Question

Which policy do you think the government should implement (1/2/3) in order the restore the output back to the maximum level during a stock market boom? Explain.       

Answer 1

During stock market boom, consumer wealth increases, which increases consumption and aggregate demand. AD curve shifts right, increasing price level and increasing output beyond maximum level.

To reduce output, government has to implement contractionary fiscal policy, using one or more of the following tools.

1. Decrease government spending, which directly reduces aggregate demand.

2. Increase personal income tax, which decreases disposable income. Lower disposable income reduces consumption and decreases aggregate demand, or

3. Increase corporate income tax, which decreases business profitability. Lower profitability reduces business investment, which decreases aggregate demand,