Suppose the government increases its spending while the economy is currently operating below potential output. How will this change affect the output gap?

• A. The output gap will remain unchanged.
• B. The output gap will become negative as actual output exceeds potential output.
• C. The output gap will decrease as actual output moves closer to potential output.
• D. The output gap will increase as actual output moves further below potential output.

Answer: (C)

Verified step by step guidance

1. Step 1: Understand the concept of the output gap, which is defined as the difference between actual output (Y) and potential output (Y*), often expressed as Output Gap = Y - Y*. A positive output gap means the economy is producing above potential, while a negative gap means it is below potential.
2. Step 2: Recognize that when the economy is operating below potential output, the output gap is negative (Y < Y*). This indicates underutilized resources and economic slack.
3. Step 3: Analyze the effect of an increase in government spending, which is a component of aggregate demand (AD). An increase in government spending shifts the aggregate demand curve to the right, increasing total demand in the economy.
4. Step 4: Understand that as aggregate demand increases, actual output (Y) rises, moving closer to potential output (Y*). This reduces the negative output gap because the economy is producing more and utilizing resources more fully.
5. Step 5: Conclude that the output gap decreases (becomes less negative) as actual output moves closer to potential output due to the fiscal stimulus from increased government spending.