Which is contractionary fiscal policy?

Question

BlackTom AI · Accepted Answer

Contractionary fiscal policy reduces aggregate demand by lowering government spending or increasing taxes to slow an overheated economy and curb inflation.

1. Relevant knowledge points and concepts
- Fiscal policy: government adjustments to spending (G) and taxation (T).
- Aggregate demand (AD) identity: AD = C + I + G + NX. Changes in G or T directly affect AD.
- Multipliers: spending multiplier = 1/(1 − MPC). Tax multiplier = −MPC/(1 − MPC). Both show how initial fiscal changes translate into total AD changes.

2. Step-by-step reasoning
- Lowering government spending (ΔG < 0) directly reduces G in the AD equation, so AD falls by the spending change times the spending multiplier.
- Raising taxes (ΔT > 0) reduces households’ disposable income, lowering consumption (C). The initial fall in consumption is MPC × ΔT, and total AD falls by that initial change times the spending multiplier (equivalently use the tax multiplier).

3. Example calculation (showing intermediate steps)
Assume marginal propensity to consume (MPC) = 0.8.
- Spending multiplier = 1/(1 − 0.8) = 5.
- If government cuts G by $10: total AD change = −$10 × 5 = −$50.
- If government raises taxes by $10: immediate drop in C = 0.8 × $10 = $8. Total AD change = −$8 × 5 = −$40 (or use tax multiplier −0.8/0.2 = −4, so −$10 × 4 = −$40).

4. Why the correct answer is correct
Both lowering government spending and raising taxes reduce aggregate demand and thus are contractionary fiscal tools. The numerical example confirms both actions shrink AD, though by different magnitudes.

5. Why other options are incorrect
- "Lowering government spending" alone is a contractionary tool (true) but the choice is incomplete compared to “both of these.”
- "Raising taxes" alone is also contractionary (true) but again incomplete.
- "Neither of these" is false because both actions clearly reduce AD.

6. Conclusion
Therefore, the correct choice is "both of these," which matches the provided answer.

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