Which of the following represents the most contractionary fiscal policy?

• A. A decrease in government spending and no change in taxes
• B. An increase in taxes and a decrease in government spending
• C. A decrease in taxes and an increase in government spending
• D. An increase in government spending and no change in taxes

Answer: (B)

Verified step by step guidance

1. Step 1: Understand what contractionary fiscal policy means. It is a policy aimed at reducing aggregate demand to slow down economic activity, often to control inflation. This is typically done by decreasing government spending, increasing taxes, or both.
2. Step 2: Analyze each option in terms of its effect on aggregate demand. A decrease in government spending reduces aggregate demand, while an increase in taxes also reduces disposable income, leading to lower consumption and aggregate demand.
3. Step 3: Compare the options: - A decrease in government spending and no change in taxes reduces demand only through spending. - An increase in taxes and a decrease in government spending reduces demand through both lower government spending and lower consumer spending. - A decrease in taxes and an increase in government spending increases aggregate demand, which is expansionary, not contractionary. - An increase in government spending and no change in taxes increases aggregate demand, also expansionary.
4. Step 4: Conclude that the most contractionary fiscal policy is the one that combines both an increase in taxes and a decrease in government spending, as it reduces aggregate demand from two sides.
5. Step 5: Summarize that contractionary fiscal policy involves reducing government spending and/or increasing taxes, and the option with both changes is the strongest contractionary measure.