Fiscal Policy

Congress extends the duration of unemployment benefits during a downturn. This action is:

1. A.Fiscal policy, because it changes federal spending in order to support demand.Correct. Fiscal policy is federal taxing and spending, and extending a benefit program is a spending decision by Congress.
2. B.Monetary policy, because it places additional money into circulation.Wrong. Money paid out in benefits is money the Treasury already raised, and the money supply is the Fed's province.
3. C.Fiscal policy, but only if the extension is financed with newly issued federal debt.Wrong. How the spending is financed affects the deficit, not whether the action counts as fiscal policy.
4. D.Monetary policy, because it is a deliberate response to changing economic conditions.Wrong. Responding to economic conditions is what both branches of policy do, so it distinguishes nothing here.

Why: The dividing line is who acts and with what instrument. Fiscal policy is Congress and the President working through taxation and federal spending; monetary policy is the Federal Reserve working through the supply of reserves and the cost of credit. Extending a benefit program is an appropriation, so it falls on the fiscal side however it is funded. Had the Fed instead bought securities to add reserves to the banking system, that would be monetary policy aimed at the same downturn.

During a downturn, federal income tax receipts fall and unemployment benefit payments rise without Congress enacting anything new. This effect is best described as:

1. A.Monetary policy operating through the reserves of the banking system.Wrong. Neither the tax receipts nor the benefit payments involve reserves, credit conditions or any action by the Fed.
2. B.Discretionary fiscal policy enacted in response to the business cycle.Wrong. Discretionary means a new law or appropriation, and by hypothesis Congress enacted nothing.
3. C.An automatic stabilizer built into fiscal programs already in force.Correct. Existing tax and benefit rules cushion demand automatically as incomes and employment fall.
4. D.A leading indicator signaling the coming phase of the business cycle.Wrong. These flows respond to a downturn already under way rather than pointing ahead to one.

Why: Fiscal policy operates in two modes. Discretionary policy requires a fresh decision, such as enacting a tax cut or appropriating money for a program. Automatic stabilizers are built into laws already on the books: a progressive income tax collects less as incomes fall, and benefit programs pay out more as unemployment rises, both without any vote. The effect cushions the downturn immediately, which is why it escapes the legislative delay that dogs discretionary action.

Two economists debate a recession. One urges higher government spending to lift aggregate demand; the other argues that steady growth in the money supply matters most and that spending programs are largely self-defeating. Their positions are best labeled:

1. A.Keynesian and monetarist, respectively.Correct. Keynesian analysis prescribes fiscal demand management, while monetarism concentrates on the growth of the money supply.
2. B.Monetarist and Keynesian, respectively.Wrong. This reverses the two schools, assigning the spending prescription to the side that distrusts it.
3. C.Monetarist and supply-oriented, respectively.Wrong. The first position is not monetarist, and the second says nothing about incentives to produce.
4. D.Keynesian and mercantilist, respectively.Wrong. The second view concerns money growth, not trade surpluses and the accumulation of foreign reserves.

Why: Keynesian theory holds that output is driven by aggregate demand and that government spending and tax changes can fill the shortfall when private demand is weak. Monetarist theory holds that the quantity of money is the dominant influence on nominal activity and prices, and that discretionary fiscal action is offset or arrives too late. The practical difference between them is which lever each school reaches for, fiscal or monetary. Both accept that policy affects the economy; they disagree over which instrument does the work.

The federal government runs a budget surplus and uses it to retire outstanding Treasury debt. Considered on its own, this action is:

1. A.Expansionary fiscal policy, because bondholders receive cash that they are free to spend.Wrong. Bondholders are repaid principal they already owned, which is a swap of assets rather than new income.
2. B.Contractionary fiscal policy, because the government withdraws more than it puts back.Correct. A surplus means taxes collected exceed spending, so the fiscal balance drains demand from the economy.
3. C.Contractionary monetary policy, because retiring bonds shrinks the money supply.Wrong. Retiring Treasury debt is a Treasury action, and only Fed operations alter bank reserves as a matter of policy.
4. D.Neutral, because the money simply moves from taxpayers across to bondholders.Wrong. Taxpayers surrendered spendable income while bondholders received a return of capital, so the two do not cancel.

Why: The fiscal stance is measured by whether the government takes more out of the private economy in taxes than it puts back through spending. A surplus does exactly that, so its immediate effect on aggregate demand is contractionary whatever is done with the money afterward. Repaying bondholders returns principal rather than creating income, so it does not offset the drain. Contrast this with the Fed buying bonds in the open market, which does add reserves and is expansionary monetary policy.