduce the size of the budget deficit

Answer: push up interest rates and thereby reduce private-sector investment

Extra government borrowing increases the demand for loanable funds, raising interest rates; more expensive credit can then displace (crowd out) private investment, weakening the expansionary effect.

In a given year a government collects $120 billion in revenue and spends $135 billion. Which of the following correctly describes its fiscal position for that year?

• A budget surplus of $15 billion
• A budget deficit of $15 billion
• A national debt of $15 billion
• A balanced budget

Answer: A budget deficit of $15 billion

Expenditure exceeds revenue by 135 − 120 = $15 billion, which is a budget deficit for that year; the national debt is the accumulation of past deficits, not a single year's shortfall.

Which of the following items of government spending is a transfer payment?

• salaries paid to state school teachers
• construction of a new motorway
• purchase of medical equipment for public hospitals
• unemployment benefits paid to jobless workers

Answer: unemployment benefits paid to jobless workers

Transfer payments redistribute income without any good or service being received in return, so they are not counted in GDP; the other options pay for labour or output (current and capital expenditure). Picking teachers' salaries is the common slip — those purchase a service.

An economy is producing above its full employment level of output and inflation is accelerating. The government raises income tax rates and cancels several public building projects. In the AD/AS model the most likely immediate effect is

• a leftward shift of the AD curve, easing pressure on the price level as real output falls back
• a rightward shift of the AD curve, raising the price level and real output at the same time
• a leftward shift of the short run AS curve, pushing the price level up while real output falls
• a movement upwards along the AD curve, caused by the change in the price level itself

Answer: a leftward shift of the AD curve, easing pressure on the price level as real output falls back

Taxation and government spending are determinants of aggregate demand, so a contractionary budget shifts the whole AD curve rather than moving the economy along it; an AS shift would raise the price level, which is the opposite of what the policy is meant to achieve.