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Fiscal, Monetary and Supply-Side Policy: Question 1

Syllabus 5.1, 5.2

Multiple choice AS 1 mark

The government of Kelbrona wants to bring down persistently high inflation. It raises the average rate of income tax and cuts its own spending on public infrastructure projects, while leaving interest rates and the money supply unchanged.

Which term best describes this combination of policy actions?

Choose an answer to check it, then compare with the worked solution below.
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Worked solution

Step 1: Classify each policy action

Raising the average rate of income tax is a change in taxation, and cutting spending on infrastructure projects is a change in government spending. Both taxation and government spending are the two instruments of fiscal policy (not monetary policy (which works through interest rates, the money supply and credit regulations) and not supply-side policy (which works by trying to shift long-run aggregate supply, LRAS, typically through measures like training, infrastructure investment or deregulation) not by cutting them).

Step 2: Expansionary or contractionary?

A higher average tax rate reduces households’ disposable income, which tends to lower consumption. A cut in government spending directly reduces the G component of Aggregate Demand. Both changes act to reduce AD rather than increase it, so this is a contractionary fiscal stance, consistent with the government’s aim of bringing down inflation.

Step 3: Rule out the other options

  • Option A is wrong because interest rates and the money supply, the tools of monetary policy, are explicitly left unchanged in the scenario.
  • Option C is wrong on two counts: the actions described are fiscal tools (tax and spending), not supply-side tools, and even if they were supply-side tools, cutting infrastructure spending would not be an expansionary supply-side measure.
  • Option D correctly identifies the contractionary direction but misclassifies the instruments as supply-side rather than fiscal.

Final answer

Option B. Contractionary fiscal policy. Raising taxation and cutting government spending are both fiscal policy tools, and using them to reduce AD and cool inflation makes this a contractionary fiscal stance.