Contractionary Policies Reduce Inflation

Steps:

• Identify inflation cause: excess aggregate demand pushes prices up.
• Apply contractionary monetary policy: raise interest rates to curb borrowing and spending.
• Apply contractionary fiscal policy: cut government spending to lower overall demand.
• Combine both for maximum reduction in aggregate demand, stabilizing prices.

Why D is correct:

• Increasing interest rates raises borrowing costs, reducing consumption/investment; decreasing government spending directly cuts demand—both shift AD curve left in AD-AS model, lowering price level.

Why the others are wrong:

• A: Decreasing exchange rates depreciates currency, raising import costs and inflation; offsets interest rate benefit.
• B: Decreasing interest rates boosts spending; depreciating exchange rates increases import prices—both expansionary, worsening inflation.
• C: Increasing government spending and decreasing interest rates expand demand, accelerating inflation.

Final answer: D