Idea Transcript
Practice Problems on Fiscal Policy 1- What are the major components of government outlays? What are the major sources of government revenues? How does the composition of the Federal government’s outlays and revenues differ from that of state and local governments? The major sources of government outlays are government purchases, transfer payments, and net interest payments. The major sources of government revenues are personal taxes, contributions for social insurance, indirect business taxes, and corporate taxes. The federal government’s outlays and revenues differ from those of state and local governments in that: (1) most spending on non-defense goods and service is done by state and local government; (2) the federal government spends far more on transfers than on nonmilitary goods and services; (3) the federal government makes grants in aid to state and local governments; (4) the federal government is a large payer of net interest, while state and local governments are net recipients of interest payments; and (5) most of the federal government’s revenues come from personal taxes and contributions for social insurance, while state and local governments rely more heavily on indirect business taxes (sale taxes). 2- Define inflation tax (also called seignorage) How does the government collect this tax, and who pays it? Can the government always increase its real revenues from the inflation tax by increasing moneys growth and inflation? The inflation tax, or seignorage, arises when the government raises revenue by printing money. The inflation tax is equal to the inflation rate times the real money supply in an all-currency economy in which the money multiplier equals 1. (More generally, the inflation tax collected by the government equals the inflation rate multiplied by the monetary base.) The government collects the inflation tax by printing money to purchase goods and services. The tax is paid by anyone who holds money, because the purchasing power of their money is eroded by inflation. The government cannot always increase its real revenues from the inflation tax by increasing money growth and inflation, because a high enough inflation rate causes the real money supply to fall enough that seignorage revenue begins to fall when inflation increases.
3- Consider an economy in which the money supply consists of both currency and deposits. The growth rate of the monetary base, the growth rate of the money supply, inflation, and expected inflation all are constant at 10% per year. Output and the real interest rate are constant. Monetary data for this economy as of January 1, 2000, are as follows: Currency in circulation $200 Bank reserves $50 Monetary base $250 Deposits $600 Money supply $800
a- What is the nominal value of seignorage over the year? (Hint: How much monetary base is created during the year) The monetary base is growing at a 10% rate, so it increases by 0.01 x $250 = $25. The nominal value of seignorage over the year is $25. b- Suppose that deposits and bank reserves pay no interest, and that banks lend deposits not held as reserves at the market rate of interest. Who pays the inflation tax (measured in nominal terms), and how much do pay? (Hint: The inflation tax paid by banks in this example is negative.) Deposit holders pay the inflation tax on their non-interest-bearing deposits of $600 x 0.10 = $60. This amount is received by banks. Banks pay the inflation tax on their non-interest-bearing reserves of $50 x 0.10 = $5. Currency holders pay the inflation tax on their non-interest-bearing currency of $200 x 0.10 = $20. Overall, deposit holders pay an inflation tax of $60, banks pay an inflation tax of - $60 + $5 = - $55, and currency holders pay an inflation tax of $20. The total inflation tax is $60 - $55 + $20 = $25.
c- Suppose that deposits pay a market rate of interest. Who pays the inflation tax, and how much do they pay? If deposit holders get the market rate of interest on their accounts, and the market rate of interest rises with inflation, then deposit holders pay no inflation tax to banks. In this case the inflation tax is borne entirely by banks ($5) and currency holders ($20).
4- Government Budget Constraint a. State and explain the government budget constraint. The Government budget constraint (in real terms) is given by; Gt = (Mt -Mt-1 )/Pt + Tt + Bt – Bt-1*(1+r) where Gt are real government expenditures, Bt are government borrowings at t, T(t) is government tax revenue and (Mt -Mt-1 )/Pt is government revenue creation in real terms by monetization.
b. If the government is not expected to increase future tax revenue or lower future spending, what might the existence of budget deficits and large government debt mean for the expected future path of inflation and the shape of the current yield curve (term structure). In answering this question, assume the real interest rate is constant. If the government cannot change its expenditures and tax revenue and has large outstanding debt then it implies that in the future the government will most likely have to monetize. This will raise expected inflation today itself and hence making the current yield curve steeper.