If the government budget risks an inflationary gap and price stability is the priority, what should you do?

• A. Raise Taxes
• B. Pursue Expansionary Policy to Increase Output
• C. Pursue Contractionary Monetary Policy to Return to Potential Output
• D. Cut Spending

Answer: (C)

An inflationary gap means actual output is above the economy’s sustainable level, which puts upward pressure on prices. When price stability is the priority, the policy should cool demand enough to bring output back to its potential and ease inflation. Contractionary monetary policy does exactly this: by reducing the money supply and raising interest rates, it slows spending and investment, lowers aggregate demand, and helps push output back toward potential. This stabilizes the price level without relying on expansion that would keep pushing prices up. While fiscal tools like higher taxes or lower spending could also reduce demand, monetary tightening is the standard way to curb inflation and return to full employment when prices are the concern.