What is contractionary fiscal policy?

• A. Central bank raises interest rates and sells bonds to reduce the money supply and curb inflation.
• B. Government decreases spending and/or increases taxes to reduce aggregate demand and slow economic growth or inflation.
• C. Government increases spending and/or decreases taxes to raise aggregate demand and boost output.
• D. Government deregulates industries to encourage investment and long-run growth.

Answer: (B)

Verified step by step guidance

1. Step 1: Understand the definition of fiscal policy. Fiscal policy involves government decisions on taxation and spending to influence the economy.
2. Step 2: Recognize that contractionary fiscal policy is used to reduce inflation or slow down an overheating economy by decreasing aggregate demand.
3. Step 3: Identify the tools of contractionary fiscal policy: the government can either decrease its spending or increase taxes, or both.
4. Step 4: Understand the effect of these actions: decreasing government spending reduces overall demand, and increasing taxes reduces consumers' disposable income, both leading to lower aggregate demand.
5. Step 5: Differentiate contractionary fiscal policy from other policies such as monetary policy (e.g., central bank raising interest rates) or expansionary fiscal policy (increasing spending or cutting taxes).