Question 2

Increasing government spending restores equilibrium when the economy is below full employment.

Fiscal action is necessary to stimulate demand and boost economic activity. Increasing government spending directly injects money into the economy, creating jobs and increasing overall demand, which helps to restore equilibrium.

A) raise taxes

Raising taxes is counterproductive in a situation where the economy is below full employment. Higher taxes reduce disposable income, leading to decreased consumer spending and further contraction of economic activity, which does not help in restoring equilibrium.

B) cut spending

Cutting spending would also be detrimental as it would further decrease demand within the economy. In a scenario of underemployment, reducing spending would exacerbate economic stagnation, making it even harder to achieve equilibrium.

C) raise reserve ratio

Increasing the reserve ratio requires banks to hold more reserves and limits their ability to lend. This action would restrict credit availability, reducing money supply and consumer spending, thus hindering efforts to restore economic equilibrium.

D) increase government spending

Increasing government spending is the most effective fiscal action in this context. It directly stimulates demand by funding projects, creating jobs, and increasing income, which encourages consumer spending and helps drive the economy towards full employment.

Conclusion

Increasing government spending is the only option that effectively addresses the issue of underemployment by stimulating economic activity. All other options, including raising taxes, cutting spending, and raising the reserve ratio, would hinder economic growth and fail to restore equilibrium, making D the definitive correct choice.