Contractionary Policies Reduce Aggregate Demand to Curb Inflation

Steps:

• Inflation rises when aggregate demand (AD) exceeds aggregate supply (AS) in the short run.
• To combat inflation, implement policies that shift AD leftward.
• Contractionary fiscal policy increases budget surplus via higher taxes or lower spending, reducing AD.
• Contractionary monetary policy raises interest rates, curbing investment and consumption to further lower AD.

Why C is correct:

• C pairs contractionary fiscal (higher surplus) and monetary (higher rates) policies, reducing AD per the AD-AS model and lowering price levels.

Why the others are wrong:

• A: Decreasing surplus expands fiscal policy, boosting AD and offsetting monetary contraction.
• B: Both actions (lower surplus, higher money supply) expand AD, accelerating inflation.
• D: Higher surplus contracts AD, but increasing money supply expands it via lower rates, creating conflicting effects.

Final answer: C