Question

Which statement best describes the likely effects of an expansionary fiscal policy?

It can increase interest rates and unemployment, but lower inflation.
It can increase interest rates, unemployment and inflation.
It can reduce interest rates and inflation, but increase unemployment.
It can reduce interest rates and unemployment, but increase inflation

Answer 1

Short answer: An expansionary fiscal policy typically raises inflation and interest rates and reduces unemployment. None of the four choices states that exactly; the closest is the second choice ("It can increase interest rates, unemployment and inflation"), but that choice is wrong about unemployment — unemployment normally falls, not rises.

Why: expansionary fiscal policy (higher G or lower taxes) shifts aggregate demand right → higher output (so lower unemployment) and a higher price level (higher inflation). In an IS–LM framework the IS curve shifts right, raising income and putting upward pressure on interest rates (crowding‑out of private investment). Exceptions occur if monetary policy accommodates or the economy is in a liquidity trap.