President Obama recently agreed in December with Republicans in Congress to exte

Question

President Obama recently agreed in December with Republicans in Congress to extend existing tax cuts that were scheduled to expire December 31 and to create new tax cuts as well. Meanwhile, recent reports suggest that the economy may expand more than expected a couple of weeks ago and grow significantly in 2011, reducing unemployment.

(1)What does the tax agreement suggest about the possibility of crowding out in 2011 and beyond? Explain.

(2)Ben Bernanke is obviously an interested observer of all this. What should he and the Fed do in response to the tax cuts and the recent economic news? Explain. It may not be helpful in this regard to consider Mr. Bernanke's public statements.

Explanation / Answer

(1)This may be only considered an opinion. I would say that taxes are almost always considered to have a "crowding out" effect. Without the heavy burden of tax increases, the economy and capital markets will be able to function more efficiently. Money is kept into consumer's pockets who theoretically could use that money to spend and stimulate the economy. Also, no increase in the capital gains tax will likely mean that investors will be more likely to invest more money provided needed capital to businesses. This also stimulates the economy. So in the end, 2011 should not see a significant "crowding out" effect. This answers your questions regarding the tax deal. The "crowding out" effect in regards to government spending is another issue entirely. Let me know if that is also a question. (2) I was always told that there is a negative correlation between inflation and unemployment. With news that the economy will grow "significantly", this suggests that unemployment will decrease. To prevent inflation from becoming an issue, the FED should consider using open market operations to sell bonds thus contracting the money supply. This will in turn increase interest rates. A rise in interest rates prevents inflation thus keeping the dollar's value stable.

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