Question: If an economy has an inflationary expenditure gap, the government could attempt to bring the economy back toward the full-employment level of GDP by _______ taxes or _______ government expenditures.

1. increasing; increasing

2. increasing; decreasing

3. decreasing; increasing

4. decreasing; decreasing

Inflationary expenditure gap occurs when the equilibrium GDP exceeds full-employment GDP. This gap occurs due to demand-pull inflation.

At full employment, only the price level increase because the output has already reached its total capacity. Beyond the potential GDP, resources cannot be employed. Thus, a high demand pulls the prices up, and equilibrium GDP moves beyond potential GDP.

Demand-pull inflation needs to be controlled to reduce the inflationary gap so that prices and equilibrium GDP decrease.A higher full employment level is the result of an excess of total spending. To control the total spending, the government has to apply the contractionary fiscal policy.The contractionary fiscal policy means an increase in taxes and a reduction in government expenditure.

High taxes will reduce the disposable income and thus the consumption expenditure. Simultaneously, a reduction in government expenditure will directly reduce the total spending in the economy. Therefore, the demand and prices will decrease, and excess GDP will be restored to full employment level.

Thus, the government can increase taxes or decrease government expenditure to reduce the inflationary expenditure gap.