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Microeconomics
Posted 9 months ago

The Central Bank of Hamsterville and the government of Hamsterville are trying to control inflation by engaging in contractionary monetary policy and contractionary fiscal policy, respectively. Assume that the budget of Hamsterville was balanced prior to engaging in contractionary fiscal policy.

What will be the impact of contractionary fiscal policy and contractionary monetary policy on real gross domestic product(GDP) and the interest rate of Hamsterville?

Choose 1 answer:

A Real GDP will decrease; interest rates will increase.
(B) Effect on real GDP will be indeterminate; effect on interest rates will be indeterminate.
(c) Real GDP will decrease; impact on interest rates will be indeterminate.
(D) Real GDP will decrease; interest rates will decrease.
(E) Real GDP will increase; interest rates will increase.
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Answer from Sia
Posted 9 months ago
Solution
a
Contractionary Fiscal Policy: Contractionary fiscal policy involves reducing government spending or increasing taxes. This leads to a decrease in aggregate demand, which typically results in a decrease in real GDP
b
Contractionary Monetary Policy: Contractionary monetary policy involves increasing interest rates or reducing the money supply. This also leads to a decrease in aggregate demand, further reducing real GDP
c
Combined Effect on Real GDP: Both contractionary fiscal and monetary policies reduce aggregate demand, leading to a decrease in real GDP
d
Effect on Interest Rates: Contractionary monetary policy directly increases interest rates. However, contractionary fiscal policy can have an indeterminate effect on interest rates because it depends on the relative magnitudes of the shifts in the supply and demand for loanable funds
Answer
(c) Real GDP will decrease; impact on interest rates will be indeterminate.
Key Concept
Contractionary Policies
Explanation
Contractionary fiscal and monetary policies both reduce aggregate demand, leading to a decrease in real GDP. The impact on interest rates is indeterminate because while contractionary monetary policy increases interest rates, contractionary fiscal policy can have varying effects depending on the shifts in the supply and demand for loanable funds.

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