Suppose the economy is operating below potential output. If policy makers try to avoid a budget deficit by raising taxes or reducing government spending, these actions would

Question

Quizplus · Accepted Answer

If the economy is operating below potential output, raising taxes or reducing government spending would result in a decrease in aggregate demand, further worsening the recession. This is because a decrease in government spending means there will be fewer government demand for goods and services, causing businesses to lose revenue and potentially lay off workers. This leads to a decrease in consumer confidence, which leads to a decrease in consumer spending. This decrease in aggregate demand will cause inflation to fall, not rise. Thus, the correct answer is C, making the recession worse.

Suppose the Economy Is Operating Below Potential Output