How does fiscal expansion affect aggregate demand and output in the short run?

• A. Increases G or lowers taxes, shifting AD right; real GDP and the price level rise in the short run.
• B. Increases G and taxes, shifting AD left; real GDP falls.
• C. Reduces G and lowers taxes; AD shifts right; GDP rises but prices fall.
• D. Increases the money supply; AD is unchanged.

Answer: (A)

Expansionary fiscal policy boosts demand by either increasing government spending or cutting taxes. When the government spends more, it directly adds to total spending in the economy. When taxes are cut, households and firms have more disposable income to spend, which raises consumption and aggregate demand. The combined effect is a rightward shift of the aggregate demand curve, amplified by the fiscal multiplier.

In the short run, with the usual upward-sloping short-run aggregate supply, this rightward shift pushes the equilibrium to a higher level of real GDP and a higher price level. The economy produces more goods and services, and overall prices rise somewhat due to the increased demand.

This is why increasing government spending or lowering taxes is the expansionary move, and it leads to higher real GDP and a higher price level in the short run. Other statements either describe contractionary actions (like increasing taxes or reducing government spending) or mix in monetary policy effects incorrectly (such as claiming the money supply changes have no effect on aggregate demand).