A Stitch in Time Could Be Harmful
Subject Economic Slowing
Topic Recession
Key Words Recession, Supply-Side Shocks, Interest Rates
News Story

Alan Greenspan, chairman of the Federal Reserve, and Treasury Secretary Paul H. O'Neil told the Senate Banking Committee that the government should not rush to adopt measures to stimulate the economy. The economy is expected to decline for a short time, in part due to the terrorist attack on September 11. Greenspan said that it is too early to tell whether the downturn is the result of the loss of physical assets that will be quickly replaced, or something more serious.

Greenspan said, "But as we struggle to make sense of our profound loss and its immediate consequences for the economy, we must not lose sight of our longer-term prospects, which have not been significantly diminished by these terrible events." The Federal Reserve put $100 billion into the U.S. banking system to cushion disruptions from the attack on the financial district of New York. The Fed also reduced interest rates by one-half percent, to 3 percent.

There were signs that the U.S. economy was beginning to stabilize after a period of slowing growth. As a result of the terrorist attack, the airline and travel industries were severely disrupted. Retail sales suffered as people stayed home, and the financial sector suffered a major setback as stock market prices fell. The Administration is planning to allocate some or most of the budget surplus for the next few years to fight terrorism and provide relief to the areas and industries most affected by the terrorist attack. In addition, the Administration has also started looking at stimulus packages as a reaction to the decline in economic activity. Among the measures being proposed are an increase in the minimum wage, a supplement for people that pay no income taxes and a reduction in the capital gains tax. A decrease in the capital gains tax has the advantage of providing a boost to stock prices because it would increase a company's after-tax income. Mr. Greenspan warned that pumping money into the economy to spark a turnaround could put upward pressure on interest rates and thereby hurt the economy's long-term prospects.

(Updated October 1, 2001)

1. Using an aggregate supply/aggregate demand diagram, show the impact on the economy of a loss of productive assets. Which curve(s) are affected? What is the impact of these shifts? What happens to aggregate income and the aggregate price level?
2. Using your diagram, illustrate the impact of federal programs that provide government funding for rebuilding these assets.
3.. Greenspan is cautioning Congress against providing too much stimulus. Could fiscal policy go too far? That is, what happens if the government provides unneeded economic stimulus?
Source John M. Berry, "Don't Rush Stimulus, Greenspan and O'Neil Warn," The Washington Post, September 21, 2001.

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