Cutting taxes and raising government spending is most effective at improving short term aggregate demand when:
private sector spending is very low, wages stay low, banks are not lending or consumers are increasing their spending.
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The best answer for this is the first option. An expansionary fiscal policy (cutting taxes and raising government spending in hopes of increasing aggregate demand) is most likely to be effective if spending in the private sector is low. The reason for this is that the government spending will then stimulate more spending on the part of the private sector.
When the government spends more money (and when it reduces taxes) people in the private sector have more money to spend. They keep more of their money instead of paying it in taxes. They receive more money from the government in return for jobs they have done. This allows them to go out and spend more. In other words, it stimulates spending by the private sector. If private sector spending is very low, it is in need of stimulation. If, by contrast, consumers are already increasing their spending, there is much less need for a stimulus. Therefore, it is most important for the government to stimulate the economy when the private sector is not spending much money on consumer goods and services.
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