If government reduces money supply, effectiveness of expansionary fiscal policy will be reduced. Recessions are treated by expansionary fiscal policy. Expanding fiscal policy involves either raising taxes or reducing spending by government.
A surplus-producing economy requires contraction. In that circumstance, a contractionary fiscal policy is best option, which would entail either raising taxes or reducing government spending. Since government spending is a part of AD, the reduction in government spending results in a reduction in total. Because lower AD will result in new short-run equilibrium with lower output, higher unemployment rate, and lower price level, it causes fall in output.
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