To close an inflationary gap through fiscal policy, the government should
a. decrease government spending in order to reduce aggregate demand.
b. increase government spending and taxes in order to both increase aggregate demand and aggregate supply.
c. decrease government spending in order to increase aggregate supply.
d. reduce taxes in order to stimulate investment, and thus increase aggregate supply.
Answer: a. Decrease government spending in order to reduce aggregate demand.
The inflationary gap means the actual real output is higher than the potential output and to reduce it government should decrease spending or increase taxes (taxes have a lower effect) which decreases the AD by the multiplier times and shifts it to left.
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