Final answer:
The two reasons to decrease aggregate demand by decreasing government spending or increasing taxes are to counter inflationary pressures in an overheated economy and as a result of automatic fiscal responses that occur when an economy experiences high aggregate demand.
Step-by-step explanation:
There are two main reasons to decrease aggregate demand by decreasing government spending (G) or increasing taxes:
- To counter inflationary pressures when the economy is producing above its potential GDP, higher taxes and reduced government spending can help cool down the economy and prevent runaway inflation.
- Automatic fiscal responses: When aggregate demand is high, incomes and corporate profits rise, which leads to increased tax payments without a change in tax rates. Simultaneously, lower unemployment means less government spending on social safety nets, which also acts to reduce aggregate demand.
Therefore, these measures are part of a contractionary fiscal policy aimed at stabilizing the economy during times of excessive growth to avoid high inflation and the creation of economic bubbles.