Contractionary fiscal policy under fixed exchange rates with overvalued currency

Steps:

• Transition to fixed exchange rate constrains monetary policy, relying on fiscal tools for internal balance like inflation control.
• Higher taxes contract aggregate demand to reduce inflationary pressures.
• Direct taxes target income, cutting consumption without immediate price hikes.
• Above PPP signals overvalued currency, where demand reduction prevents devaluation pressure on the peg.

Why A is correct:

• Direct taxes lower disposable income, shifting AD left in the AD-AS model to curb demand-pull inflation and support an overvalued fixed rate per PPP equilibrium.

Why the others are wrong:

• B: Undervalued currency (below PPP) eases import competition, reducing need for aggressive contraction to defend the peg.
• C: Indirect taxes increase production costs, causing cost-push inflation that worsens price levels.
• D: Indirect taxes fuel inflation like C, while undervalued rate offers less peg stability benefit.

Final answer: A