Check Your Understanding

1. Question

   In each of the following cases, determine whether the policy is an expansionary or contractionary fiscal policy:

   1. Several military bases around the country, which together employ tens of thousands of people, are closed.

      This is a contractionary fiscal policy because it is a reduction in government purchases of goods and services.

   2. The number of weeks an unemployed person is eligible for unemployment benefits is increased.

      This is an expansionary fiscal policy because it is an increase in government transfers that will increase disposable income.

   3. The federal tax on gasoline is increased.

      This is a contractionary fiscal policy because it is an increase in taxes, which will reduce disposable income.

2. Question

   Explain why federal disaster relief, which quickly disburses funds to victims of natural disasters such as hurricanes, floods, and large-scale crop failures, will stabilize the economy more effectively after a disaster than relief that must be legislated.

   Federal disaster relief that is quickly disbursed is more effective at stabilizing the economy than legislated aid because there is very little time lag between the time of the disaster and the time when relief is received by victims. In contrast, the process of creating new legislation is relatively slow, so legislated aid is likely to entail a time lag in its disbursement, potentially destabilizing the economy.

3. Question

   Suppose someone says, “Using monetary or fiscal policy to pump up the economy is counterproductive—you get a brief high, but then you have the pain of inflation.”

   1. Explain what this means in terms of the AD–AS model.

      An economy is overstimulated when an inflationary gap is present. This will arise if an expansionary monetary or fiscal policy is implemented when the economy is currently in long-run macroeconomic equilibrium. This shifts the aggregate demand curve to the right, in the short run raising the aggregate price level and aggregate output and creating an inflationary gap. Eventually, nominal wages will rise and shift the short-run aggregate supply curve to the left, and aggregate output will fall back to potential output. This is the scenario predicted by the speaker.

   2. Is this a valid argument against stabilization policy? Why or why not?

      No, this is not a valid argument. When the economy is not currently in long-run macroeconomic equilibrium, an expansionary monetary or fiscal policy does not lead to the outcome described above. Suppose a negative demand shock has shifted the aggregate demand curve to the left, resulting in a recessionary gap. An expansionary monetary or fiscal policy can shift the aggregate demand curve back to its original position in long-run macroeconomic equilibrium. In this way, the short-run fall in aggregate output and deflation caused by the original negative demand shock can be avoided. So, if used in response to demand shocks, fiscal or monetary policy is an effective policy tool.