Contractionary fiscal policy effectiveness depends on initial AD level

Steps:

• Cutting government spending shifts AD leftward, aiming to lower the price level and reduce inflation.
• Effectiveness is greatest when initial AD is high, causing excess demand and inflation.
• If initial AD is low, the economy has slack, so further AD reduction has minimal impact on prices.
• Compare starting positions: lowest AD (AD₁) yields least policy impact.

Why A is correct:

• AD₁ starts at the lowest level, where the economy is below full employment; per the AD-AS model, leftward shift here barely reduces the price level due to excess capacity.

Why the others are wrong:

• B: AD₂ is moderately low, allowing some price reduction from AD shift.
• C: AD₃ is higher, enabling noticeable inflation control via contraction.
• D: AD₄ is highest (overheating), maximizing policy effectiveness on prices.

Final answer: A