Question

The government can reduce inflation with the help of both fiscal and monetary policy. An effective combination of these policies to reduce inflation would be to _______ and _______ 

• Increase taxes; lower the reserve requirement ratio 

• Increase taxes; sell government bonds 

• Decrease taxes; buy government bonds 

• Decrease government spending; lower discount rate

Answer 1

The correct option would be

• Increase taxes , sell govt bonds

The reason being that decreasing inflation would require contractionary fiscal and monetary policy. Under contractionary fiscal policy, the government can increase taxes and decrease government spending, which would decrease the aggregate expenditure and the GDP, thereby shifting the IS curve and AD curve to the left. Under contractionary monetary policy, the central bank can reduce the money supply so that the interest rate would increase (since the LM curve shifts left in the IS curve) thereby reducing the GDP. A combination of both of these would reduce the inflation.

The appropriate fiscal policy to reduce inflation is mentioned in first, second and fourth option. In the first option, the lowering of the reserve requirement ratio would increase the value of money multiplier, and would increase the money supply. In the third option, the decrease in taxes is expansionary fiscal policy, and the buying of government bond would lead to infusion of money supply in the economy, ie it is an expansionary monetary policy. In the fourth option, the lowering of discount rate would mean to reduce the interest rate, which would occur when there is expansionary monetary policy. It is in the second option, where both the policies are contractionary, and would lead to decrease in price.