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Question
Microeconomics
Posted 5 months ago
King Thranduil of the Woodland Realm is trying to rescue the kingdom from a severe recession by engaging in expansionary fiscal policy. As a result of the expansionary fiscal policy, the Woodland Realm now has a budget deficit. Meanwhile, the president of the central bank is Smaug, who wants to maintain a steady interest rate.
What is the appropriate action for the central bank to take in order to reduce the impact of the expansionary fiscal policy on interest rates?
Choose 1 answer:
(A) Increase taxes
(B) Sell bonds
(c) Increase the reserve requirement
(D) Buy bonds
(E) Decrease taxes
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Answer from Sia
Posted 5 months ago
Solution
a
Expansionary Fiscal Policy: Expansionary fiscal policy involves increasing government spending or decreasing taxes to stimulate economic activity. This often leads to a budget deficit
b
Impact on Loanable Funds: The budget deficit increases the demand for loanable funds, which can lead to higher interest rates
c
Central Bank's Role: To counteract the increase in interest rates, the central bank can engage in open market operations
d
Buying Bonds: By buying bonds, the central bank increases the money supply, which helps to lower or stabilize interest rates
Answer
(D) Buy bonds
Key Concept
Open Market Operations
Explanation
The central bank can buy bonds to increase the money supply, which helps to reduce or stabilize interest rates in the face of expansionary fiscal policy.
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