Use the following to answer questions: -(Figure: Short-Run Equilibrium) Refer to Figure: Short-Run Equilibrium. If the economy is at equilibrium at Y₁ and P₁, the appropriate policy to return the economy to potential output would be a(n): A) increase in transfer payments. B) increase in government spending. C) increase in taxes. D) decrease in taxes.

Question

Quizplus · Accepted Answer

The economy is producing above potential output, which implies excess demand in the economy. In order to reduce this excess demand and return the economy to potential output, the appropriate policy would be to reduce aggregate demand, which can be accomplished by decreasing government spending or increasing taxes. Since there is no option for decreasing government spending, the only appropriate policy would be to increase taxes (choice C). An increase in transfer payments or government spending would only serve to increase aggregate demand, exacerbating the existing excess demand problem.

Use the Following to Answer Questions