Which of the following represents the most contractionary fiscal policy?
Multiple Choice
a $30 ?billion tax increase
a $30 ?billion increase in government spending
a $30 ?billion decrease in government spending
a $30 ?billion tax cut
The Correct Answer and Explanation is :
The most contractionary fiscal policy is:
a $30 billion decrease in government spending.
Explanation:
Fiscal policy refers to the use of government spending and taxation to influence economic activity. Contractionary fiscal policy is designed to reduce aggregate demand, slow down economic growth, and curb inflation. It typically involves either decreasing government spending, increasing taxes, or both.
Key Analysis of Each Option:
- $30 billion tax increase:
A tax increase reduces disposable income for households and businesses, leading to lower consumption and investment. This is contractionary, but its effect depends on the marginal propensity to consume (MPC). - $30 billion increase in government spending:
This represents an expansionary fiscal policy because it injects money into the economy, boosting aggregate demand and potentially accelerating economic growth. - $30 billion decrease in government spending:
This is the most contractionary option. Government spending directly contributes to aggregate demand. Reducing it leads to a direct decline in economic activity, particularly in sectors reliant on government contracts or funding. Furthermore, the multiplier effect amplifies this reduction, as decreased government spending leads to lower incomes and thus further reductions in consumption and investment. - $30 billion tax cut:
A tax cut increases disposable income, stimulating consumer spending and investment. This is expansionary, not contractionary.
Why Decreased Government Spending Is Most Contractionary:
While both tax increases and spending cuts can reduce aggregate demand, spending cuts are generally more direct and impactful. Tax increases depend on how much individuals alter their consumption in response, whereas government spending reductions immediately withdraw funds from the economy. This makes a spending cut more effective in contracting economic activity.
Thus, a $30 billion decrease in government spending represents the most contractionary fiscal policy.