Question

Consider Figure 24-6. The government could close the existing output gap by

A) decreasing the net tax rate.
B) implementing an expansionary fiscal policy.
C) decreasing government transfer payments.
D) increasing the net tax rate.
E) increasing government purchases.

Answer 1

The appropriate response to a recessionary gap is for the government to reduce taxes or increase spending in order to stimulate the economy and shift the aggregate expenditure function. Expansionary fiscal policy can increase aggregate demand through government spending or tax cuts, while contractionary fiscal policy decreases aggregate demand through decreases in consumption, investment, and government spending.

Step-by-step explanation:

The appropriate response to a recessionary gap is for the government to reduce taxes or increase spending so that the aggregate expenditure function shifts up from AEo to AE₁. When this shift occurs, the new equilibrium E₁ now occurs at potential GDP as shown in Figure B9 (a).

Expansionary fiscal policy increases the level of aggregate demand, through either increases in government spending or reductions in tax rates. Contractionary fiscal policy does the reverse: it decreases the level of aggregate demand by decreasing consumption, decreasing investment, and decreasing government spending, either through cuts in government spending or increases in taxes. The aggregate demand/aggregate supply model is useful in judging whether expansionary or contractionary fiscal policy is appropriate.