A contractionary monetary policy combined with an expansionary fiscal policy will most likely result in which of the following outcomes?

• A. A guaranteed reduction in the inflation rate regardless of other factors
• B. Simultaneous increase in both aggregate demand and aggregate supply
• C. Lower interest rates and decreased government spending, leading to a decrease in aggregate demand
• D. Higher interest rates and increased government spending, potentially offsetting each other's effects on aggregate demand

Answer: (D)

Verified step by step guidance

1. Step 1: Understand the effects of contractionary monetary policy. This policy typically involves increasing interest rates or reducing the money supply, which tends to decrease aggregate demand by making borrowing more expensive and reducing consumer and business spending.
2. Step 2: Understand the effects of expansionary fiscal policy. This policy involves increasing government spending or decreasing taxes, which tends to increase aggregate demand by injecting more money into the economy and encouraging consumption and investment.
3. Step 3: Analyze how these two policies interact. The contractionary monetary policy raises interest rates, which tends to reduce aggregate demand, while the expansionary fiscal policy increases government spending, which tends to increase aggregate demand.
4. Step 4: Recognize that the increase in interest rates from monetary policy can partially or fully offset the increase in aggregate demand caused by higher government spending, leading to a potential balance or neutral effect on aggregate demand.
5. Step 5: Conclude that the combined effect is higher interest rates and increased government spending, which may offset each other’s impact on aggregate demand, rather than guaranteeing a reduction in inflation or simultaneous increases in aggregate demand and supply.