Can Supply-Side Policies Reduce Inflation?
Discuss why whether or not supply-side policy measures can reduce inflation.
(8 marks)
CIE O Level November 2021
Supply-Side Policies
Answer
(Step 1: Define inflation and supply side policy)
Governments may employ supply-side policy to correct cost-push inflation.
Inflation occurs when there is a sustained increase in the general price level. Cost-push inflation occurs when prices are pushed up by increases in the cost of production.
Supply-side policies increase the productive potential of the economy, they help to prevent the general price level from rising beyond control. Supply-side policies are long-term strategies aimed at increasing the productive capacity of the economy by using policies to improve the quality and/or quantity of factors of production.
Step 2: Discuss how supply side policy measures can reduce inflation
The ability of supply-side policies to reduce inflationary pressures by keeping firms costs of production down will help in lowering cost push inflation.
Increased spending on training can raise labour productivity and so reduce labour costs or at least reduce the upward pressure on labour costs.
Lower corporation tax may encourage firms to buy more efficient capital equipment, which can also put downward pressure on price rises.
A government may decide to provide subsidies to firms facing, for instance, higher fuel costs, so that they do not have to raise their prices.
Supply-side policies will increase productivity and lower costs of production,
This will lead to a shift in the aggregate supply curve from AS to AS1.
This will result in a fall in the price level from P to P1. The level of inflation is reduced.
(Step 3: Discuss why supply side policies are not always effective to lower inflation rate)
However supply side policies are not always effective to lower inflation rate.
In the short run, some supply-side policy measures may actually contribute to inflation. For instance, cuts in income tax may increase aggregate demand before they increase aggregate supply.
Some of the interventionist policies that include investment in human capital will be costly and a drain on government budget and its results may take a long time to come forth.
Increased spending on training may be successful in raising the skills of workers but if their pay rises by more than their productivity, costs of production will still rise.
Lower corporation tax may not result in more investment if firms are pessimistic about the future.
It may also be the case that the country does not have the capacity to expand its potential given limited supply of land.
(Step 4: Conclude)
To conclude, supply side policies seek to increase productivity, competition and innovation – all of which can maintain lower prices. These are ways of controlling inflation in the medium term. However it is effective only to an extent.
MARKING SCHEME
Discuss whether or not supply-side policy measures can
reduce inflation.
In assessing each answer, use the table opposite.
Why they might:
• they may increase total (aggregate) supply, reducing
cost-push inflation
• they can allow total (aggregate) demand to increase
without causing inflation
• education and training can increase labour productivity,
reducing labour costs
• a cut in direct taxes may increase the incentive to be
more productive and more innovative
• labour market reforms may reduce power of trade unions
and reduce rise in wages
• subsidies can lower costs of production
Why they might not:
• privatisation does not always increase competition and
so does not always lower prices
• education and training can be expensive, may be in
areas that are not in demand and will have a time lag
• cuts in income tax may increase total (aggregate)
demand as well as total (aggregate) supply
• resource limitations / unable to increase productive
capacity due to e.g. limited land available
• inflation may be caused by rise in price of raw materials
which have no domestic substitute e.g. oil
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Preview:
(Step 1: Define inflation and supply side policy)
Governments may employ supply-side policy to correct cost-push inflation.
Inflation occurs when there is a sustained increase in the general price level. Cost-push inflation occurs when prices are pushed up by increases in the cost of production.
Supply-side policies increase the productive potential of the economy, they help to prevent the general price level from rising beyond control. Supply-side policies are long-term strategies aimed at increasing the productive capacity of the economy by using policies to improve the quality and/or quantity of factors of production.
(Step 2: Discuss how supply side policy measures can reduce inflation)
The ability of supply-side policies to reduce inflationary pressures by keeping firms costs of production down will help in lowering cost push inflation.
Increased spending on training can raise labour productivity and so reduce labour costs or at least reduce the upward pressure on labour costs.
Lower corporation tax may encourage firms to buy more efficient capital equipment, which can also put downward pressure on price rises.
A government may decide to provide subsidies to firms facing, for instance, higher fuel costs, so that they do not have to raise their prices.
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