Fiscal Policy worksheet
The answer key prints on its own page, so hand out everything before it.
Fiscal Policy: practice worksheet
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
2. If the marginal propensity to consume (MPC) is 0.8, the spending multiplier is:
- (A) 2
- (B) 4
- (C) 5
- (D) 10
3. Which of the following is an example of an automatic stabilizer?
- (A) A congressional vote to increase infrastructure spending
- (B) A presidential announcement of a tax rebate
- (C) Unemployment benefits that rise automatically as joblessness increases
- (D) A Federal Reserve decision to lower interest rates
4. 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
5. In the AD/AS model, contractionary fiscal policy would:
- (A) Shift AD to the left, decreasing the price level and real GDP
- (B) Shift AD to the right, increasing the price level and real GDP
- (C) Shift SRAS to the right, decreasing the price level
- (D) Shift LRAS to the left, decreasing potential output
6. 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
7. The crowding-out effect refers to the situation where:
- (A) Government spending on infrastructure displaces private workers in the construction industry
- (B) Increased government borrowing pushes up interest rates, reducing private investment
- (C) Tax cuts reduce consumer spending as households save the extra income
- (D) Trade deficits reduce domestic production capacity
8. 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)
9. If the economy is in a recessionary gap, the appropriate fiscal policy response is to:
- (A) Decrease government spending to reduce the budget deficit
- (B) Increase taxes to control inflation
- (C) Increase government spending or cut taxes to shift AD right
- (D) Decrease the money supply to lower interest rates
10. 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
Fiscal Policy: answer key
1. (B) 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. (C) 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. (C) Automatic stabilizers kick in without any new legislation. Unemployment insurance is the cleanest example. Eligibility rules were set years ago, so when layoffs spike, claims ramp up automatically and pump money into household budgets. Unemployment claims went from 211,000 a week in February 2020 to 6.9 million a week by late March 2020 with zero new votes in Congress. Options A and B are discretionary actions that require legislative or executive decisions. Option D is monetary policy, which also requires an active Fed decision.
4. (B) 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.
5. (A) Contractionary fiscal policy cuts spending or raises taxes, which pulls AD left. Output falls along SRAS, and the price level drops. The policy is aimed at inflationary gaps, but it's politically difficult because nobody wants to vote for tax hikes or spending cuts. Option B describes expansionary policy, which is the opposite. Options C and D incorrectly locate fiscal policy on the supply side of the AD/AS model.
6. (D) 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.
7. (B) When the government borrows heavily to fund a deficit, it competes with private borrowers for the same pool of savings. Interest rates rise. Factories that would have been built at 4% don't pencil out at 7%. Developers shelve projects. Car buyers decide they can't afford the monthly payment. Net result: part of the stimulus effect gets eaten by the private investment that didn't happen. During the 2008 crisis, this effect was minimal because rates were already near zero and private investment had already collapsed. Option A confuses labor-market effects with the financial channel that defines crowding out.
8. (D) 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.
9. (C) Recessionary gap means output is below potential GDP and unemployment is above the natural rate. Expansionary fiscal policy pushes AD right, raising output and prices. That closes the gap. Option A would make the recession worse by pulling AD further left. Option B is contractionary and wrong for this situation. Option D is monetary policy, not fiscal, and decreasing the money supply would raise rates, not lower them.
10. (B) 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).