Which policy tool uses government spending and taxation to influence the economy?

• A. Fiscal policy
• B. Monetary policy
• C. Productivity policy
• D. Contractionary policy

Answer: (A)

The idea being tested is how government decisions on spending and taxes steer the economy by changing overall demand. This instrument is fiscal policy. By increasing government spending or cutting taxes, the government puts more money into people’s hands and into the economy, lifting consumption and investment and raising aggregate demand. The opposite actions—cutting spending or raising taxes—cool the economy and reduce demand. Monetary policy, in contrast, influences the economy through interest rates and the money supply, not through the budget balance. Productivity policy focuses on long-run growth through reforms to efficiency and capacity, rather than short-term demand management. Contractionary policy describes a stance aimed at lowering demand, which can be achieved via fiscal or monetary means, but the tool that directly uses government spending and taxation is fiscal policy.