Expansionary Fiscal Policy and Devaluation to Boost Aggregate Demand

Steps:

• Deflation requires increasing aggregate demand (AD) to raise prices.
• In a fixed exchange rate open economy, monetary policy is constrained to maintain the peg, so rely on fiscal policy and exchange rate adjustments.
• Lower taxes provide expansionary fiscal stimulus by increasing consumption and investment.
• Devaluation makes exports cheaper and imports costlier, improving net exports and AD.

Why A is correct:

• Lower direct taxes raise disposable income, directly boosting consumption (C) and investment (I) per Keynesian consumption function (C = c(Y - T)); devaluation enhances net exports (NX) under Mundell-Fleming model for fixed rates.

Why the others are wrong:

• B: Revaluation appreciates currency, reducing NX and worsening deflation.
• C: Lower indirect taxes mainly cut consumption costs but less effectively stimulate investment than direct taxes.
• D: Revaluation reduces NX, counteracting any fiscal stimulus from lower indirect taxes.

Final answer: A