CFA Level I · CFA Level I Exam · Fiscal Policy
An economy is operating above potential GDP and inflation is accelerating. Which fiscal action is most likely appropriate to reduce inflationary pressure?
Raising taxes and reducing government spending is most appropriate. Both measures lower aggregate demand, which cools an economy running above potential output and eases inflation. Cutting taxes, raising transfers, or borrowing to spend would add demand and worsen inflationary pressure.
- ARaise taxes and reduce government spendingCorrect
- BReduce taxes and increase transfer payments
- CIncrease government spending financed by borrowing
Explanation
Overheating calls for lower aggregate demand. Higher taxes reduce disposable income and consumption, and lower spending directly reduces demand. The other two options raise demand and would add to inflation.
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