Question

Country X's economy is in an inflationary gap. Which of the following combinations of fiscal and monetary policy actions would restore full employment in the short run?

Answer 1

Answer:

To restore full employment in the short run during an inflationary gap condition, the government has to apply contractionary fiscal and monetary policies that will reduce the supply of money.

Explanation:

     An inflationary gap is an economic situation that is characterised by excess demand. Particularly it is that situation when the real gross domestic product of a country is greater than the projected gross domestic product. In this condition, actual aggregate demand is higher than potential aggregate demand implying that more goods and services are needed to satisfy consumers. From another perspective, this could be caused by a fall in aggregate supply while aggregate demand remains stable.

Government intervention in this case is to reduce the money supply by implementing contractionary fiscal policies such as increasing taxes, reducing government expenditure which in turn reduces disposable income. Contractionary monetary policies that could be applied include increasing short-term interest rates, increasing reserve requirements. Though this policies come in with some unwanted side effects such as unemployemnt, they however serve as short term adjustment measures for an inflationary gap condition.