Question

Which of the following would help a government reduce an inflationary output gap?

1. Raising taxes

2. Lowering taxes

3. Increasing government spending

4. Decreasing government spending

Short answer

Option (a): raising taxes; option (d): decreasing government spending

Step-by-step solution

Explanation for correct options

During an inflationary expenditure gap, the total spending hikes due to a pull in prices by heavy consumer demand. The demand has to be cut down to reduce the inflationary gap.The economy's aggregate demand can be reduced either by increasing the taxes or decreasing government spending or both simultaneously.

Higher taxes will minimize the disposable income of consumers, and the consumption expenditure will decline, which will ultimately reduce the aggregate demand or expenditure in the economy. The inflationary output gap will be minimized.

Decreased government spending will directly shrink the economy's aggregate expenditure. As aggregate expenditure declines, the price level will also decline, which reduces the inflationary gap.

Explanation for incorrect options

A lowering of taxes will enhance the consumption capacity of households.As a result, private consumption will be pushed forward, increasing the aggregate expenditure further, widening the inflationary gap.On the other hand, increasing government spending will lift the aggregate expenditure resulting in a multiplied inflationary output gap.

Therefore options (b) and (c) are incorrect.