Question

Suppose that survey measures of consumer confidence indicate a wave of pessimism is sweeping the country. If policymakers donothing, what will happen to aggregate demand? What should the Fed do if it wants to stabilize aggregate demand? If the Fed does nothing, what might Congress do to stabilize aggregate demand? Would these monetary and fiscal policies be consideredexpansionary or contractionary?

How would critics of active monetary and fiscal policy respond to the above proposals to stabilize aggregate demand?

Answer 1

There is a wave of pessimism which is likely to bring recession in the economy.

If policymakers do nothing, aggregate demand will shift to the left because consumption is reduced. This reduces output level and price level so that recession reduces economic activity.

Fed should increase money supply if it wants to stabilize aggregate demand. This will shift the aggregate demand to the right, which raises output level and price level.

If the Fed does nothing, Congress can increase government spending or reduce taxes do to stabilize aggregate demand. This will shift the aggregate demand to the right, which raises output level and price level.

These monetary and fiscal policies are considered to be expansionary.

Critics argue that fiscal policy is less effective because of many lags in the policy, right from recognition to implementation. There are leakages in the economy as well such as saving for fiscal policy multiplier and consumption for money multiplier. This undermines the power of these policies.