Which of the following is a potential negative effect of an expansionary fiscal policy?

• A. It reduces aggregate demand.
• B. It can lead to higher inflation.
• C. It causes a decrease in government spending.
• D. It typically increases unemployment.

Answer: (B)

Verified step by step guidance

1. Step 1: Understand what expansionary fiscal policy means. It involves increasing government spending or decreasing taxes to boost aggregate demand in the economy.
2. Step 2: Recall the effects of higher aggregate demand. When aggregate demand increases, it can lead to higher output and employment in the short run.
3. Step 3: Consider the potential negative effects. If aggregate demand grows too quickly or the economy is near full capacity, this can cause demand-pull inflation, which means prices rise.
4. Step 4: Analyze the options given. Expansionary fiscal policy does not reduce aggregate demand; it increases it. It does not cause a decrease in government spending; it usually increases it. It typically reduces unemployment rather than increasing it.
5. Step 5: Conclude that the main potential negative effect among the options is that expansionary fiscal policy can lead to higher inflation due to increased aggregate demand pushing prices up.