Questions: Fiscal Policy

Question 1

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

• A. Congress passing an infrastructure spending bill during a recession
• B. Unemployment insurance payments that automatically rise as joblessness increases
• C. The Federal Reserve cutting interest rates in response to slowing growth
• D. A presidential executive order implementing a payroll tax holiday

Answer: (B)

Automatic stabilizers operate without any new legislative action — they respond mechanically to economic conditions. Unemployment insurance payments rise automatically when unemployment rises (injecting purchasing power during downturns) and fall during expansions. The other options all require deliberate discretionary decisions by Congress, the Fed, or the president, making them discretionary rather than automatic.

Question 2

A $100 billion tax cut stimulates aggregate demand by the same amount as $100 billion of direct government spending.

• T. True
• F. False

Answer: False

Government spending directly adds $100 billion to aggregate demand — every dollar spent is a dollar of AD before the multiplier applies. A tax cut increases household disposable income by $100 billion, but households save a fraction of each extra dollar (determined by the marginal propensity to save). Since the marginal propensity to consume (MPC) is less than one, only MPC × $100 billion flows directly into demand. The spending multiplier is therefore larger than the tax cut multiplier, a well-established result in Keynesian analysis.

Question 3

Describe the three types of lags that reduce the effectiveness of discretionary fiscal policy.

Model answer: Recognition lag: the delay before policymakers identify that the economy has deteriorated and needs intervention. Legislative lag: the time for Congress to debate, negotiate, pass, and sign fiscal legislation. Implementation lag: the time for appropriated funds to actually flow into the economy as spending. Together, these lags mean fiscal stimulus may arrive after the downturn has already begun to reverse.

These lags are why automatic stabilizers are often preferred for short-term stabilization — they act without any of these delays. Discretionary fiscal policy works better for large, prolonged downturns (like 2008-09) where there is enough lead time for the lags to matter less, and where the stimulus effect is needed over a sustained period rather than at a precise moment.