Suppose the economy is at equilibrium at point B. What effect would expansionary fiscal policy most likely have?

• A. It would increase aggregate demand, shifting the equilibrium to a higher output and price level.
• B. It would reduce government spending and increase taxes, causing a contraction in the economy.
• C. It would decrease aggregate demand, leading to lower output and price level.
• D. It would leave aggregate demand unchanged, keeping the equilibrium at point B.

Answer: (A)

Verified step by step guidance

1. Step 1: Understand the concept of expansionary fiscal policy. Expansionary fiscal policy involves increasing government spending, decreasing taxes, or both, with the goal of stimulating economic activity.
2. Step 2: Recall the aggregate demand (AD) curve represents the total demand for goods and services in the economy at different price levels. Expansionary fiscal policy increases disposable income and government purchases, which increases aggregate demand.
3. Step 3: Analyze the effect of an increase in aggregate demand. When AD increases, the AD curve shifts to the right, leading to a higher equilibrium output and price level in the short run.
4. Step 4: Connect this to the equilibrium point B. Since the economy is initially at equilibrium at point B, an increase in aggregate demand will move the economy to a new equilibrium with higher output and price level, away from point B.
5. Step 5: Conclude that expansionary fiscal policy does not reduce government spending or increase taxes (which would be contractionary), nor does it leave aggregate demand unchanged. Instead, it increases aggregate demand, shifting equilibrium to higher output and price level.