Question

If an economy has an inflationary expenditure gap, the government could attempt to bring the economy back toward the full-employment level of GDP by _____ taxes or _____ government expenditures. a. Increasing; increasing. b. Increasing; decreasing. c. Decreasing; increasing. d. Decreasing; decreasing.

Short answer

The solution is option b: increasing taxes and decreasing government expenditures.

Step-by-step solution

Understanding the Problem

An inflationary expenditure gap occurs when the aggregate demand in an economy exceeds its full-employment level of GDP, leading to inflation. The goal is to reduce excess demand and bring the economy back to full employment.

Options Consideration

There are two main fiscal policy tools the government can use to correct an inflationary gap: taxes and government expenditures. The government can either increase taxes to reduce disposable income and thus consumption, or it can decrease government spending, both aiming to lower aggregate demand.

Evaluating Option a

Option a suggests increasing both taxes and government expenditures. Increasing government expenditures would actually increase aggregate demand, which is counterproductive in an inflationary gap.

Evaluating Option b

Option b suggests increasing taxes and decreasing government expenditures. Increasing taxes will help reduce consumption by reducing disposable income, and decreasing government expenditures will directly cut down aggregate demand, both of which will help eliminate the inflationary gap.

Evaluating Option c

Option c suggests decreasing taxes and increasing government expenditures. Both actions would increase aggregate demand, worsening the inflationary gap, which is not the goal.

Evaluating Option d

Option d suggests decreasing both taxes and government expenditures. Decreasing government expenditures helps reduce the aggregate demand. However, decreasing taxes would increase disposable income and potentially increase consumption, which is not helpful for closing an inflationary gap.

Conclusion

The correct action to eliminate an inflationary expenditure gap is to increase taxes and decrease government expenditures to reduce aggregate demand, aligning with option b.

Key concepts

Inflationary Gap

An inflationary gap occurs when an economy's actual economic output exceeds its potential output at full employment. In simple terms, it's when there's too much money chasing too few goods, pushing prices up, creating inflation. This situation emerges because the aggregate demand in the economy surpasses the aggregate supply at the full-employment equilibrium level. As a result, the economy faces upward pressure on prices.
The inflationary gap indicates a need for policy intervention to bring the economy back to a sustainable equilibrium level. Typically, this involves implementing measures that reduce aggregate demand, leading us to explore the tools available in fiscal policy.

Aggregate Demand

Aggregate demand is the total demand for goods and services in an economy at a given time and price level. It includes the sum of consumption, investment, government spending, and net exports (exports minus imports).

• Consumption: This includes spending by households on durable goods like cars and non-durable goods like food.
• Investment: Businesses investing in capital goods like machinery and tools.
• Government Spending: Expenditures on goods and services by the government.
• Net Exports: The difference between the value of exports and imports.

Aggregate demand is critical in determining the level of economic activity. When it exceeds full-employment levels, it can lead to an inflationary gap as seen in our problem statement. Thus, managing aggregate demand is crucial for maintaining steady economic growth without triggering inflation.

Government Expenditures

Government expenditures refer to the spending by the government on various goods and services that are necessary to run the nation. This can include spending on infrastructure, healthcare, education, and defense.
In the context of correcting an inflationary gap, it's important for the government to reduce its spending to lower the aggregate demand. When government cuts its expenditures:

• The initial demand for goods and services from the government decreases.
• This reduction helps slow down the overall economic activity.
• As a result, inflation pressures are eased.

Reducing government expenditures, therefore, plays a crucial role in contracting the inflationary gap and stabilizing prices.

Taxes

Taxes are financial charges imposed by the government on individuals and businesses. They are a primary tool used for redistributing income and managing the economy.
Especially in controlling an inflationary gap, increasing taxes can be effective because:

• Increased taxes reduce the disposable income available to consumers, leading to less spending.
• With less money to spend, the overall demand for goods and services decreases.
• This decrease in demand helps cool down the inflationary pressures on the economy.

Thus, strategically managing taxes is essential for fiscal policy, aiding in moderating economic cycles and controlling excess demand that can lead to inflation.