Suppose the economy has been producing its potential, but it is now experiencing a recession. Which of the following is a discretionary fiscal policy that would bring the economy closer to its potential output? Check all that apply.
1) A tax cut
2) A tax increase
3) The sale of bonds by the Fed
4) An additional $10 billion in spending on agricutural subsidies
1 3
1) and 2)
A discretionary fiscal policy refers to deliberate changes in government spending and taxation to influence the economy. In this case, when the economy is in a recession and needs to move closer to its potential output, the following options can be considered:
1) A tax cut: This is a correct option as a tax cut can increase disposable income, leading to increased consumer spending and aggregate demand, which can help stimulate the economy and move it closer to its potential output.
2) A tax increase: This is an incorrect option. Increasing taxes would reduce disposable income, leading to lower consumer spending and aggregate demand, which could further worsen the recession.
3) The sale of bonds by the Fed: This is an incorrect option. The sale of bonds by the Fed is a monetary policy tool, specifically Open Market Operations, that affects the money supply and interest rates and is not categorized as a discretionary fiscal policy.
4) An additional $10 billion in spending on agricultural subsidies: This is an incorrect option. Although increasing spending on agricultural subsidies may benefit a specific sector, it would not directly address the recession or help the economy move closer to its potential output.
Therefore, the correct answer is:
1) A tax cut
To determine which of the options would bring the economy closer to its potential output, we need to understand the impact of each policy.
1) A tax cut: This is a discretionary fiscal policy that can stimulate economic activity by putting more money in the hands of consumers and businesses. With more money available, consumers are likely to increase their spending, leading to an increase in aggregate demand and potentially boosting the economy towards its potential output. Therefore, a tax cut can bring the economy closer to its potential output.
2) A tax increase: This is a discretionary fiscal policy that reduces the disposable income of consumers and businesses. When taxes are increased, consumers have less money available to spend, which can lead to a decrease in aggregate demand. As a result, a tax increase is unlikely to bring the economy closer to its potential output.
3) The sale of bonds by the Fed: This option refers to a monetary policy action rather than a discretionary fiscal policy. The sale of bonds by the Federal Reserve is a contractionary monetary policy tool that aims to reduce the money supply. While it can impact interest rates and money supply, it does not directly address the level of economic activity. Therefore, this policy option is not relevant to the question.
4) An additional $10 billion in spending on agricultural subsidies: This is a discretionary fiscal policy that involves increased government spending. When the government spends more on agricultural subsidies, it injects more money into the economy, which can increase aggregate demand and potentially stimulate economic growth. Therefore, an additional $10 billion in spending on agricultural subsidies can bring the economy closer to its potential output.
Based on the above analysis, options 1) A tax cut, and 4) An additional $10 billion in spending on agricultural subsidies are the discretionary fiscal policies that would bring the economy closer to its potential output.