Expansionary Policy in Fixed Exchange Rates

Steps:

• Identify policy: Reducing taxation (fiscal expansion) and lowering interest rates (monetary expansion) boosts aggregate demand.
• Context: Fixed exchange rate limits independent monetary policy; expansion suits domestic recession over external imbalances.
• Match problems: High unemployment and low investment signal weak demand, needing stimulus without inflation pressure.
• Rule out: Inflation or BOP deficits require contraction or capital inflows via higher rates.

Why D is correct:

• Keynesian policy: Expansionary measures increase AD via C + I + G + (X-M), lowering unemployment and raising investment.

Why the others are wrong:

• A: Demand inflation requires contractionary policy to curb rising prices; BOP deficit needs higher rates for capital inflows.
• B: Demand inflation demands reduced spending, not tax cuts or lower rates.
• C: BOP deficit in fixed rates requires higher interest rates to defend currency, conflicting with lowering them.

Final answer: D