The chapter suggests that the economy, like the human body, has "natural restorative powers."
a. Illustrate the short-run effect of a fall in aggregate demand using an aggregate demand/aggregatesupply diagram. What happens to total output, income, and employment?
b. If the government does not use stabilization policy, what happens to the economy over time? Illustrate this adjustment on your diagram. Does it generally occur in a matter of months or a matter of years?
c. Do you think the "natural restorative powers" of the economy mean that policymakers should be passive in response to the business cycle?
Policymakers who want to stabilize the economy must decide how much to change the money supply, government spending, or taxes. Why is it difficult for policymakers to choose the appropriate strength of their actions?
The problem of time inconsistency applies to fiscal policy as well as to monetary policy. Suppose the government announced a reduction in taxes on income from capital investments, like new factories.
a. If investors believed that capital taxes would remain low, how would the government's action affect the level of investment?
b. After investors have responded to the announced tax reduction, does the government have an incentive to renege on its policy? Explain.
c. Given your answer to part b, would investors believe the government's announcement? What can the government do to increase the credibility of announced policy changes?
d. Explain why this situation is similar to the time-inconsistency problem faced by monetary policymakers.
Chapter 2 explains the difference between positive analysis and normative analysis. In the debate about whether the central bank should aim for zero inflation, which areas of disagreement involve positive statements and which involve normative judgments?
Why are the benefits of reducing inflation permanent and the costs temporary? Why are the costs of increasing inflation permanent and the benefits temporary? Use Phillips-curve diagrams in your answer.
Suppose the federal government cuts taxes and increases spending, raising the budget deficit to 12 percent of GDP. If nominal GDP is rising 5 percent per year, are such budget deficits sustainable forever? Explain. If budget deficits of this size are maintained for 20 years, what is likely to happen to your taxes and your children's taxes in the future? Can you personally do something today to offset this future effect?
Explain how each of the following policies redistributes income across generations. Is the redistribution from young to old or from old to young?
a. an increase in the budget deficit
b. more generous subsidies for education loans
c. greater investments in highways and bridges
d. an increase in Social Security benefits
What is the fundamental trade-off that society faces if it chooses to save more? How might the government increase national saving?