CA Foundation · Business Economics · Business Cycles
When the economy is overheating with inflation well above target, which combination of policy measures would be most appropriate to cool demand?
Raising the repo rate and reducing government spending is the right mix, because both are contractionary tools. Costlier credit and lower public spending reduce aggregate demand and cool an overheating economy, whereas rate cuts, tax cuts or higher spending would add demand and push inflation up further.
- ACut the repo rate and increase government spending
- BRaise the repo rate and reduce government spendingCorrect
- CCut the repo rate and reduce taxes
- DRaise government spending and lower the cash reserve ratio
Explanation
Inflation from excess demand calls for contractionary policy. Raising the repo rate makes credit costlier and cutting government spending reduces aggregate demand. The other options each include at least one expansionary tool that would add to demand and worsen inflation.
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