Final answer:
During a recession caused by slowing growth in potential output, the government should adopt expansionary fiscal policies like lowering taxes or ramping up spending, to increase aggregate demand and stimulate the economy towards potential GDP.
Step-by-step explanation:
When recessions are the result of slowing growth in potential output, the government's best policy is to:
- Increase aggregate demand
Demand-side economic theory suggests that during a recession, if unemployment increases, an effective response is expansionary fiscal policy. This approach includes lowering taxes or increasing government spending, both of which can stimulate economic output and decrease unemployment. For example, reducing taxes gives individuals more disposable income and encourages consumer spending, which increases aggregate demand.
Similarly, enhancing government spending on infrastructure adds directly to aggregate demand and can also have a multiplier effect, infusing more money into the economy as those funds circulate. Thus, the correct response from the available options is to increase aggregate demand, which involves adopting measures that encourage consumer spending and investment. This policy shift is designed to move the economy closer to potential GDP by stimulating economic activity.