Q. Which of the following is/are NOT measure/measures to control deflation?
1.Increasing bank reserve limits
3.Cutting tax rates
Choose the correct answer from below given codes:
Explanation: Deflation is a serious economic issue that can exacerbate a crisis and turn a recession into a full-blown depression. When prices fall and are expected to drop in the future, businesses and individuals choose to hold on to money rather than spend or invest. This leads to a drop in demand, which in turn forces businesses to cut production and sell off inventories at even lower prices. Here are some ways that governments fight deflation.
Monetary Policy Tools:
- Lowering bank reserve limits: In a fractional reserve banking system, as in the U.S. and other developed nations, banks use deposits to create new loans. By regulation, they are only allowed to do so to the extent of the reserve limit. That limit has typically been set at around 5-10% in the U.S., meaning that for every $100 deposited with a bank, it can loan out $90 and keep $10 as reserves. Of that new $90, $81 can be turned into new loans and $9 kept as reserves, and so on, until the original deposit creates $1000 worth of new credit money: $100 / 0.10 multiplier. If the reserve limit is relaxed to 5%, twice as much credit would be generated, incentivizing new loans for investment and consumption.
- Quantitative easing: When nominal interest rates are lowered all the way to zero, central banks must resort to unconventional monetary tools. Quantitative easing (QE) is when private securities are purchased on the open market, beyond just treasuries. Not only does this pump more money into the financial system, but it also bids up the price of financial assets, keeping them from declining further.
Fiscal Policy Tools:
- Increasing government spending: Keynesian economists advocate using fiscal policy to spur aggregate demand and pull an economy out of a deflationary period. If individuals and businesses stop spending, there is no incentive for firms to produce and employ people. The government can step in as a spender of last resort with hopes of keeping production going along with employment. The government can even borrow money to spend by incurring a fiscal deficit. Businesses and their employees will use that government money to spend and invest until prices begin to rise again with demand.
- Cutting tax rates: If governments cut taxes, more income will stay in the pockets of businesses and their employees, who will feel a wealth effect and spend money that was previously earmarked for taxes. One risk of lowering taxes during a recessionary period is that overall tax revenues will drop, which may force the government to curtail spending and even cease operations of basic services. There has been conflicting evidence as to whether or not general and specific tax cuts actually stimulate the real economy.
Source: TMH Ramesh Singh