Which economic theory argues that government can stimulate the economy by increasing spending or cutting taxes?

• A. Monetarism
• B. Classical economics
• C. Supply-side economics
• D. Keynesian economics

Answer: (D)

The main concept tested is the use of fiscal policy to influence aggregate demand. In Keynesian economics, when private demand falters—like during a recession—the government can step in to stimulate the economy by increasing spending or cutting taxes. This raises total demand in the economy, leading to higher output and more jobs. The impact is amplified by the multiplier effect: a change in fiscal policy can have a larger overall effect on GDP than the initial injection of spending or tax relief. A key point is that, in the short run, prices and wages can be sticky, so automatic adjustments aren’t enough to restore full employment quickly; active demand-side policy helps close the gap. As the economy improves, the need for stimulus typically wanes and policy can shift toward stabilization and budget considerations. This differs from monetarist views that emphasize money supply to manage the economy, classical ideas that markets self-correct with flexible prices, and supply-side approaches that stress boosting production incentives rather than directly bolstering demand.