15. Examine the following policy combinations: Fiscal policy Monetary policy (A)

Question

15. Examine the following policy combinations:

Fiscal policy                    Monetary policy
(A) Increase taxes            Increase the reserve ratio
(B) Decrease spending    Sell Treasury securities
(C) Decrease taxes       Buy Treasury securities
(D) Increase spending        Increase the reserve ratio
(E) Decrase taxes       Increase the discount rate

a) Suppose the economy starts out at full employment. Which combination would the best reaction to a demand shock (a negative shock to aggreagate demand)? Why?

b) Which combination would be the best response to a shock to aggregate supply? Why?

Explanation / Answer

a) (C) Decrease taxes       Buy Treasury securities

Negative demand shock means demand of goods and services decreases in the economy. This can be recover by increase in government spending or reduction in taxes and by buying of treasury securities. These fiscal and monetary instruments increases the money supply in the economy and resulted in the demand of goods and services.

b) Increase in reserve ratio, discount rate and selling of treasury securities reduces the supply of money in the economy. If we have to solve the problem of deficient supply due to AS shock then we have to increase the supply of money. So, (C) Decrease in taxes and Buy Treasury securities increases money supply.

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