If the current equilibrium output lies above potential output, then an appropriate fiscal policy would be to _____, which will shift the AD curve to the _____.
A) decrease government purchases; right
B) increase government purchases; left
C) decrease government purchases; left
D) raise tax rates; right

Question

Quizplus · Accepted Answer

If the current equilibrium output lies above potential output, there is a presence of inflationary gap which means that aggregate demand is higher than aggregate supply. To reduce the aggregate demand, the government needs to decrease its purchases which will shift the AD curve to the left, leading to a decrease in demand-pull inflation and reduction in the gap between actual and potential output. Therefore, choice C, which suggests decreasing government purchases and shifting the AD curve to the left, is the appropriate fiscal policy in this situation.

If the Current Equilibrium Output Lies Above Potential Output, Then