Figure: Aggregate Demand Shifts 2 Refer to the figure. Suppose the economy is initially at point A in the diagram. If a decrease in investment spending causes a shift of the AD curve from AD₁ to AD₂, then the government can avoid a short-run recession by: A) increasing taxes so that the AD curve shifts back to AD₁. B) increasing taxes so that the AD curve shifts further in to AD₃. C) increasing government spending so that the AD curve shifts back to AD₁. D) increasing government spending so that the AD curve shifts further in to AD₃.

Question

Quizplus · Accepted Answer

Since there has been a decrease in investment spending, it means that aggregate demand has decreased. The best way to avoid a short-run recession is to increase government spending so that the AD curve shifts back to its initial position (AD₁). Option A is incorrect because increasing taxes would further decrease aggregate demand (since taxes are an injection in the circular flow of income) and worsen the recession. Option B is also incorrect because it would lead to an increase in aggregate demand, which would put pressure on the economy's resources and potentially cause inflation. Option D is incorrect because increasing government spending to that level would cause an oversupply of output and lead to inflation. Therefore, the best choice is option C.

Figure: Aggregate Demand Shifts 2 Refer to the Figure