In the context of expansionary and contractionary fiscal policy, reducing tax rates is an example of which type of fiscal policy?

• A. Expansionary fiscal policy, because it increases aggregate demand by raising households’ disposable income
• B. Monetary policy, because it is implemented by the central bank through changes in the money supply
• C. Neutral fiscal policy, because it has no effect on aggregate demand or real GDP
• D. Contractionary fiscal policy, because it decreases aggregate demand by reducing government spending

Answer: (A)

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 the two main types of fiscal policy: expansionary and contractionary. Expansionary fiscal policy aims to increase aggregate demand, while contractionary fiscal policy aims to decrease it.
3. Step 3: Analyze the effect of reducing tax rates. When taxes are reduced, households have more disposable income, which tends to increase consumption and aggregate demand.
4. Step 4: Connect the increase in aggregate demand due to higher disposable income with expansionary fiscal policy, since the goal is to stimulate economic activity.
5. Step 5: Eliminate other options: monetary policy is controlled by the central bank, neutral fiscal policy has no effect on aggregate demand, and contractionary fiscal policy reduces aggregate demand, which is the opposite effect of tax cuts.