Question

Q.1. You’re flipping through the newspaper, reading about shocks that have hit the U.S. economy and reading what Congress is planning to do about the shocks. (Remember that “shocks” can be either good or bad.) Is Congress even getting the direction of
its response right? And if it is getting the basic direction correct, is it fighting against a long-run aggregate supply shock, where a fiscal response may not be very effective? While these policy choices will each have effects on long-run growth and on income distribution, in this chapter you should focus only on the big picture effect on aggregate demand. In each of the following cases, state whether the action taken by Congress is likely to be in the wrong direction, the correction direction for an AD shock, or the correction direction for a long-run aggregate supply shock but expect a big change in inflation.

b. Many banks have failed, and the money supply has fallen. In response, Congress decides to cut back on government purchases to save money. (2 points)

Answer 1

Wrong direction

1. Many banks have failed, and the money supply has fallen. In response, Congress decides to raise income taxes to pay down the federal debt.
2. Many banks have failed, and the money supply has falhlen. In response, Congress decides to cut back on government purchases to save money.
3. Oil prices double over the course of a year, from $2 per gallon to $4 per gallon. In response, Congress raises taxes on companies that refine and deliver petroleum products.

Correct direction for an AD shock

1. A wave of investor euphoria (“irrational exuberance”) about the Internet has increased spending growth. Congress raises income taxes on the richest Americans in response.
2. The Federal Reserve has followed a slow-money-growth policy, despite the wishes of Congress. In response, Congress cuts taxes and increases government purchases.

Correct direction for a Solow growth shock, but expect a big increase in inflation.

1. Oil prices double over the course of a year, from $2 per gallon to $4 per gallon. In response, Congress sends $300 checks to every American family so that people can better afford to pay for gas.