Which combination of fiscal policy actions would be most contractionary for an economy experiencing severe demand-pull inflation?
a. increase taxes and government spending
b. decrease taxes and government spending
c. increase taxes and decrease governmnet spending
d. decrease taxes and increase government spending
c. Both policy actions would cool (contract) the economy
. Both policy actions would cool (contract) the economy
To combat severe demand-pull inflation in an economy, the most contractionary combination of fiscal policy actions would be to increase taxes and decrease government spending.
By increasing taxes, individuals and businesses would have less disposable income, which would reduce their spending. This reduction in spending would help to decrease the overall demand in the economy, thereby alleviating the inflationary pressure.
Simultaneously, decreasing government spending would also contribute to a contractionary effect. The government's reduced spending would lead to a decrease in the demand for goods and services, further helping to mitigate the inflationary pressures.
Therefore, the combination of increasing taxes and decreasing government spending (option c) would be the most effective contractionary fiscal policy approach in addressing severe demand-pull inflation.
To determine which combination of fiscal policy actions would be most contractionary for an economy experiencing severe demand-pull inflation, we need to understand the impact of each policy action on aggregate demand.
Demand-pull inflation occurs when the overall level of demand in the economy exceeds the available supply, leading to rising prices. To address this situation, the government would want to implement contractionary fiscal policy measures.
a. Increase taxes and government spending: This policy combination would consist of two expansionary measures. Increasing taxes reduces disposable income, which can lower consumer spending and overall demand. However, increasing government spending would inject more money into the economy, potentially increasing demand. This policy combination does not align with the goal of contractionary policy.
b. Decrease taxes and government spending: This policy combination would be contractionary. Decreasing taxes boosts disposable income, encouraging consumers to spend more. However, reducing government spending can reduce overall demand, as the government decreases its own consumption and investment. This combination is somewhat contractionary but might not be as effective in addressing severe demand-pull inflation.
c. Increase taxes and decrease government spending: This combination is the most contractionary among the options. Increasing taxes effectively reduces disposable income, leading to a decrease in consumer spending and overall demand. Simultaneously, decreasing government spending reduces the injection of funds into the economy, further contracting demand. By implementing both measures, this combination aims to cool down the economy and address demand-pull inflation.
d. Decrease taxes and increase government spending: This combination is expansionary in nature. Decreasing taxes increases disposable income, encouraging higher consumer spending and demand. Additionally, increasing government spending injects more funds into the economy, further boosting aggregate demand. This policy combination does not align with the objective of contractionary fiscal policy.
Therefore, the correct choice is c. Increase taxes and decrease government spending, as it would be most contractionary for an economy experiencing severe demand-pull inflation.