In testifying before Congress in mid-2012, then Fed Chairman Ben Bernanke noted that the economic recovery “could be endangered by the confluence of tax increases and [government] spending reductions that will take effect early next year if no legislative action is taken.”
a. Use an IS–MP graph to show the effects of tax increases and government spending reductions on the output gap. Briefly explain what your graph shows.
b. In the same testimony, Bernanke referred to “the additional negative effects likely to result from public uncertainty about how these [taxing and government spending] matters will be resolved.” What components of aggregate expenditure might be affected by an increase in uncertainty? Use an IS–MP graph to show the effects of uncertainty on the output gap. Briefly explain what your graph is showing.