Suppose 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

When an economy is in an inflationary gap, aggregate demand (AD) is greater than potential output (Yp), causing inflation. To close this gap, fiscal policy should decrease AD, which can be achieved by decreasing government purchases or increasing taxes. Lowering tax rates or increasing the investment tax credit would both increase AD, making it less effective in closing the gap. Lowering the real interest rate is a monetary policy tool, not fiscal policy. Therefore, decreasing government purchases (choice B) is the best fiscal policy option to move equilibrium aggregate output closer to the level of potential output.

Suppose the Economy Is in an Inflationary Gap