Question

In his book The Optimum Quantity of Money​, Milton Friedman talks about a helicopter dropping​ $2,000 over a community. The cash dropped by the helicopter gives the people in this community more money to spend. A tax cut also has the same​ effect: it increases disposable income. Suppose tax​ cuts, analogous to the helicopter​ drop, were proposed as a method to shift the labor demand curve to the right following a recession. How effective do you think this policy would​ be? A. Somewhat​ effective, but only to the extent that most of the tax cut is concurrently spent on domestic​ output, that multiplier effects​ occur, and crowding out is small. B. Very​ effective, since tax cuts are concentrated among wealthy individuals who usually spend all or most of the extra income. C. Not​ effective, since the majority of the tax cut is saved and any portion spent leads to complete crowding out. D. Not​ effective, since the tax cuts go to consumers rather than to the employers​ (demanders) of labor.

Answer 1

Answer:

A) Somewhat​ effective, but only to the extent that most of the tax cut is concurrently spent on domestic​ output, that multiplier effects​ occur, and crowding out is small.

Explanation:

First of all, the larger amount of money would increase the inflation rate since aggregate supply hasn't increased. The number of goods and services offered do not vary, then only thing that varies is the amount of disposable money.

The larger the multiplier, the larger the positive effect. The multiplier formula = 1 / MPS (marginal propensity to save). Even though inflation increases, still the economy is going to grow. That unless the local residents decide to purchase many imported goods. The larger the amount of imported goods purchased, the lower the positive effects.

This type of policy can be very effective under conditions where deflation or inflation rates are near 0 or even negative. Although high inflation is very bad for the economy, a small amount of inflation is always needed to boost economic growth. The healthy inflation is around 1.5 - 2% per year. This way salaries and wages can grow, pushing aggregate demand and supply.