Question

Which of the following changes will have the smallest expansionary effect on aggregate demand in the short run?

1) Increase in government spending
2) Decrease in taxes
3) Increase in interest rates
4) Decrease in consumer spending

Answer 1

The correct answer is option 3. An increase in interest rates will have the smallest expansionary effect on aggregate demand in the short run.

Step-by-step explanation:

In this case, an increase in interest rates will have the smallest expansionary effect on aggregate demand in the short run.

1. Increasing government spending will directly increase aggregate demand as the government's spending injects money into the economy.
2. A decrease in taxes will increase disposable income, leading to higher consumer spending, which will boost aggregate demand.
3. However, an increase in interest rates will discourage borrowing and reduce both consumer spending and investment spending, resulting in a smaller expansionary effect on aggregate demand.
4. A decrease in consumer spending, while it may reduce aggregate demand, will still have a larger effect than a change in interest rates.

Therefore, among the given options, an increase in interest rates will have the smallest expansionary effect on aggregate demand in the short run.