Question

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

Short answer

b. Increasing taxes; decreasing government expenditures.

Step-by-step solution

Understanding the Inflationary Gap

An inflationary expenditure gap occurs when the equilibrium level of GDP exceeds the full employment level of GDP. This means demand is greater than what the economy can produce at full employment, which typically leads to inflation.

Analyzing Fiscal Policy Options

The government can use fiscal policy to reduce the inflationary gap. To do this, it needs to reduce aggregate demand. Fiscal policy mainly includes adjusting taxes or government spending.

Adjusting Taxes

By increasing taxes, the government reduces consumers' disposable income, leading to decreased consumer spending, which in turn reduces aggregate demand.

Adjusting Government Spending

By decreasing government expenditures, the government directly reduces the total spending in the economy, thus leading to a decrease in aggregate demand.

Selecting the Correct Option

To close an inflationary gap, the government should either increase taxes or decrease government spending, as both actions will reduce aggregate demand.

Key concepts

Fiscal Policy

Fiscal policy involves the government's use of spending and taxation to influence the economy. It's like the government's toolkit to stabilize economic activity. When the economy faces challenges like inflation or a recession, fiscal policy steps in. It can aim to boost the economy during slow periods or cool it down during booms. The government might change how much it spends on public services or adjust tax rates. This helps manage the overall demand in the economy.

There are two primary tools in fiscal policy:

• Government Spending: Investing in public services, infrastructure, and public workers.
• Taxes: Adjusting tax rates to influence consumer and business spending behavior.

During an inflationary gap, when prices are rising too fast, fiscal policy helps stabilize this by reducing aggregate demand. This is often done by manipulating taxes or spending.

Aggregate Demand

Aggregate demand is the total demand for goods and services in an economy. It's a big picture of all the money spent by households, businesses, and the government. Think about it as the sum of everything we want to buy, adding up personal spending, businesses investing, government expenses, and net exports.

When aggregate demand is very high, like in an inflationary gap, it can lead to inflation because demand outpaces what the economy can produce. This is when actions such as increasing taxes or decreasing government spending are considered by the government to help manage it.

To adjust aggregate demand, governments use both fiscal policy (changing levels of taxation and government spending) and monetary policy (altering interest rates and the money supply), although in this context, we are focusing solely on fiscal measures.

Full Employment GDP

Full employment GDP refers to the maximum amount of goods and services an economy can produce when it is using all its resources efficiently, with low and stable unemployment. Imagine it as the sweet spot of economic production, where almost everyone who wants a job has one, and resources are used optimally without driving up inflation.

When the economy's actual GDP exceeds this level, it indicates an inflationary gap. This excess leads to price pressures as too much money chases too few goods, causing inflation. Addressing this requires policy measures to bring GDP back towards this sustainable level.

Government Spending

Government spending is a major component of fiscal policy. It involves how much the government invests in various sectors. This can include infrastructure, education, healthcare, and defense. This spending injects money into the economy, influencing aggregate demand.

During an inflationary gap, one way to reduce demand is by cutting government spending. Less spending means less money floating around, which can help curb inflation. This contrasts with situations where the economy is sluggish, and increased government spending might be used to stimulate growth.

Balancing the right level of spending is crucial to ensuring economic stability, as overspending can lead to inflation, while underspending might not fully support economic growth.

Taxes

Taxes are financial charges imposed by the government on individuals and businesses. They play a vital role in fiscal policy by influencing disposable income. When people have more income, they tend to spend more, increasing aggregate demand.

In the context of an inflationary gap, increasing taxes is a common approach to reduce demand. By taking more money out of consumers' hands, spending decreases, which helps to bring down the prevailing demand that is causing inflation.

Tax adjustments must be carefully managed, as they impact consumer behavior and can have wide-reaching effects on the overall economy. The right balance helps stabilize demand while supporting public services and infrastructure.