Question

For the purpose of restoring equilibrium in an economy currently operating at over full employment, what should be done?

• A. Taxes must be reduced
• B. Repo rate must be reduced
• C. Government expenditure must be reduced
• D. Securities must be purchased by the central bank

Answer 1

The Correct Option is C

To restore equilibrium in an economy operating at over full employment, it is essential to address the excessive demand causing inflationary pressures. One effective method is to reduce government expenditure. Here, we explain the reasoning behind this approach: 

1. Over full employment indicates that the economy is producing beyond its sustainable capacity, leading to demand-pull inflation.
2. To counteract this, the government should implement contractionary fiscal policies to reduce aggregate demand.
3. Reducing government expenditure directly lowers aggregate demand, helping to decrease inflationary pressures and bring the economy back to its potential output level.
4. This ensures resources are allocated efficiently without causing inflation, thus restoring equilibrium in the economy.

Therefore, reducing government expenditure is the appropriate action to stabilize an economy facing over full employment.

Answer 2

In an economy operating at over full employment equilibrium, inflationary pressures begin to build up because of excessive demand. When demand exceeds the economy's productive capacity, prices rise, leading to inflation.

To restore equilibrium and reduce inflationary pressures, the government can reduce its expenditure. This action will lead to a contraction in aggregate demand, effectively cooling down the economy and helping to control inflation.

It is important to note that reducing taxes or lowering interest rates would have the opposite effect. These actions would increase demand further, worsening the inflationary problem. With more disposable income and cheaper borrowing costs, consumption and investment would rise, thus pushing prices even higher.

Therefore, to tackle inflation in such a scenario, a reduction in government expenditure is a more effective tool for controlling demand and restoring balance in the economy.