Question

Suppose the economy is at a level of output above the natural level. It could use __________ policy to stabilize the economy by __________ interest rates.

contractionary; decreasing

expansionary; decreasing

contractionary; increasing

expansionary; increasing

Answer 1

ANSWER: contractionary; increasing

When the economy is above its naturtal level, it means aggreagate demand is greater than usual. In the figure shown full employment level of income is at Yf (at equilibrium e). When investment increases than the usual level Aggregate demand curve shifts outside forming equilibrium at e1, whcih will cause an inflationary pressure on economy. Inorder to stabilise economy, aggragte demand has to be reduced. one method used to reduce aggregate demand is to  increasing interest rate . When interest rate increases, investment decreases and aggregate demand curve shift downward forming equilibrium at e.