Fiscal Policy Practice Questions

8 representative multiple-choice questions on fiscal policy for AP Macroeconomics, drawn from our 15-question bank for this module. Work through each one, then open “Show answer” for the correct choice and an explanation. For scored, timed practice across the full bank, take a full practice test.

1. 1. Which of the following describes expansionary fiscal policy?

   • A. The Federal Reserve lowers interest rates by buying bonds
   • B. Congress increases government spending or cuts taxes to boost aggregate demand
   • C. The Treasury pays down the national debt
   • D. Congress raises taxes to reduce the budget deficit
   Show answer

   Correct answer: B. Congress increases government spending or cuts taxes to boost aggregate demand

   Expansionary fiscal policy is Congress using spending increases or tax cuts to shift AD right, boost real GDP, and lift the price level. The 2009 Recovery Act ($831B) and the 2020 CARES Act ($2.2T) are the textbook examples. Option A describes monetary policy, which is handled by the Fed, not Congress. Option C is a debt management decision, not policy aimed at AD. Option D is contractionary fiscal policy and does the opposite of what the question asks.

2. 2. If the marginal propensity to consume (MPC) is 0.8, the spending multiplier is:

   • A. 2
   • B. 4
   • C. 5
   • D. 10
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   Correct answer: C. 5

   Spending multiplier = 1 / (1 - MPC) = 1 / (1 - 0.8) = 1 / 0.2 = 5. Each dollar of government spending expands AD by $5 as it recirculates through the economy. Higher MPC means more of each dollar gets passed along to the next person, which makes each round bigger and the multiplier larger. Option D (multiplier of 10) would require an MPC of 0.9, not 0.8.

3. 3. The tax multiplier is typically smaller in absolute value than the spending multiplier because:

   • A. Tax cuts affect only high-income earners
   • B. Some of the tax cut is saved rather than spent in the first round
   • C. Tax cuts take longer to implement than spending programs
   • D. The government collects taxes to fund the cut
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   Correct answer: B. Some of the tax cut is saved rather than spent in the first round

   When the government spends $1, the full dollar enters AD immediately. When it cuts taxes by $1, households save a portion (1 - MPC) before anything gets spent. The first round of the multiplier process is smaller, so the tax multiplier always ends up exactly 1 less in absolute value than the spending multiplier. That gap (MPS worth of first-round leakage) compounds through every subsequent round. Option C isn't the economic reason; it's a practical consideration. Option D mixes in budget accounting rather than the multiplier mechanics.

4. 4. Suppose the government increases spending by $100 billion and the MPC is 0.75. By how much will aggregate demand shift if there is no crowding out?

   • A. $75 billion
   • B. $100 billion
   • C. $300 billion
   • D. $400 billion
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   Correct answer: D. $400 billion

   Spending multiplier = 1 / (1 - 0.75) = 1 / 0.25 = 4. Total shift in AD = 4 × $100B = $400B. The multiplier assumes no crowding out and a constant MPC at every round. Option B ignores the multiplier entirely and just counts the initial government injection. Option C applies a multiplier of 3, which would correspond to a tax cut of $100B, not a spending increase.

5. 5. Which of the following would have the largest impact on aggregate demand per dollar spent?

   • A. A $1 billion tax cut (MPC = 0.6)
   • B. A $1 billion tax cut (MPC = 0.9)
   • C. $1 billion in direct government spending (MPC = 0.6)
   • D. $1 billion in direct government spending (MPC = 0.9)
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   Correct answer: D. $1 billion in direct government spending (MPC = 0.9)

   Two rules apply here. First, direct spending beats tax cuts because all $1B enters AD immediately instead of some being saved. Second, a higher MPC produces a larger multiplier. Combining both gives Option D the biggest bang for the buck: spending multiplier of 1 / (1 - 0.9) = 10, so $1B × 10 = $10B shift. Option B has a tax multiplier of -9 for a $9B shift. Option C has a spending multiplier of 2.5 for a $2.5B shift. Option A has a tax multiplier of -1.5 for a $1.5B shift. Direct spending at high MPC wins.

6. 6. An increase in the progressive income tax rate structure primarily functions as:

   • A. A discretionary fiscal policy tool
   • B. An automatic stabilizer that reduces disposable income during expansions
   • C. A monetary policy tool used by the Federal Reserve
   • D. A way to increase the money supply
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   Correct answer: B. An automatic stabilizer that reduces disposable income during expansions

   A progressive tax structure is automatic because it doesn't require new laws once set up. During expansions, rising incomes push households into higher brackets, which pulls purchasing power out of the economy without any legislative action. During contractions, falling incomes move people into lower brackets automatically, which softens the blow. This happens quietly in the background across millions of taxpayers. Option A confuses the initial rate-setting decision (discretionary) with the automatic ongoing stabilization (structural).

7. 7. Suppose the economy is operating below potential with MPC = 0.8. Congress wants to close a $200 billion recessionary gap. What size of increase in government spending would be required, ignoring crowding out?

   • A. $40 billion
   • B. $50 billion
   • C. $100 billion
   • D. $200 billion
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   Correct answer: A. $40 billion

   Spending multiplier = 1 / (1 - 0.8) = 5. Required spending increase = $200B / 5 = $40B. Option D ignores the multiplier entirely. Option B ($50B) would use a multiplier of 4, which corresponds to MPC = 0.75, not 0.8. The multiplier does the heavy lifting; that's why policymakers can close a $200B gap with only $40B in direct stimulus as long as MPC is strong and crowding out is limited.

8. 8. Which combination of fiscal policies would be most effective for an economy experiencing both high unemployment and a large budget deficit?

   • A. Increase spending significantly, even at the cost of a larger deficit, to address unemployment
   • B. Cut spending and raise taxes to address the deficit, ignoring unemployment
   • C. A targeted, temporary stimulus paired with medium-term deficit reduction plans
   • D. Maintain current policies and wait for self-correction
   Show answer

   Correct answer: C. A targeted, temporary stimulus paired with medium-term deficit reduction plans

   This is the classic policy dilemma of conflicting goals. High unemployment calls for expansionary fiscal policy, but a large deficit argues for restraint. The standard economic prescription is to address the immediate unemployment crisis with targeted, temporary stimulus (expansionary policy now) while committing to structural deficit reduction over the medium term through tax reform or entitlement adjustments. This balances the short-run demand problem with long-run fiscal sustainability. Option A ignores the real risks of rising debt service costs and higher interest rates. Option B deepens the recession by pulling AD left when the economy is already weak. Option D ignores the active policy choices available.