Final answer:
To combat inflation, the federal government can employ monetary policy to raise interest rates, use fiscal policy to decrease spending or increase taxes, and apply indexing to safeguard incomes from inflation.
Step-by-step explanation:
To control inflation, the federal government can utilize various macroeconomic policies. If aggregate expenditure is greater than potential GDP, one approach is to reduce the amount of money in circulation. This can be achieved by employing three main strategies:
- Monetary Policy: The Federal Reserve can increase interest rates, which discourages borrowing and slows down spending.
- Fiscal Policy: The government can decrease spending or increase taxes to reduce the disposable income available to consumers and businesses.
- Indexing: Adjustments are made in payments such as wages, taxes, and social benefits to match the rate of inflation, helping to maintain the purchasing power of the dollar over time.
The relationship between indexing and inflation is that indexing helps to protect incomes from the erosive effects of inflation.