Question

Question: Explain how each of the following illustrates one of the three principles of economy-wide interactions.

1. The White House urged Congress to pass a package of temporary spending increases and tax cuts in early 2009, a time when employment was plunging and unemployment soaring.
2. With oil prices plummeting, Canadian and U.S. oil companies have been forced to shut down their productive wells. In cities throughout North Dakota, Wyoming, Taxes, and Alaska, restaurants and other consumer businesses are failing.
3. In the mid-2000s, Spain, which was experiencing a big housing boom, also had the highest inflation rate in Europe.

Short answer

1. It depicts the concept that government policy changes spending.
2. It depicts the concept that one person’s income is another person’s spending.
3. It depicts that overall spending sometimes gets out of line with the economy’s productive capacity.

Step-by-step solution

Explanation for part (a)

The decision to increase the spending and reduce tax rates represents the suggestion to correct the issue of unemployment. As the tax rate declines, the consumer’s disposable income increases; consumer spending will increase with disposable income. Thus, the concept that government policy increases aggregate spending.

Explanation for part (b)

The fall in the oil prices makes the business unprofitable, which leads to shutdowns. The oil companies have laid off laborers from their companies, paying less to the remaining laborers, and thus, the workers' income falls. With the fall in income, their spending also reduces on the restaurant and other businesses. Thus, the concept is that one person’s spending is another person’s income.

Explanation for part (c)

The housing sector has high spending compared to the economy’s capacity to produce houses. As the spending is high and production is less, this will increase house prices in Spain. The price increase will spread to other sectors and eventually to countries involved in trading, thus, leading to a rise in the general price level or inflation in entire Europe. Hence, the overall spending sometimes gets out of line with the economy’s productive capacity.