Define Inflationary Gap. State, how the government can control the situation of inflationary gap, using the taxation policy.

Question

Accepted Answer

**Inflationary Gap** is the excess of actual aggregate demand over the aggregate demand required to establish full employment equilibrium. It arises when AD > AS at full employment level, leading to rise in general price level.

**Government can control inflationary gap using taxation policy by:**
- **Increasing direct taxes** (income tax, corporate tax) reduces disposable income of households and profits of firms, leading to reduced consumption and investment expenditure
- **Increasing indirect taxes** (GST, excise duty) raises prices of goods, discouraging consumption
- Both measures reduce aggregate demand, helping to close the inflationary gap