Question

"In response to rising inflationary pressures, the Mexican central bank tightened monetary policy, at the same time the government announced tax increases and spending cuts to balance the budget. These policies might cause a recession in the short-run." True or false why ?

Answer 1

The above statement is true.

Whenever there are inflationary pressures in the economy central bank may tighten monetary policy by increasing the benchmark interest rates which reduces the supply of money ( liquidity ) in the economy.

Fiscal policy to contain inflation is aimed at reducing flow of money in the economy such as by increasing taxes, and reducing government spending.

However these measures may cause a recession in the short run.

When the central bank tightens monetary policy it becomes dearer for the businesses and people to take loans from the bank. Thus, increased borrowing cost leads to fall in investment which subsequently leads to job losses.

Likewise fiscal policy measures such as increasing taxes and reducing government spending leads to shutting down of many businesses due to increased cost of operation. Shutting down of firms again leads to unemployment in the economy.

Rising unemployment and shutting down of businesses leads to business sentiment going down and subsequently it leads to recession as seen in the world during the great financial crisis ( 2007-2009 ).