Final answer:
An inflationary gap occurs when AD and SRAS intersect to the right of natural real GDP, indicating the economy is producing beyond its sustainable capacity, leading to inflation. Contractionary fiscal policy can help realign AD with potential GDP. Conversely, if AD intersects SRAS to the left of natural GDP, this suggests a recession, and expansionary fiscal policy can help increase AD.
Step-by-step explanation:
An inflationary gap exists when Aggregate Demand (AD) and Short-Run Aggregate Supply (SRAS) intersect to the right of natural real GDP (potential GDP). When the AD curve shifts to the right, perhaps due to an increase in consumer spending or government spending, it leads to an intersection with SRAS at a level above potential GDP, signaling that the economy is producing beyond its sustainable capacity. This can result in upward pressure on wages and prices, commonly understood as inflation. In such cases, contractionary fiscal policy, such as reducing government spending or increasing taxes, can be used to shift the AD curve back to the left, aiming to bring the economy back to its potential output.
If AD intersects SRAS to the left of natural real GDP, it would indicate an economic output below the economy's potential, often associated with a recession and increased unemployment. Fiscal policy could be adjusted in the opposite direction, becoming more expansionary to increase aggregate demand and move the economy towards its potential GDP.