Question

Explain any one fiscal measure which the government of the nation can initiate to curtail the situation of inflationary gap in the economy.

Hint:

To correct an inflationary gap, AD must fall. The government can raise tax rates, which cuts disposable income and consumption, and so reduces AD.

Answer 1

Step 1: Understanding the Concept:
An inflationary gap arises when Aggregate Demand is more than the AD needed to reach full employment output. The excess demand pushes prices up. To close the gap, AD has to be brought down.

Step 2: Key Approach:
Fiscal policy means the use of government taxes and spending to control the economy. In an inflationary gap, the government follows a contractionary (tight) fiscal policy.

Step 3: Measure chosen: increase in tax rates:
The government raises the rates of taxes, for example income tax.
People now pay more tax. So their disposable income (the purchasing power left with them) falls.
With lower disposable income, households cut their consumption spending.

Step 4: Effect on Aggregate Demand:
Lower consumption expenditure reduces Aggregate Demand in the economy.
As AD falls towards the full employment level of AD, the excess demand is removed. The inflationary gap is corrected and the price rise slows down.

Step 5: Other valid measures:
A cut in government expenditure also reduces AD. Any one valid fiscal measure earns the marks.

Final Answer:
The government can increase tax rates. This lowers disposable income and so lowers AD, which corrects the inflationary gap.