Final answer:
To maintain price stability when inflation is a concern, despite low unemployment, the government should employ contractionary fiscal policy by increasing taxes or cutting spending to shift aggregate demand to the left. This aims to prevent inflation without significantly impacting employment or output levels.
Step-by-step explanation:
If the government's primary concern is to maintain price stability at a level of P1, the appropriate fiscal policy response would involve contractionary measures. Specifically, this means the government could either increase taxes or cut government spending, effectively shifting the aggregate demand (AD) curve to the left from ADi towards ADf. This shift would relieve inflationary pressures by reducing the pressure for a higher price level while keeping the economy at full employment.
Fiscal policy is concerned with government spending and taxation. It is used to influence economic conditions such as inflation, unemployment, and economic growth. In this context, with low unemployment and rising price levels, a contractionary fiscal policy would help maintain price stability without causing a significant rise in unemployment or a substantial decrease in output.
To target price stability specifically, the government's response should be carefully calibrated to ensure that the decrease in aggregate demand does not push the economy into a recession, especially if aggregate expenditure exceeds potential GDP.