Plugging the Inflationary Gap

The figure below represents an economy that has grown so quickly that the aggregate demand has been pushed to the right, beyond the long run aggregate supply curve. AD₁ represents the current state of the economy. It intersects with the short run aggregate supply curve at E₁. The intersection means that the overall price level has increased from what would be it is equilibrium level where the aggregate demand, the long run aggregate supply and the short run aggregate supply curve would all intersect at point E₂.

Figure 2 adapted from Krugman & Wells, p. 381

            The current equilibrium has raised the price level so that the economy is undergoing a period of inflation. To move the economy from the equilibrium from the point E₁ to E₂, the government in charge of this economy needs to undergo some contractionary fiscal policy to move the aggregate demand curve from AD₁ to AD₂, making the equilibrium point meet the line of potential output instead of outpacing it.  There are several options that this government has to enact its contractionary fiscal policy. One option is to decrease the amount of direct government purchases of goods and services. Another option is to increase taxes so that consumers have less money to spend. A second way to limit money in consumer hands would be to decrease the amount of transfers the government sends to consumers (Krugman & Wells p. 381).

            All three options would have the effect of lowering the aggregate demand so that the economy would be able to cool off and the period of inflation would dissipate, moving the aggregate demand curve to the point where the equilibrium point is on both on the short run and the long run aggregate supply curves.