Question

If the government implements an expansionary fiscal policy, what action can the central bank take to maintain a stable itnerest rate?

a. Increase the required reserve ratio

b. increase personal income tax rates

c. decrease personal income tax rates

d. sell government bonds

e. buy government bonds

Answer 1

Correct option is (d).

An expansionary fiscal policy is implemented by increasing government spending and/or by lowering tax, both of which increases budget deficit, to finance which, government resorts to borrowing. Higher borrowing increases interest rate, to stabilize (decrease) which, central bank uses contractionary monetary policy of lowering money supply, by selling government bonds in open market.

(Note: Money supply can be decreased by increasing required reserves too, but central banks prefer open market sale of government securities as the most commonly used monetary policy tool)