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Difficulty: MediumFiscal Policy Tools and Economic Stabilization

During a period of persistent demand-pull inflation, an economy experiences rapid increases in the general price level driven by excess aggregate demand. Which of the following fiscal policy measures should the government adopt to stabilize the economy?

  1. Increase personal income tax rates and cut spending on public projectsAnswer
  2. B
    Reduce income tax rates and expand government expenditure on infrastructure
  3. C
    Sell government treasury bills in the open market and raise commercial bank reserve requirements
  4. D
    Increase government transfer payments to households while maintaining budget deficits

Answer

The government should implement contractionary fiscal policy by raising direct tax rates and cutting public spending to reduce aggregate demand and cool down inflation.
The correct action is to raise personal income taxes and reduce government spending. Higher tax rates lower disposable income for consumers, which decreases private consumption expenditure. Simultaneously, reduced government spending cuts public sector demand. Together, these contractionary fiscal measures lower aggregate demand and bring inflation under control.

Step-by-Step Solution

1
Identify the macroeconomic problem
The economy is experiencing demand-pull inflation caused by excessive aggregate demand.
Economic stabilization requires dampening total expenditure to align demand with supply.
2
Distinguish fiscal policy instruments from monetary policy instruments
Fiscal policy involves government taxation and spending, whereas monetary policy involves central bank reserve ratios, interest rates, and open market operations.
The question specifically asks for a fiscal policy solution.
3
Select the appropriate fiscal direction
Contractionary fiscal policy (higher taxes and reduced public spending) contracts disposable income and aggregate demand.
Reducing total demand lowers pressure on overall price levels.

Key Concept

Contractionary Fiscal Policy for Inflation Control
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Topics

Fiscal Policy Tools and Economic Stabilization

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