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CA Foundation · Business Economics · Business Cycles

During a boom, when inflation is rising sharply and the economy is overheating, which combination of policy measures is consistent with a contractionary stabilisation approach?

Raising the repo rate and reducing government expenditure is the correct contractionary combination. Both measures lower aggregate demand, by making borrowing costlier and cutting public spending, which helps control inflation during a boom. The other options inject more money or demand and would push prices up further.

  1. ACut the repo rate and increase government spending
  2. BRaise the repo rate and reduce government expenditureCorrect
  3. CReduce the cash reserve ratio and cut taxes
  4. DRaise subsidies and lower the statutory liquidity ratio

Explanation

To cool an overheated economy, aggregate demand must be reduced. A higher policy rate makes credit costlier and lower government spending cuts demand directly. The other options all expand credit or demand and would worsen inflation, so they are expansionary.

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