Fiscal Policy and Aggregate Demand

Steps:

• Increasing income tax is a contractionary fiscal policy that reduces disposable income for households.
• Lower disposable income decreases consumer spending on goods and services.
• Reduced spending lowers aggregate demand in the economy.
• Lower aggregate demand helps control rising prices, targeting price stability.

Why D is correct:

• Price stability requires low and stable inflation rates; increasing income tax curbs demand-pull inflation by shifting the aggregate demand curve leftward, as per the AD-AS model.

Why the others are wrong:

• A: Higher taxes reduce imports (lowering demand for foreign currency), likely appreciating rather than depreciating the exchange rate.
• B: Contractionary policy slows economic activity, hindering GDP growth.
• C: Reduced aggregate demand decreases output, raising cyclical unemployment.

Final answer: D