Question

Contractionary fiscal policy is deliberate government action to influence aggregate demand and the level of real GDP through a. expanding and contracting the money supply. b. encouraging business to expand or contract investment. c. regulating net exports. d. decreasing government spending or increasing taxes.

Short answer

The correct answer for the given multiple-choice question is (d) decreasing government spending or increasing taxes, as it is the tool used in contractionary fiscal policy to influence aggregate demand and the level of real GDP. Other options mentioned involve monetary and trade policy tools, which are not directly related to fiscal policy.

Step-by-step solution

Understand the concept

Contractionary fiscal policy refers to government actions that are designed to reduce aggregate demand and decrease the level of real GDP. This is usually done to combat inflation during an economic boom. These policies may include decreasing government spending, increasing taxes, or both. Step 2: Analyzing the possible answers

Analyze the options given

Let's take a look at each of the options and evaluate if they match the definition of contractionary fiscal policy: a. Expanding and contracting the money supply is a monetary policy tool, not a fiscal policy. Therefore, this option is incorrect. b. Encouraging business to expand or contract investment is also not a fiscal policy tool. This option is incorrect as well. c. Regulating net exports is a part of trade policy and is not directly related to fiscal policy. This option is incorrect. d. Decreasing government spending or increasing taxes is a direct government action that affects aggregate demand and the level of real GDP. This matches the definition of contractionary fiscal policy. Therefore, this option is correct. Step 3: Confirming the correct answer

Confirm the correct choice

Based on our analysis in Step 2, we can conclude that option (d) decreasing government spending or increasing taxes is the correct answer as it is the tool used in contractionary fiscal policy to influence aggregate demand and the level of real GDP.

Key concepts

Aggregate Demand

Imagine the economy as a machine where all products and services produced are like cogs and wheels working together. If people start to buy fewer goods and services, it's like some cogs slow down—this is a drop in aggregate demand. In a nutshell, aggregate demand represents the total demand for goods and services in an economy at a given price level over a certain time period.

When a government employs contractionary fiscal policy by either reducing its spending or increasing taxes, it pulls money out of the economy. This means there's less cash in people's pockets to spend, leading to a decrease in aggregate demand. You can think of it like a big group dinner where suddenly everyone has less money to chip in for the bill—overall, the table's demand for dessert might go down.

Real GDP

Real GDP, or Gross Domestic Product, is like the national scorecard—it tells us how much the country is producing in terms of goods and services, but adjusted for changes in price (inflation). If the real GDP goes up, it means the economy is growing because more stuff is being made and sold.

Contractionary fiscal policy is like when a coach tells the team to slow down because they're playing too fast and making mistakes—in this case, the mistake is too much inflation. By decreasing government spending or increasing taxes, the government slows economic activity, which can reduce the real GDP. It's like everyone suddenly decides to save instead of buy new sneakers, so fewer sneakers are produced.

Government Spending

Government spending works like the fuel in the economy's engine. When the government spends money, it might be building roads, paying teachers, or buying tanks. This spending sends money circulating through the economy as people get paid and spend their income on other goods and services.

In times of an economic boom, when inflation is climbing over the fence, contractionary fiscal policy turns down the spending 'fuel'. It's like a party where the host starts to offer fewer snacks to calm down the guests who are starting to party too hard. The idea is to make sure the economy doesn't get overheated with too much spending.

Economic Boom

An economic boom is like a grand party for the economy—business is booming, people have jobs, and cash is flowing. However, just like any good party, there can be a point where it gets too wild. Prices start to rise too quickly, and the economy can overheat—this is when there's too much money chasing too few goods.

The government can use contractionary fiscal policy like lowering the music volume by reducing spending or increasing taxes. Think of it as a way to gently nudge some guests home so the party remains fun and doesn't end with neighbors calling the cops due to high inflation.

Inflation

Inflation is when prices go up and the value of money goes down. Imagine you go to your favorite ice cream shop and find out your regular scoop now costs more scoops of money. That's inflation for you—it means you're getting less bang for your buck.

During an economic boom, too much money is chasing too few goods, and everyone's competing to buy the same things, pushing prices up—that's where contractionary fiscal policy comes in. By decreasing spending or increasing taxes, the government is like a parent giving fewer allowances, so there's less money to spend on ice cream, thus helping to cool down inflation.

Tax Policy

Now let's talk about how the government can turn the dial on the economy with tax policy. Taxes are like the gym membership fees the government collects to keep the country's infrastructure fit. But when the government senses the economy is getting too muscular and overheating with activity, it can adjust taxes to help restore balance.

By increasing taxes through contractionary fiscal policy, the government is effectively taking more money out of circulation—like saving part of your allowance for a rainy day instead of spending it right away. This can help to reduce how much money people have to spend, dialing back aggregate demand and putting a lid on inflation.