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. Fit each of the following cases into one of three categories:
1. Wrong direction
2. Correct direction for an AD shock
3. Correct direction for a long-run aggregate supply shock, but expect a big change in inflation
a. Many banks have failed, and the money supply has fallen. In response, Congress decides to raise income taxes to pay down the federal debt. (Historical note: This policy response was similar to FDR’s campaign platform when he ran for president in 1932.) b. Many banks have failed, and the money supply has fallen. In response, Congress decides to cut back on government purchases to save money.
c. A wave of investor euphoria (“irrational exuberance”) about the Internet has increased spending growth. Congress raises income taxes on the richest Americans in response.
d. Oil prices double over the course of a year, from $3 per gallon to $6 per gallon. In response, Congress sends $300 checks to every American family so that people can better afford to pay for gas.
e. Oil prices double over the course of a year, from $3 per gallon to $6 per gallon. In response, Congress raises taxes on companies that refine and deliver petroleum products.
f. The Federal Reserve has followed a slow-money-growth policy, despite the wishes of Congress. In response, Congress cuts taxes and increases government purchases.