Suppose the economy is initially at Point A in the diagram. If an increase in investment spending causes a shift of the AD curve from AD1 to AD4, then the government can avoid a short run increase in inflation by

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Quizplus · Accepted Answer

If the AD curve shifts out to AD4, it means there is an increase in aggregate demand which results in an increase in price levels and inflation. To avoid this, the government can increase taxes, which will reduce consumption spending and investment spending. This will cause the AD curve to shift back to AD1, where inflation will not be as high as at AD4. Increasing government spending will further shift the AD curve out to AD5, which could result in even higher inflation. Therefore, the best choice is to increase taxes so that the AD curve shifts back to AD1.

Suppose the Economy Is Initially at Point a in the Diagram