If we are supposed to “slow down the economy,” we will have to engage in contractionary fiscal policy. In other words, we will have to accept Keynesian ideas and we will have to try to cause aggregate demand to decline.
Fiscal policy is made up government spending and taxes. The government can increase or decrease either of these aspects of fiscal policy. Keynesian economists believe that the government can and should use fiscal policy to raise or lower aggregate demand.
In the situation that you describe in this scenario, the government needs to reduce aggregate demand. That is, it needs people to buy fewer goods and services. When people buy less, price will drop and firms will not have to produce as many goods. This will cause the equilibrium to return to the long run aggregate supply level. So how can the government cause this to happen? First, the government is supposed to raise taxes. Second, it is supposed to spend less money. By doing these two things, the government will take money out of people’s pockets. They will have to pay higher taxes and the government will not be putting as much money into their pockets through government spending. When the people have less money they will, all other things being equal, buy fewer goods and services. Aggregate demand will drop, and the economy will cool. You can see this process at work in the interactive graph in the link below.
If the government does not do these things, Keynesians say, the economy will overheat. This means that average prices will rise and we will experience excessively high levels of inflation.
(Please note that supply-side economists and politicians would reject this. They believe that reduced taxes and reduced regulations, among other things, would cause supply to rise. They would prefer to do this rather than to engage in the Keynesian policies mentioned above.)
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