Which best explains how contractionary policies can hamper economic growth?
A They increase consumer demand.
B They can increase inflation.
C They reduce taxes which raises deficits.
D They reduce disposable income.
The correct answer and explanation is :
Correct Answer: D) They reduce disposable income.
Explanation:
Contractionary policies are economic tools used by governments or central banks to slow down economic growth, often in response to high inflation. These policies aim to decrease the money supply in the economy, reduce consumer spending, and control inflation. The two most common types of contractionary policies are contractionary fiscal policy and contractionary monetary policy.
Contractionary fiscal policy involves raising taxes or cutting government spending, both of which can reduce the overall demand in the economy. Contractionary monetary policy, on the other hand, often includes raising interest rates or selling government bonds, which makes borrowing more expensive and decreases the money supply.
The key impact of these policies is that they reduce disposable income, which is the amount of money individuals and households have left to spend or save after paying taxes. When people have less disposable income, they spend less on goods and services. This decline in consumer spending slows down business revenues, which can lead to reduced production, lower profits, and possibly layoffs or slowed hiring. As a result, economic growth is hampered.
Option D is correct because reduced disposable income directly leads to decreased consumer demand, lower business activity, and slower GDP growth. It reflects how contractionary policies achieve their goal of slowing inflation but at the cost of slowing the economy.
Let’s examine why the other options are incorrect:
- A) They increase consumer demand – This is false. Contractionary policies reduce, not increase, consumer demand.
- B) They can increase inflation – This is the opposite of their purpose. Contractionary policies are used to decrease inflation, not raise it.
- C) They reduce taxes which raises deficits – Contractionary policies typically increase taxes or cut spending, not reduce taxes. Lowering taxes is actually expansionary, not contractionary.
In summary, contractionary policies slow economic growth by reducing disposable income, which leads to decreased consumer spending and overall economic activity.