Aggregate Demand

Two economists debate a recession. One urges higher government spending to lift aggregate demand; the other argues that steady growth in the money supply matters most and that spending programs are largely self-defeating. Their positions are best labeled:

1. A.Keynesian and monetarist, respectively.Correct. Keynesian analysis prescribes fiscal demand management, while monetarism concentrates on the growth of the money supply.
2. B.Monetarist and Keynesian, respectively.Wrong. This reverses the two schools, assigning the spending prescription to the side that distrusts it.
3. C.Monetarist and supply-oriented, respectively.Wrong. The first position is not monetarist, and the second says nothing about incentives to produce.
4. D.Keynesian and mercantilist, respectively.Wrong. The second view concerns money growth, not trade surpluses and the accumulation of foreign reserves.

Why: Keynesian theory holds that output is driven by aggregate demand and that government spending and tax changes can fill the shortfall when private demand is weak. Monetarist theory holds that the quantity of money is the dominant influence on nominal activity and prices, and that discretionary fiscal action is offset or arrives too late. The practical difference between them is which lever each school reaches for, fiscal or monetary. Both accept that policy affects the economy; they disagree over which instrument does the work.

The federal government runs a budget surplus and uses it to retire outstanding Treasury debt. Considered on its own, this action is:

1. A.Expansionary fiscal policy, because bondholders receive cash that they are free to spend.Wrong. Bondholders are repaid principal they already owned, which is a swap of assets rather than new income.
2. B.Contractionary fiscal policy, because the government withdraws more than it puts back.Correct. A surplus means taxes collected exceed spending, so the fiscal balance drains demand from the economy.
3. C.Contractionary monetary policy, because retiring bonds shrinks the money supply.Wrong. Retiring Treasury debt is a Treasury action, and only Fed operations alter bank reserves as a matter of policy.
4. D.Neutral, because the money simply moves from taxpayers across to bondholders.Wrong. Taxpayers surrendered spendable income while bondholders received a return of capital, so the two do not cancel.

Why: The fiscal stance is measured by whether the government takes more out of the private economy in taxes than it puts back through spending. A surplus does exactly that, so its immediate effect on aggregate demand is contractionary whatever is done with the money afterward. Repaying bondholders returns principal rather than creating income, so it does not offset the drain. Contrast this with the Fed buying bonds in the open market, which does add reserves and is expansionary monetary policy.

Congress votes to raise the statutory limit on how much the Treasury may borrow. Considered on its own, what is the effect on aggregate demand?

1. A.Expansionary, because the government may now borrow and therefore spend more.Wrong. The limit governs borrowing capacity rather than spending levels, which earlier appropriations already fixed.
2. B.Essentially none, because it authorizes borrowing for spending already enacted.Correct. Raising the ceiling simply permits the Treasury to fund commitments Congress had already made.
3. C.Contractionary, because the additional borrowing will crowd out private investment.Wrong. Crowding out flows from the borrowing itself, and that borrowing was coming once the spending was enacted.
4. D.Expansionary, because newly issued Treasury debt adds directly to the money supply.Wrong. Treasury debt held by the public is not money, and issuing it does not expand the money supply.

Why: Fiscal stimulus comes from decisions about taxes and spending, not from the mechanics of funding them. The borrowing limit caps the Treasury's ability to issue debt to pay for commitments Congress already made in earlier legislation. Raising it changes no tax rate and appropriates no new dollar, so on its own it adds nothing to demand. Refusing to raise it would force an abrupt disruption in payments, which is a very different question from whether raising it is stimulative.