Expansionary Fiscal Policy to Combat Deflation

Steps:

• Identify deflation as falling prices from weak aggregate demand.
• Recognize need for policies that boost demand to raise prices.
• Evaluate fiscal tools: governments use spending increases or tax cuts.
• Select option aligning with reducing budget surplus for demand stimulus.

Why D is correct:

• Reducing budget surplus means higher government spending or lower taxes, increasing aggregate demand via the multiplier effect in Keynesian theory.

Why the others are wrong:

• A: Raising interest rates tightens monetary policy, reducing investment and demand, worsening deflation.
• B: Increasing direct taxes cuts household income, lowering consumption and aggregate demand.
• C: Cutting indirect taxes mildly boosts demand but is less comprehensive than surplus reduction for broad fiscal expansion.

Final answer: D