1. In this problem, the multiplier is 1/.1 or 10 so, the increase in government spending = $10 billion. For tax cut question, initial spending of $10 billion is still required, but only .9 (= MPC) of a tax cut will be spent. So .9 x tax cut = $10 billion or tax cut = $11.11 billion. Part of the tax reduction ($1.11 billion) is saved, not spent.
2. Options are to reduce government spending, increase taxes, or some combination of both. If the price level is flexible downward, it will fall. In the real world, the goal is to reduce inflation— to keep prices from rising so rapidly—not to reduce the price level. A “conservative” economist might favor cuts in government spending since this would reduce the size of government. A
“liberal” economist might favor a tax hike; it would preserve government spending programs.
3. It takes time to ascertain the direction in which the economy is moving (recognition lag), to get a fiscal policy enacted into law (administrative lag); and for the policy to have its full effect on the economy (operational lag). Meanwhile, other factors may change, rendering inappropriate a particular fiscal policy. Nevertheless, discretionary fiscal policy is a valuable tool in preventing severe recession or severe demand‐pull inflation.
A political business cycle is the concept that politicians are more interested in reelection than in stabilizing the economy. Before the election, they enact tax cuts and spending increases to please voters even though this may fuel inflation. After the election, they apply the brakes to restrain inflation; the economy will slow and unemployment will rise. In this view the political process creates economic instability.
The disappointing report means that once again the Federal Reserve is unlikely to consider tightening fiscal policy. That means interest rates will remain at historically low
levels