Final answer:
The most effective way to close an inflationary gap is to raise income tax, as it reduces consumer spending and consequently lowers aggregate demand, which can help reduce inflation. The correct option is C. Raising income tax
Step-by-step explanation:
The most effective strategy for the government to close an inflationary gap is to implement policies that decrease aggregate demand. Raising income tax would be such a strategy, as it generally reduces consumer spending by decreasing disposable income, leading to a leftward shift of the AD curve and a potential reduction in inflationary pressures.
In contrast, raising government spending, lowering income tax, and lowering federal interest rates are generally expansionary fiscal or monetary policies that would typically be used to combat a recession rather than inflation. These measures increase aggregate demand, which could potentially widen the inflationary gap instead of closing it.
To aid in understanding, in a Keynesian framework, an aggregate demand and supply (AD/AS) diagram illustrates how a tax increase would correct inflation by decreasing aggregate demand. This contractionary policy might have politically challenging implications, but it is effective in managing inflation. The correct option is C. Raising income tax