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I was studying for my macroeconomics test by solving test banks and I came upon this question which has been really bugging me.

To decrease the price level

A.the Fed could buy bonds and the government could increase the corporate profit tax.

B.A decrease in income tax and an increase in corporate profit tax

C.the Fed could sell bonds and the government could lower the corporate profit tax.

D.An increase in government spending and a decrease in the price of raw material

Answer : C

I don't understand why the answer is C. If I take it answer by answer:

A) Expansionary monetary policy + contractionary fiscal policy = unknown result (Aggregate demand curve could shift to the left or to the right depending on which policy was more effective).

B) Either contractionary or expansionary fiscal policy depending on the values of increases/decreases. Employee income surpasses corporate profits income in most cases so I would consider this expansionary fiscal policy which raises the price level.

C) Contractionary monetary policy + expansionary fiscal policy. Why would they choose this as the right answer? It's as ambiguous as the others, the shift in the AD curve is unknown.

D) Expansionary fiscal policy (shift of the AD curve to the right) + shift of the AS curve to the right (which lowers the price level), again leads to an unknown result for the price level)

Am I approaching these questions badly or are they as ambiguous as I think they are? Also, when monetary policy and fiscal policy oppose each other, which one takes the lead on the shift of the AD curve? I feel like that it would solve a lot of problems to know that.

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2 Answers 2

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I believe that tax policies refer to the supply side (AS). Since no information is given about government expenses in a, b and c, I would only shift AD in response to the monetary policy actions in a and c, and the explicit increase in goverment spending in option D.

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  • $\begingroup$ Thanks for your answer! If i understand correctly, I should consider tax changes to affect the AS curve instead of the AD curve? That sounds plausible to me because my book only mentions government spending for shifts in the AD curve. With your logic, answer C would be the right one too? Or is it still ambiguous? Because changes in AS curve also affect the price level. $\endgroup$
    – Omrane
    Dec 7, 2015 at 23:20
  • $\begingroup$ Correct! C would indeed be the right answer, AD and AS shift down. B and D are ambiguous. For D, AD shifts up and AS shifts down. For B AS shifts up and down. $\endgroup$
    – Wecon
    Dec 8, 2015 at 6:20
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It looks like a question with an error to me. I think the author of the question intended two contractionary policies for C: 'Sell bonds and increase taxes'.

Whenever I do tests from test banks, I often come across errors, especially if those test banks are free.

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