Suppose that the economy is in an inflationary gap. To move equilibrium aggregate output closer to the level of potential output, the BEST fiscal policy option is to:
A) lower tax rates.
B) decrease government purchases.
C) increase the investment tax credit.
D) lower the real interest rate.

Question

Quizplus · Accepted Answer

In an inflationary gap, the economy is producing at a level higher than its potential output, leading to upward pressure on prices. To move equilibrium aggregate output closer to the level of potential output, the government can use contractionary fiscal policy, which involves reducing aggregate demand. Decreasing government purchases is an effective option as it directly reduces government spending and therefore aggregate demand in the economy. Lowering tax rates or increasing the investment tax credit would be expansionary fiscal policies, which would increase aggregate demand and exacerbate the inflationary gap. Lowering the real interest rate is a monetary policy option, which is not mentioned in the question as a choice.

Suppose That the Economy Is in an Inflationary Gap