Check Yourself Solutions for Chapter 17 through Chapter 21

Chapter 17-1

  1. Individual income taxes plus Social Security and Medicare taxes represent 81% of federal revenues.

  2. A person in the fourth quintile pays an effective federal tax rate of 17.4%. On an income of $80,000, this would be $13,920 in tax. A person in the top quintile pays an effective rate of 25.5% on income of $160,000, thus a tax of $40,800. Because the person who made twice as much paid more than twice as much in tax, this gives evidence of progressivity in the tax system.

Chapter 17-2

  1. Social Security and Medicare spending currently account for just over 40% of federal spending.

  2. GDP gives us an idea of the capacity of the economy to pay debt so the debt-to-GDP ratio tells us what the debt is relative to the capacity to pay the debt.

Chapter 17-3

  1. In the next 40 years, Social Security and especially Medicare and Medicaid are likely to increase relative to GDP. This means that the level of overall government spending relative to GDP is likely to increase.

  2. If the pace of idea generation quickens, this will lead to a positive shift in the long-run aggregate supply growth curve. In other words, the economy will be able to produce more goods and services. This would lead to a decrease in the debt-to-GDP ratio (all other things equal). This would increase the government’s ability to pay for increased benefits for retirees.

B-14

Chapter 18-1

The two types of expansionary fiscal policy are the government spends more money, or the government cuts taxes and thereby gives people more money to spend.

Chapter 18-2

  1. The 2008 tax rebate was less powerful than expected because many people saved the rebate and paid down debt, rather than spending it.

  2. A permanent cut in income tax rates can generate a larger fiscal stimulus than a temporary cut because people likely will save a large portion of a temporary tax cut, to pay for future taxes. But if the tax cut is permanent, they may choose to spend more. Of course, telling people that a tax cut is permanent is quite different from getting people to believe that it is permanent!

  3. A permanent investment tax credit produces a smaller fiscal stimulus than a temporary investment tax credit because to get the temporary tax credit, firms must spend money on equipment right away but a permanent investment tax credit gives firms the option of waiting to invest.

Chapter 19-1

  1. Domestic producers gain from a tariff and domestic consumers lose.

  2. Trade protectionism leads to wasted resources because it shifts production from the lowest-cost producers to higher-cost producers.

  3. You hear more often about people who gain from trade restrictions than people who lose because the gains from trade restrictions are concentrated on a few winners, while the losses are diffused over many losers. Even though the total gains are smaller than the total losses, the concentrated benefits mean that the winners have a greater incentive to argue for trade restriction than the losers do to argue against it.

  4. In Figure 19.3, area C represents the deadweight loss; it results from the lost gains from trades not happening.

Chapter 19-2

  1. The movement of the garment trade overseas has been a net benefit for the United States because clothing is now much cheaper for U.S. consumers and U.S. workers specialize in the fields in which they are most productive.

  2. If the U.S. government subsidized the Silicon Valley computer industry, it would encourage more computer chip manufacturing, but at a higher cost (production would not be as efficient). This would be a waste of resources. Foreign competitors would be pushed out of the industry. Consumers of computer chips would benefit from the subsidy, but they would benefit by less than the cost to U.S. taxpayers.

B-15

Chapter 20-1

  1. If an inhabitant of Nebraska buys a German sports car for $30,000, this lowers the U.S. current account balance by $30,000.

  2. If a German sports car manufacturer opens a new plant in South Carolina, this investment is a capital account surplus for the United States.

  3. The current and capital accounts are two sides of the same coin. When the capital account is in surplus, the current account will tend to mirror that in deficit, and vice versa.

Chapter 20-2

  1. If the U.S. dollar is a safe haven currency, then in times of risk people will demand dollars, increasing their value.

  2. If the Fed increases the money supply, this will reduce the value of the dollar compared to the euro.

  3. If purchasing power parity holds and the nominal exchange rate is 1 pound for 2 dollars, a Big Mac should cost in London if it costs $4.00 in New York.

  4. A tariff will hinder market exchange and thus the arbitrage of differing prices. This limits purchasing power parity.

Chapter 20-3

  1. In the short run, a Fed increase in the money supply will cause a depreciation in the exchange rate, leading to an increase in U.S. exports. In the long run, the temporary boost to exports will dissipate, and the increase in the money supply will lead to inflation.

  2. In an open economy, monetary policy is more effective than fiscal policy. Expansionary monetary policy will tend to reduce interest rates, causing a currency depreciation and increased exports. In contrast, expansionary fiscal policy will tend to increase interest rates, causing an appreciation of the exchange rate and reduced exports.

Chapter 20-4

  1. A floating exchange rate describes when the value of a country’s currency is determined by the forces of supply and demand.

  2. The European Central Bank controls the monetary policy of the European Union.

Chapter 21-1

National voters have a smaller chance of influencing the election than do local voters, which suggests that people have a greater incentive to be informed about local issues. On the other hand, local issues are less important than national issues and there is less free information (e.g., from Jon Stewart) about local issues than about national issues, which suggests local voters would be even more rationally ignorant than national voters.

B-16

Chapter 20-2

  1. Because of the benefits that special interests receive from current programs, they would fight against the establishment of a commission to examine federal waste. If the commission was set up, these special interests would then try to “capture” the commission: argue that their specific programs were needed, and exert political pressure to keep these programs. The bearers of the costs of these programs—the taxpayers—are too large and diverse a group to zero in on any particular program. The commission idea might be popular, but the chance of its success is low.

  2. The beneficiaries of the local history collection at the library are the users of the collection. Ultimately, the taxpayers of the state pay for it. Benefits are concentrated on a small group, while the costs are spread over a large body of people (the taxpayers). Don’t be surprised if the reading room is named after the state senator!

Chapter 20-3

If voters are myopic, politicians could prefer a policy with small gains now and big costs later (let’s get reelected and maybe someone else will have to deal with the large costs down the road) than a policy with small costs now and large gains later (why jeopardize my chance to get reelected?). For these reasons, dealing with a large potential problem, such as the fiscal sustainability of Medicare, is often put off until the last minute when the solutions are much more difficult and costly.

Chapter 20-4

The free flow of ideas helps democracies function by getting alternatives out and on the table. Voters will always be rationally ignorant to some extent, but the more information that is out there and available at low cost, the more voters will be informed, at least about the big issues. Debate and dissent can improve the quality of ideas. The free flow of information reduces the possibility of corruption. New ideas help democracies adapt to changing conditions.