Expansionary Policies to Combat Deflation

Steps:

• Identify the economic issue: A -0.6% CPI change indicates deflation, where prices fall and economic activity slows.
• Recall policy goals: To restore price stability, use expansionary monetary and fiscal policies to boost demand and raise prices.
• Evaluate monetary policy: Reducing interest rates lowers borrowing costs, encouraging spending and investment.
• Evaluate fiscal policy: Increasing government spending injects money into the economy, stimulating demand.

Why D is correct:

• D combines expansionary monetary policy (lower interest rates increase money supply via the liquidity preference theory) with expansionary fiscal policy (higher spending boosts aggregate demand per Keynesian economics), countering deflation by raising price levels.

Why the others are wrong:

• A: Both actions are contractionary, raising costs and reducing demand, worsening deflation.
• B: Higher spending expands demand, but increasing income tax reduces disposable income, offsetting the stimulus.
• C: Lower rates expand demand, but cutting spending contracts it, creating mixed effects that fail to reliably combat deflation.

Final answer: D