Passage: As inflation rises, even governments previously committed to budget discipline are spending freely…
Passage: As inflation rises, even governments previously committed to budget discipline are spending freely to help households. Higher interest rates announced by central banks are supposed to help produce modest fiscal austerity, because to maintain stable debts while paying more to borrow, governments must cut spending or raise taxes. Without the fiscal backup, monetary policy eventually loses traction. Higher interest rates become inflationary, not disinflationary, because they simply lead governments to borrow more to pay rising debt-service costs. The risk of monetary unmooring is greater when public debt rises, because interest rates become more important to budget deficits.
Based on the above passage, the following assumptions have been made:
1. Fiscal policies of governments are solely responsible for higher prices.
2. Higher prices do not affect the long-term government bonds.
Which of the assumptions given above is/are valid?
1 only
2 only
Both 1 and 2
Neither 1 nor 2
Solution
Assumption 1 is invalid: the passage discusses how fiscal and monetary policies interact to impact inflation; it does not suggest fiscal policies are solely responsible for higher prices. Assumption 2 is invalid: the passage does not mention any interaction between long-term government bonds and higher prices. Hence neither assumption is valid.