Question

Situation: Real GDP is growing stronger than anticipated; unemployment is at 3.5%; inflation has been accelerating from 4% last year to over 6% this year.

For each of the following policy actions, you must state whether you Agree or Disagree that the action should be taken in the economic situation as described above. In other words, if you believe it is the right thing to do, answer Agree. If you think it is not appropriate, answer Disagree.

1)Reducing bank reserve requirements

A) Agree

B)Disagree

2)Raising the tax on gasoline at the pump by 25 cents per gallon

A) Agree

B) Disagree

Answer 1

Situation: Real GDP is growing at a faster rate than anticipated growth rate, unemployment level is low and inflation is rising. So, we can say that it is a boom like situation (Aggregate demand is rising which is causing firm to produce more by employing more labor and rise in aggregate demand leads to inflation).

1)Reducing bank reserve requirements: Disagree

This is because if central bank decides to reduce the reserve requirement for commercial banks, it means they can lend more money in the economy, or indirectly we can say that by using this tool, central bank is pumping more money into the economy. As the money supply rises, the aggregate demand will increase further and hence inflation rate. So, considering the current scenario, the central bank should not reduce bank reserve requirements as it will cause price level to rise and aggregate demand to rise which creates a situation of excess demand.

2) Raising the tax on gasoline at the pump by 25 cents per gallon: Disagree

This is because gasoline is an important input. It is used in transportation og goods and services. Once, the tax on gasoline increases, it increases the cost of transportation of goods and services which means increase in cost of production. As the cost of production rises, the producers will supply less. The aggregate supply falls as compared to aggregate demand. It is the case of negative supply shock. This will shift the aggregate supply curve to left, which creates a situation of STAGFLATION, which is the combination of two situation, stagnant (or falling) output and inflation.