Final answer:
To close an inflationary gap, the government can increase taxes or reduce spending, shifting the Y-AE graph's aggregate expenditure curve downwards. For a recessionary gap of $200 with C=88+0.9YD and NT=0.2Y, the increase in government spending needed can be computed using the fiscal multiplier.
Step-by-step explanation:
To address an inflationary gap in which the economy's actual output exceeds its potential output, the government needs to decrease aggregate expenditure. This is typically done through tax increases or spending cuts. On a Y-AE graph, this policy would be represented by a downward shift of the aggregate expenditure curve. If the initial equilibrium is above potential GDP (say at $8,000 when potential GDP is $7,000), a higher tax rate would decrease disposable income, thereby reducing consumption and shifting the AE curve downwards. This shift brings the new equilibrium point in line with the level of potential GDP, thus closing the inflationary gap.
If an economy has a recessionary gap of $200, and the consumption function is given by C=88+0.9YD, where YD is disposable income (Y-T) and taxes (NT) are 0.2Y, the required increase in government spending (G) to close this gap can be calculated. Since the marginal propensity to consume (MPC) is 0.9 and the tax rate is 0.2, the multiplier is 1/(1 - MPC*(1 - tax rate)) = 1/(1 - 0.9*(1 - 0.2)). The required increase in G would be the recessionary gap divided by the multiplier.