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In the context of Keynesian economics, what would be an ideal government response to an overheated economy ?
- A.Reduce taxes
- B.Implement contractionary fiscal policies
- C.Increase government spending
- D.Encourage consumer spending
Solution
Keynesian fiscal policy
Correct option: (b) Implement contractionary fiscal policies.
An economy is said to be 'overheated' when aggregate demand runs ahead of its capacity to produce, so prices rise sharply. Keynes treats this as a problem of excess demand, and fiscal policy is the tool used to pull that demand back.
A contractionary fiscal policy works in two ways at once: the government cuts its own spending and raises taxes, which lowers disposable income and therefore consumption.
The other three options - cutting taxes, raising government spending and encouraging consumers to spend - are all expansionary. They are the Keynesian cure for a recession, and in an overheated economy they would only add to inflation.
A contractionary fiscal policy works in two ways at once: the government cuts its own spending and raises taxes, which lowers disposable income and therefore consumption.
The other three options - cutting taxes, raising government spending and encouraging consumers to spend - are all expansionary. They are the Keynesian cure for a recession, and in an overheated economy they would only add to inflation.
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