CA Foundation · Business Economics · Business Cycles
Suppose the economy is overheating, with demand-pull inflation building up near the peak of a business cycle. Which combination of policy actions is most appropriate to stabilise it?
Raising the repo rate and reducing government expenditure is correct. Both are contractionary measures that lower aggregate demand and cool demand-pull inflation near the peak. The other options include at least one expansionary step, such as lower rates, tax cuts, or higher spending, which would worsen the overheating.
- ACut the repo rate and increase government expenditure
- BRaise the repo rate and reduce government expenditureCorrect
- CCut taxes and raise the cash reserve ratio
- DRaise the repo rate and increase subsidies
Explanation
Overheating needs a contractionary policy to cut aggregate demand. A higher repo rate makes credit costlier and lower government spending reduces demand directly. The other options mix an expansionary measure (tax cut, rate cut, higher spending or subsidies) with a contractionary one, so they work against each other.
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