Macroeconomics for Business 2080 Board Question Paper

Four Features of Macroeconomics

1. Analysis of Economy-Wide Aggregates: Investigates aggregate indicators such as GDP, national income, general price level, and total employment.
2. General Equilibrium Framework: Analyzes the simultaneous interaction and balance across goods, factor, and money markets.
3. Policy-Driven Science: Provides actionable analytical frameworks for national budgetary and monetary policy design.
4. Dynamic Focus: Emphasizes long-term economic growth trends, structural transformation, and business cycle fluctuations.

Effective Demand

Effective demand is the point on the aggregate demand schedule where aggregate demand price ($ADP$) exactly equals aggregate supply price ($ASP$):

$$ADP = ASP$$

It represents the actual level of expenditure at which entrepreneurs expect to recover their production costs and standard profits, directly determining the equilibrium level of employment and output in a Keynesian economy.

Components of Labor Market Equilibrium

1. Demand for Labor ($N_d$): Downward-sloping function of the real wage ($N_d = f(W/P)$), derived from the diminishing marginal productivity of labor ($MP_L = W/P$).
2. Supply of Labor ($N_s$): Upward-sloping function of the real wage ($N_s = g(W/P)$), reflecting the substitution of leisure for work.
3. Equilibrium Real Wage ($W/P^*$): The market-clearing wage where labor demand equals labor supply ($N_d = N_s$), ensuring full employment in classical theory.

Profit-Push Inflation

Profit-push inflation (also known as mark-up inflation or administered price inflation) occurs when oligopolistic or monopolistic firms exploit their dominant market power to artificially raise profit margins and selling prices above competitive levels, even in the absence of cost increases or excess aggregate demand.

Two Implications of Say’s Law of Markets

1. Impossibility of General Overproduction: Aggregate production automatically generates equivalent aggregate purchasing power; hence, prolonged general overproduction or glut in the market is impossible.
2. Impossibility of Involuntary Unemployment: Flexible wages and prices guarantee that any surplus labor is quickly absorbed, maintaining automatic full employment.

Economic Values Used in Computing Rate of Inflation

1. Consumer Price Index (CPI): Measures price changes of a fixed consumer basket of goods and services purchased by typical households.
2. Wholesale Price Index (WPI) / Producer Price Index (PPI): Measures average price movements at wholesale or manufacturing factory-gate levels.
3. GDP Deflator: Ratio of Nominal GDP to Real GDP, reflecting price changes across all domestically produced final goods and services.

Cost Drivers of Globalization

Cost drivers are factors that compel multinational firms to expand global operations to reduce production costs and gain competitive advantages:

1. Economies of Scale & Scope: Accessing global markets allows firms to manufacture in large volumes, lowering per-unit fixed costs across specialized product lines.
2. Labor Cost Differentials: Relocating labor-intensive manufacturing or digital back-office services to developing nations with competitive wage rates (e.g., outsourcing to South Asia).
3. Access to Low-Cost Raw Materials & Resources: Establishing facilities near natural resources, affordable renewable energy, or agricultural raw materials reduces procurement expenses.
4. Logistics & Technological Advancements: Modern containerized shipping, automated port handling, and low-cost telecommunications significantly reduce transport and coordination costs.
5. High Product Development & R&D Costs: Spreading high initial fixed investments in research, pharmaceutical clinical trials, or software across worldwide consumers.

Assumptions of Keynes’s Psychological Law of Consumption

1. Normal Economic Conditions: The law applies during normal, peacetime economic environments without hyperinflation, war, or revolution.
2. Stable Institutional and Psychological Factors: Consumer habits, customs, income distribution, population size, and price levels remain constant.
3. Laissez-Faire Free Enterprise System: Consumers possess sovereign freedom to allocate income between consumption and savings without rationing or state coercion.

Three Core Values of Economic Development (Michael Todaro)

1. Sustenance (The Ability to Meet Basic Needs): Ensuring universal access to life-sustaining basic necessities: food, shelter, healthcare, and security.
2. Self-Esteem (To Be a Person): Cultivating national identity, dignity, self-respect, and freedom from domestic and international exploitation.
3. Freedom from Servitude (To Be Able to Choose): Expanding human capabilities, political freedoms, and the range of personal and social choices.

Components of Financial Inclusion

1. Access to Financial Services: Physical and digital availability of formal banking points, microfinance branches, and mobile banking agents.
2. Usage of Financial Services: Depth, regularity, and frequency of using deposit accounts, payment networks, formal credit lines, and insurance policies.
3. Quality of Financial Services: Affordability, consumer protection, transparency, and suitability of financial products tailored to marginalized households.

Static Analysis in Macroeconomics

Macro-static analysis is the study of macroeconomic equilibrium at a given point in time, assuming other conditions remain unchanged (ceteris paribus). It investigates the relationships among macroeconomic aggregates without considering the path, time lags, or adjustment process required to achieve that equilibrium.

1. Core Characteristics of Static Analysis:

• Timeless Nature: All variables in the structural model are dated to the same time period ($Y_t = C_t + I_t$). It is a frozen snapshot of an economic state.
• Resting Position Focus: It determines the final resting equilibrium position where conflicting economic forces (such as aggregate demand and supply, or savings and investment) balance each other.
• Simultaneous Relations: Equations are solved simultaneously without dynamic difference equations.

2. Types of Macro-Static Analysis:

1. Simple Macro-Statics:
   • Examines a single equilibrium state at a specific point in time (e.g., determining equilibrium national income where $Y = C + I$).
2. Comparative Macro-Statics:
   • Compares two different equilibrium states resulting from a change in an exogenous parameter (e.g., comparing initial equilibrium $Y_1$ with new equilibrium $Y_2$ after an autonomous shift in investment $\Delta I$).
   • Limitation: It explains where the economy settles, but not how or how fast it traversed between the two equilibria.

3. Strengths and Limitations:

• Strengths: Elegantly simplifies complex economic realities, provides clear analytical solutions, and serves as an indispensable baseline for policy evaluation.
• Limitations: Unrealistic assumption of instantaneous adjustments; ignores transitional unemployment, price adjustment frictions, and business cycle oscillations.

Derivation of Investment and Tax Multipliers

Consider a standard closed three-sector Keynesian economy:

$$Y = C + I + G$$

$$C = a + b(Y - T)$$

Where:

• $a = \text{Autonomous consumption}$
• $b = \text{Marginal Propensity to Consume (MPC)}$, where $0 < b < 1$
• $T = \text{Autonomous lump-sum tax}$
• $I = \text{Autonomous investment}$
• $G = \text{Autonomous government expenditure}$

Substitute $C$ into the equilibrium condition:

$$Y = a + b(Y - T) + I + G$$

$$Y = a + bY - bT + I + G$$

$$Y - bY = a - bT + I + G$$

$$Y(1 - b) = a - bT + I + G$$

$$Y = \frac{a + I + G - bT}{1 - b}$$

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1. Derivation of Investment Multiplier ($K_i$):

Suppose autonomous investment increases by $\Delta I$, while $a, G,$ and $T$ remain constant. Taking the change in income $\Delta Y$:

$$\Delta Y = \frac{\Delta I}{1 - b}$$

Dividing both sides by $\Delta I$:

$$K_i = \frac{\Delta Y}{\Delta I} = \frac{1}{1 - b} = \frac{1}{MPS}$$

Significance: Because $0 < b < 1$, the investment multiplier is strictly greater than 1. An initial injection of investment generates a multiple expansion in national income through successive rounds of consumption spending.

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2. Derivation of Tax Multiplier ($K_t$):

Now suppose autonomous lump-sum tax increases by $\Delta T$, while $a, I,$ and $G$ remain constant:

$$\Delta Y = \frac{-b \cdot \Delta T}{1 - b}$$

Dividing both sides by $\Delta T$:

$$K_t = \frac{\Delta Y}{\Delta T} = -\frac{b}{1 - b}$$

Key Properties:

• The negative sign demonstrates an inverse relationship: higher taxes shrink disposable income ($Y_d$), reducing consumer demand and lowering equilibrium national income.
• The absolute value of the tax multiplier is always less than the investment multiplier ($|K_t| < K_i$) because a portion of the tax cut is saved rather than spent ($K_i - |K_t| = \frac{1 - b}{1 - b} = 1$, the Balanced Budget Multiplier).

Factors Causing Poverty in Nepal

Poverty in Nepal is multidimensional, rooted in historical, economic, geographic, and institutional factors:

1. Low Agricultural Productivity and Land Fragmentation:
   • Over 60% of the population depends on subsistence agriculture characterized by fragmented landholdings, lack of year-round irrigation, traditional tools, and vulnerability to monsoon vagaries.
2. Sluggish Industrialization and Job Creation:
   • Slow growth in domestic manufacturing fails to absorb the semi-skilled labor pool, leaving youths reliant on low-wage informal work or overseas migration.
3. Difficult Topography and Regional Disparities:
   • Rugged Himalayan and hilly terrains increase the unit cost of infrastructure delivery, leaving remote districts (e.g., Karnali and Sudurpashchim) economically isolated.
4. Deficits in Human Capital (Health & Education):
   • Disparities in access to quality education and affordable healthcare diminish earning potential and trap families in intergenerational poverty cycles.
5. High Dependency on Fragile Remittances:
   • Remittances have reduced absolute poverty headcount, but heavy reliance exposes families to global labor market volatility without creating sustainable domestic wealth.
6. Vulnerability to Natural Disasters and Climate Change:
   • Frequent earthquakes, floods, and landslides destroy physical assets and livelihoods, pushing vulnerable near-poor households back below the poverty line.
7. Governance Deficits and Inefficient Public Spending:
   • Leakages, bureaucratic delays, and weak implementation of poverty alleviation programs dilute public welfare impact.

Part 1: Features of Nepal’s Monetary Policy (2023-24 / FY 2080-81)

Nepal Rastra Bank (NRB) formulated the Monetary Policy for 2023-24 with a “cautiously flexible” stance aimed at maintaining macroeconomic and external stability while supporting economic recovery:

1. Targeting Inflation and External Reserves:
   • Anchored inflation target around 6.5% and targeted foreign exchange reserves sufficient to cover at least 7 months of merchandise and services imports.
2. Policy Rate Adjustments:
   • Lowered the policy repo rate from 7.0% to 6.5% and reduced the Bank Rate from 7.5% to 7.0% within the interest rate corridor to stimulate productive lending.
3. Statutory Liquidity and Reserve Ratios:
   • Maintained Cash Reserve Ratio (CRR) at 4.0% and Statutory Liquidity Ratio (SLR) at 12% for commercial banks to preserve financial system soundness.
4. Credit Growth Targets:
   • Projected domestic private sector credit growth at 11.5% and broad money supply ($M_2$) growth at 12.5%.
5. Loan Restructuring and Working Capital Guidelines:
   • Introduced flexibility in the Working Capital Loan Guidelines 2022 to provide relief to cash-strapped domestic enterprises and SMEs.

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Part 2: Numerical Problem - GDP Accounting

(a) Computation of Nominal GDP, Real GDP, GDP Deflator, and Inflation Rate

(Base Year = 2021; Base Prices: $P_{A,2021} = 900$, $P_{B,2021} = 80$)

1. Nominal GDP:

• 2021: $(300 \times 900) + (1000 \times 80) = 270,000 + 80,000 = \mathbf{350,000}$
• 2022: $(350 \times 1000) + (1300 \times 120) = 350,000 + 156,000 = \mathbf{506,000}$
• 2023: $(375 \times 1200) + (1700 \times 140) = 450,000 + 238,000 = \mathbf{688,000}$

2. Real GDP (at 2021 Constant Prices):

• 2021: $(300 \times 900) + (1000 \times 80) = \mathbf{350,000}$
• 2022: $(350 \times 900) + (1300 \times 80) = 315,000 + 104,000 = \mathbf{419,000}$
• 2023: $(375 \times 900) + (1700 \times 80) = 337,500 + 136,000 = \mathbf{473,500}$

3. GDP Deflator ($(\text{Nominal GDP} / \text{Real GDP}) \times 100$):

• 2021: $\frac{350,000}{350,000} \times 100 = \mathbf{100.00}$
• 2022: $\frac{506,000}{419,000} \times 100 = \mathbf{120.76}$
• 2023: $\frac{688,000}{473,500} \times 100 = \mathbf{145.30}$

4. Rate of Inflation:

• 2022: $\frac{120.76 - 100.00}{100.00} \times 100 = \mathbf{20.76\%}$
• 2023: $\frac{145.30 - 120.76}{120.76} \times 100 = \frac{24.54}{120.76} \times 100 = \mathbf{20.32\%}$

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(b) Why Real GDP is a Better Measurement of Welfare than Nominal GDP

Nominal GDP can rise simply due to price inflation without any increase in physical output. Real GDP is superior because:

1. It measures the genuine expansion in physical goods and services available to consumers, isolating real productive capacity.
2. It prevents money illusion by stripping away price distortions.
3. It provides an objective baseline for measuring material living standards over time.

Solution: Consumption and Saving Functions

Part (a): Derivation of Linear Consumption and Saving Functions

From the schedule:

1. Autonomous Consumption ($a$):

   • When disposable income $Y_d = 0$, consumption expenditure $C = 80$.
   • Thus, $a = 80$.

2. Marginal Propensity to Consume (MPC or $b$):

   $$MPC = \frac{\Delta C}{\Delta Y_d} = \frac{240 - 80}{200 - 0} = \frac{160}{200} = 0.80$$

3. Linear Consumption Function:

   $$C = a + b Y_d$$
   $$\mathbf{C = 80 + 0.80 Y_d}$$

4. Linear Saving Function:

   $$S = -a + (1 - b)Y_d$$
   Since $MPS = 1 - MPC = 1 - 0.80 = 0.20$:
   $$\mathbf{S = -80 + 0.20 Y_d}$$

(Verification: At $Y_d = 400$: $C = 80 + 0.8(400) = 400$, $S = -80 + 0.2(400) = 0$. Exactly matches schedule break-even point).

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Part (b): Three Propositions of Keynes’s Psychological Law of Consumption

In graphical terms, plotting $Y_d$ against $C$ shows the $45^\circ$ guideline ($Y_d = C$) intersected by the consumption line ($C = 80 + 0.8Y_d$) at the break-even point $Y_d = 400$.

Three Propositions:

1. Proposition 1: When aggregate disposable income increases, consumption spending also increases, but by less than the increase in income ($0 < \frac{\Delta C}{\Delta Y_d} < 1$).
   • Illustration: As $Y_d$ rises by 200 (from 0 to 200), $C$ increases by only 160 (from 80 to 240).
2. Proposition 2: The increased income is divided between consumption and saving in definite proportions ($\Delta Y_d = \Delta C + \Delta S$).
   • Illustration: When $Y_d$ rises by 200, $\Delta C = 160$ and $\Delta S = 40$, satisfying $160 + 40 = 200$.
3. Proposition 3: An increase in income leads to an increase in both consumption and saving. An expansion in income never leads to a decline in either $C$ or $S$.
   • Illustration: At every successive higher income level, both $C$ rises (80 $\rightarrow$ 240 $\rightarrow$ 400 $\rightarrow$ 560 $\rightarrow$ 720) and $S$ rises ($-80 \rightarrow -40 \rightarrow 0 \rightarrow 40 \rightarrow 80$).

Contraction Phases of Trade Cycles

A trade cycle consists of upward and downward movements in aggregate economic activity. The downward downswing comprises two distinct contractionary phases: Recession and Depression (Trough).

1. Phase 1: Recession

• Turning Point: The contraction begins immediately after the peak (boom), triggered by profit margin compression, rising interest rates, and waning consumer demand.
• Key Characteristics:
  • Deceleration of Investment: Entrepreneurs revise sales expectations downward, reducing planned capital orders.
  • Inventory Accumulation: Unsold stocks build up, compelling factories to curtail production shifts.
  • Liquidity Squeeze and Credit Tightening: Banks tighten lending standards as debt defaults surface.
  • Rising Unemployment: Firms lay off temporary and marginal workers, initiating downward pressure on aggregate purchasing power.

2. Phase 2: Depression and Trough

• Severe Underutilization: The lowest point of the trade cycle where economic activity reaches rock bottom.
• Key Characteristics:
  • High Involuntary Unemployment: Extensive joblessness across all industrial sectors.
  • Deflationary Spiral: Widespread price and wage declines as sellers slash prices to liquidate stock.
  • Collapse in Business Confidence: Animal spirits vanish; even at near-zero interest rates, private investment remains paralyzed.
  • Excess Industrial Capacity: Factories operate far below installed capacity.

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Counter-Cyclical Fiscal Measures to Stabilize the Economy

During contraction phases, private consumption and investment collapse; therefore, active expansionary fiscal policy is the primary engine to revive effective demand:

1. Aggressive Expansion in Public Works & Capital Expenditure:
   • Government launches labor-intensive public infrastructure projects (roads, hydropower, schools, hospitals).
   • This directly injects autonomous purchasing power, creating employment and activating the investment multiplier.
2. Substantial Tax Relief and Rebates:
   • Reducing personal income taxes increases household disposable income ($Y_d$), supporting consumer spending.
   • Reducing corporate taxes, offering accelerated depreciation allowances, and granting investment tax credits restore corporate profitability.
3. Expansion of Social Safety Nets and Direct Transfer Payments:
   • Expanding unemployment benefits, direct cash transfers, and food subsidies directly targets low-income segments with high marginal propensity to consume ($MPC$).
4. Planned Deficit Financing:
   • The government runs deliberate fiscal deficits financed through domestic borrowing and central bank credit rather than raising tax rates, injecting net purchasing power into the economy.
5. Operation of Automatic Fiscal Stabilizers:
   • Progressive tax brackets automatically collect less revenue during downturns, while welfare claims automatically rise, cushioning the contraction without waiting for legislative delays.

Process of Measuring GDP by Product (Value-Added) Method

The Product Method (or Value-Added Method) measures national income by assessing the total gross value of goods and services produced by all domestic productive enterprises in an economy during an accounting year.

1. Steps in Measurement:

1. Classification of Productive Enterprises:
   • Primary Sector: Agriculture, forestry, fishing, mining.
   • Secondary Sector: Manufacturing, construction, electricity, gas, and water supply.
   • Tertiary Sector: Trade, transport, banking, education, healthcare, and public administration.
2. Estimation of Gross Value of Output ($GVO$):
   $$GVO = \text{Total Sales} + \Delta \text{Stock} (\text{Closing Stock} - \text{Opening Stock})$$
3. Estimation of Intermediate Consumption ($IC$):
   • Deducting the purchase of raw materials, power, fuel, and intermediate services used up in the production process.
4. Calculation of Gross Value Added at Market Price ($GVA_{mp}$):
   $$GVA_{mp} = GVO - IC$$
5. Aggregation to $GDP_{mp}$:
   $$GDP_{mp} = \sum GVA_{mp} (\text{Primary} + \text{Secondary} + \text{Tertiary})$$

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2. Illustrative Example: The Bread Production Chain

• Summing final retail sales yields Rs. 2,600.
• Summing value added across all four stages: $1000 + 500 + 700 + 400 = \mathbf{Rs.\ 2,600}$.
• Crucial Rule: Taking total output (Rs. 7,300) without deducting intermediate consumption would overstate output by Rs. 4,700 due to double counting.

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Conceptual Difficulties in Measuring GDP by Product Method

1. Ambiguity Between Final and Intermediate Goods:
   • A single commodity can be both final and intermediate depending on its use (e.g., electricity used in a home is a final consumer good; used in a factory, it is an intermediate input).
2. Treatment of Non-Monetized Subsistence Production:
   • In agrarian developing nations like Nepal, substantial farming output is consumed directly by farm households without entering formal market transactions, requiring subjective imputation.
3. Imputed Value of Owner-Occupied Dwellings:
   • Calculating imputed rental income for homeowners who live in their own properties lacks actual transaction records.
4. Valuation of Government and Free Public Services:
   • Public administration, national defense, and police services have no market price and must be valued purely at factor cost (salaries paid).
5. Treatment of Second-Hand Goods & Capital Gains:
   • Sale proceeds of existing homes, used cars, or shares do not represent current production and must be rigorously excluded.
6. Shadow and Illegal Economy:
   • Unreported informal businesses, smuggling, and cash transactions evade tax authorities and national statistics bureaus.

Comprehensive Solution: IS-LM Equilibrium & Policy Evaluation

Given Structural Parameters:

• Consumption Function: $C = 400 + 0.75(Y - T)$
• Tax Function: $T = 200 + 0.20Y$
• Investment Function: $I = 400 - 4000i$
• Government Expenditure: $G = 500$
• Transactions Demand for Money: $M_t = 0.50Y$
• Speculative Demand for Money: $M_{sp} = 200 - 2000i$
• Total Money Demand: $M_d = M_t + M_{sp} = 0.50Y + 200 - 2000i$
• Money Supply: $M_s = 800$

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Part (i): Equilibrium Rate of Interest ($i$) and Output ($Y$)

1. Derivation of IS Curve (Product Market Equilibrium):

$$Y_d = Y - T = Y - (200 + 0.20Y) = 0.80Y - 200$$

$$C = 400 + 0.75(0.80Y - 200) = 400 + 0.60Y - 150 = 250 + 0.60Y$$

Product market equilibrium:

$$Y = C + I + G$$

$$Y = (250 + 0.60Y) + (400 - 4000i) + 500$$

$$Y = 1150 + 0.60Y - 4000i$$

$$Y - 0.60Y = 1150 - 4000i$$

$$0.40Y = 1150 - 4000i$$

$$Y = 2875 - 10000i \quad \text{--- [Equation 1: IS Curve]}$$

2. Derivation of LM Curve (Money Market Equilibrium):

$$M_s = M_d$$

$$800 = 0.50Y + 200 - 2000i$$

$$0.50Y = 600 + 2000i$$

$$Y = 1200 + 4000i \quad \text{--- [Equation 2: LM Curve]}$$

3. Equating IS and LM Curves:

$$2875 - 10000i = 1200 + 4000i$$

$$14000i = 1675$$

$$i = \frac{1675}{14000} \approx 0.11964 = \mathbf{11.96\%}$$

Substitute $i$ into Equation 2:

$$Y = 1200 + 4000(0.11964) = 1200 + 478.57 = \mathbf{1678.57 \text{ billion}}$$

• Equilibrium Interest Rate ($i$): $11.96\%$
• Equilibrium Output ($Y$): Rs. 1,678.57 billion

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Part (ii): Simultaneous Effect of $\Delta G = 100$ and $\Delta M_s = 200$

• New Government Expenditure: $G' = 500 + 100 = 600$
• New Money Supply: $M_s' = 800 + 200 = 1000$

1. New IS Curve:

$$Y = (250 + 0.60Y) + (400 - 4000i) + 600 = 1250 + 0.60Y - 4000i$$

$$0.40Y = 1250 - 4000i$$

$$Y = 3125 - 10000i \quad \text{--- [New IS Equation]}$$

2. New LM Curve:

$$1000 = 0.50Y + 200 - 2000i$$

$$0.50Y = 800 + 2000i$$

$$Y = 1600 + 4000i \quad \text{--- [New LM Equation]}$$

3. New Equilibrium:

$$3125 - 10000i = 1600 + 4000i$$

$$14000i = 1525$$

$$i' = \frac{1525}{14000} \approx 0.10893 = \mathbf{10.89\%}$$

Substitute $i'$:

$$Y' = 1600 + 4000(0.10893) = 1600 + 435.71 = \mathbf{2035.71 \text{ billion}}$$

Simultaneous Effects:

• Equilibrium Output: Increases by Rs. 357.14 billion ($1678.57 \rightarrow 2035.71$).
• Equilibrium Rate of Interest: Decreases by $1.07\%$ ($11.96\% \rightarrow 10.89\%$) because the liquidity injection from the monetary expansion more than compensated for the upward interest rate pressure from the fiscal expansion.

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Part (iii): Critical Evaluation: Are These Measures Effective to Control Inflation?

No, these measures are completely inappropriate and counterproductive for controlling inflation.

Critical Comments:

1. Both Measures are Expansionary:
   • An increase in government spending ($\Delta G = +100$) directly expands aggregate demand.
   • An increase in money supply ($\Delta M_s = +200$) reduces interest rates, encouraging private investment borrowing and further boosting aggregate spending.
2. Worsening Demand-Pull Inflation:
   • In an economy already facing inflationary pressures, adding purchasing power pushes aggregate demand further beyond full-capacity output, aggravating demand-pull inflation.
3. Correct Policy Prescription to Control Inflation:
   • Contractionary Fiscal Policy: Reduce public spending ($G$) and/or increase tax rates ($t$) to curb disposable income.
   • Contractionary Monetary Policy: Reduce money supply ($M_s$) through open market sales and increase benchmark interest rates to tighten private credit.