Question

Contractionary fiscal policy could involve a combination of government:__________. A. spending cuts and income tax cuts. B. spending increases and income tax increases. C. spending increases and income tax cuts. D. spending cuts and income tax increases.

Answer 1

D) Spending cuts and income tax increases

Step-by-step explanation:

The idea behind contractionary fiscal policy is to cool down an economy that is growing to keep it from overheating and creating bubbles. Contractionary fiscal policy can also result because of large budget deficits, and poor financial prospects in the world market.

Spending cuts reduce GDP because government spending G is a part of GDP, as the following formula shows:

Y = C + I + G + NX

Where Y = GDP, C = Consumption, I = Investment, G = Government spending, and NX = net exports (exports minus imports).

Increasing taxes also reduce economic activity because consumption C depends on disposable income, and disposable income equals Y-T, so consumption is a function of disposable income:

C(Y-T)

thus, if Y-T is less, C will be less, and Y will be less.