Final answer:
A potential problem with a temporary tax decrease is that individuals may save rather than spend the extra funds, thus not increasing aggregate demand as intended. People often respond more to permanent policy changes, making temporary cuts less effective. Additionally, such temporary measures can have adverse long-term effects on national savings.
Step-by-step explanation:
What is a potential problem with a temporary tax decrease designed to increase aggregate demand if people know that it is temporary? One potential problem with a temporary tax decrease is that people may choose to save the extra money instead of spending it. This is because individuals might anticipate that the tax decrease is short-lived and prefer to hold onto the additional funds for when tax rates revert back to their original levels. This behavior does not contribute to an increase in aggregate demand, which is the intended purpose of the tax cut.
Moreover, it's important to consider the difference in behavior that a temporary tax policy might elicit compared to a permanent change. Typically, individuals and firms are likely to react more strongly to a permanent policy change than a temporary one, as a permanent change affects their long-term financial planning. Temporary fiscal policies are less effective in influencing spending behavior because people may not see a need to adjust their long-term financial plans for a short-term change.
Additionally, temporary tax cuts can lead to undesired economic outcomes, such as not significantly boosting aggregate demand or contributing to national savings decline over the long run. The latter can have negative effects on the future standard of living, as a decrease in national savings means the economy builds up its capital stock more slowly.