Wiley CPA Exam Review Page 1 of 3

Q: ECON-0072
An economy is at the peak of the business cycle. Which of the following policy packages is the most
effective way to dampen the economy and prevent inflation?

A: Increase government spending, reduce taxes, increase money supply, and reduce interest rates.
B: Reduce government spending, increase taxes, increase money supply, and increase interest rates.
C: Reduce government spending, increase taxes, reduce money supply and increase interest rates.
D: Reduce government spending, reduce taxes, reduce money supply, and reduce interest rates.

Answer A is incorrect because all of these items have the effect of expanding the economy and
causing inflation.

Answer B is incorrect because increasing the money supply has the effect of expanding the economy
and causing inflation.

The requirement is to identify the policy package that would be most effective at dampening the
economy and preventing inflation. Answer C is correct because reducing government spending,
increasing taxes, reducing the money supply, and increasing interest rates all have the effect of
dampening the economy and preventing inflation.

Answer D is incorrect because increasing taxes and interest rates have the effect of expanding the
economy and causing inflation.

Text Link

A. Monetary Policy

Depository institutions (banks, savings and loans, and credit unions, etc.) borrow savers’ money
and lend the money to consumers, businesses, and governments. The Federal Reserve (the US
central bank), through its open market controls the actions of depository institutions and can affect
the supply of money in the following ways:

1. Reserve requirements. When a bank lends money, it gives the borrower a check drawn on
the bank itself. The Federal Reserve controls a bank’s ability to issue check-writing deposits
by imposing a reserve requirement on checking deposits. The institution must hold in reserve
(much of which is on deposit at a Federal Reserve Bank) a certain percentage of their total
checking deposits. The Federal Reserve can influence interest rates by changing the reserve
requirements and therefore increasing or decreasing the supply of money. However, making
changes in reserve requirements is rarely done.

2. Open-market operations. A more common instrument of monetary policy is open-market

operations (by the Federal Open-Market Committee), which involves the purchase or sale
of government securities using the Federal Reserve Bank deposits. If the Federal Reserve
purchases government securities, they are able to increase the monetary supply and,
therefore, put downward pressure on interest rates. When a central bank is purchasing
government securities and expanding the money supply, it is called an expansionary open-
market operation. If a central bank is selling government securities it is said to be pursuing
a contractionary open-market operation, because this reduces the money supply.

3. The discount rate. When a bank has a reserve deficiency it may borrow funds from a
Federal Reserve Bank. By setting the discount rate for such borrowing, the Federal Reserve
can influence interest rates in the economy.

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4. Economic analysis. In making its monetary decisions, the Federal Open-Market Committee
does extensive economic analysis. In speeches by the members and when providing the basis
for its decisions insights are provided into the state of the economy. This information also
may have an effect on economic factors such as interest rates, business spending, and the
stock prices.

5. The Federal Reserve uses monetary policy to attempt to sustain economic growth while
keeping inflation under control. Monetary policy works on the principle that a decrease in
interest rates will stimulate the economy, and an increase in interest rates will slow the
economy. Lower interest rates tend to encourage consumer and business spending because
finance charges are lower. Higher interest rates tend to discourage spending because finance
charges are higher. It also encourages saving because the return on savings is higher.

6. The effects of monetary policy depend on their effects on the expectations of investors,
businesses, and consumers. If monetary expansion leads the financial markets to revise their
expectations about inflation, interest rates and output, the effect on output will be dramatic.
On the other hand, if expectations remain unchanged, the effects will be minimal.

7. Rational expectations assume that investors, firms, and consumers develop expectations
about inflation, interest rates, and output based on a consideration of all available
information. This is contrasted to adaptive expectations in which investors, firms and
consumers adjust their expectations based on new information. As an example, if they find
that inflation is higher than expected, they adjust their expectation upward.

B. Fiscal Policy

Fiscal policy is government actions, such as taxes, subsidies, and government spending, designed
to achieve economic goals. As an example, a reduction of taxes increases personal disposable
income, which will serve to stimulate economic activity. The economy may also be stimulated
through increased government spending. An increase in deficit, either due to an increase in
government spending or to a decrease in taxes, is called a fiscal expansion. On the other hand,
increases in taxes to reduce a deficit is called fiscal contraction.

1. Taxes. Taxes are levied by a government based on two general principles: (1) the ability to
pay (e.g., progressive income taxes), and (2) derived benefit (e.g., gasoline taxes used to pay
for roads). The following are the major types of taxes:

a. Income tax. Income taxes are levied on taxable income. In the US the rate structure is
generally progressive. However, there are a number of social and economic incentives
built into the system that dilute its progressive structure.

b. Property tax. Property taxes are levied based on wealth. They generally are progressive
based on the value of the property.

c. Sales tax. Sales taxes are levied based on the amount of income spent. Sales taxes are
viewed as regressive because low-income individuals pay the same percentage rate as
high-income individuals.

d. Wage taxes. The most significant wage tax in the US is the social security tax. This tax
is borne both directly (the employee’s share) and indirectly (the employer’s share) by
employees because without the tax, wages would be higher.

e. Value-added tax. A tax commonly used in other industrial nations is the value-added tax
(VAT). Value-added taxes are levied on the increase in value of each product as it

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proceeds through production and distribution processes. Ultimately, the tax is paid by the
final consumer. The VAT is thought to encourage savings because it taxes consumption
instead of earnings.

2. Both monetary and fiscal policy take time to have the desired effects for a number of reasons,
including

a. Consumers take time to adjust their consumption based on changes in personal disposal
income

b. Firms take time to adjust investment based on changes in sales

c. Firms take time to adjust spending based on changes in interest rates

d. Firms take time to adjust production based on changes in sales

3. Fiscal polices can have a large effect on the size of budget deficits. In the long and medium
run, a budget deficit reduction is likely to be beneficial to the economy. Lower budget
deficits usually mean more savings and investment, and therefore, more output. In the short
run, a reduction in budget deficit leads to reductions in spending and therefore less output.

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