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Government Policy Options for Dealing with Inflation

Discuss the policy options available to a government faced with inflation, and consider which is most likely to be effective. [12]

Category:

Macroeconomic Factors and Policies

[CIE AS level November 2016]

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Answer

Tip: The focus of the question is NOT focused on the causes, types and consequences of inflation. Policies to tackle inflation should be explained and evaluation should be made the effectiveness of these policies. A suitable conclusion is important.


Step ➊ : Define ‘inflation’ in the introduction.


Inflation occurs when there is a sustained increase in the general price level. High inflation rates are considered to be damaging to an economy in several ways. It discourages investment and long term economic growth. It makes an economy uncompetitive. It leads to a fall in the value of money and menu costs. This is why most central banks and governments target low inflation. If inflation rises above this inflation target there are certain economic policies that can be applied. Policies to solve the problem of inflation include fiscal policy, monetary policy and supply-side policies.


Step ➋ : Discuss how fiscal policy can be used to solve inflation and it’s limitations.


➤ 2.2.1 To reduce demand-pull inflation, governments employ deflationary fiscal policy.

Fiscal policy can be used to correct demand-pull inflation. Demand-pull inflation occurs when prices are pulled up by increases in aggregate demand that are not matched by equivalent increases in aggregate supply. Fiscal policy is the means by which a government adjusts its spending levels and tax rates to monitor and influence a nation's economy.

➤ 2.1.2 Contractionary fiscal policy can be implemented by increasing income tax or cutting government spending.

Higher-income tax reduces disposable income and therefore reduces consumer spending. That also happens when the government cuts subsidies or transfer payments including welfare programs.

Contractionary fiscal policy helps to lower the price level by shifting the aggregate demand curve to the left. This is shown in the figure below.

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Contractionary fiscal policy will reduce aggregate demand, there will be a shift in the aggregate demand curve from AD to AD1. There will be a fall in the general price level from P to P1


➤ 2.2 Fiscal policy, however, is not always effective to reduce inflation.

Raising income tax to reduce demand-pull inflation may backfire. This is because workers may seek higher wages to maintain their disposable income. If their wage claims are granted, firms’ costs of production may increase. Higher costs can generate cost-push inflation. Higher income tax rates may also create disincentive effects. Some workers may respond to a reduction in disposable income by leaving the labour force. This will reduce the economy’s productive capacity and so reduce aggregate supply.

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Step ➌ : Discuss how monetary policy can be used to solve inflation and it’s limitations.
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➤ 3.1 Monetary policy can be used to reduce demand-pull inflation.

Monetary policy involves altering the supply of money in the economy or manipulating the rate of interest. Central banks have a target rate for inflation and instructed to use interest rate changes to achieve it. If the inflation rate is rising outside its target range, a central bank is likely to raise the rate of interest. The cost of borrowing is likely to rise which may discourage large-scale purchases including the purchase of houses and cars. Savings may be increased as the return from saving will rise. This will help to reduce aggregate demand and help the government to tackle demand-pull inflation.


➤ 3.2 Monetary policy is not always effective to tackle inflation.


A rise in the rate of interest may not always discourage consumer expenditure. Commercial banks usually do keep their interest rates in line with the central bank’s as it is the rate they will have to pay if they need to borrow from the central bank. There is, however, no guarantee that they will always raise their interest rates when the central bank increases its rate. Furthermore, even if consumers are faced with higher interest rates, they may not reduce their spending if they are optimistic about the future.

There may be time lags. It can take up to 18 months for interest rate increases to reduce spending.

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Step ➍ : Discuss how supply-side policy can be used to solve inflation and it’s limitations.
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➤ 4.1 Governments may also employ supply-side policy measures to correct cost-push inflation.

Cost-push inflation occurs when prices are pushed up by increases in the cost of production. For example, 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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Supply-side policies will increase productivity and lower costs of production, leading 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.


➤ 4.2 However supply side policies might not always be effective.

In the short run, some supply-side policy measures may actually contribute to inflation. For instance, increased government spending on education and cuts in income tax may increase aggregate demand before they increase aggregate supply. In addition, the effects of supply-side policy measures are uncertain. For instance, privatised firms that have considerable market power may raise their price

The country’s firms may also not respond to the increased competitive pressure to keep down their cost and price rises. 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.

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Step ➎ : Conclude which policy is more effective. (evaluation)
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To conclude, supply-side policies can be considered as the most effective policy to tackle inflation compared to fiscal and monetary policy. Supply-side policy measures have the potential to benefit all of a government’s policy objectives in the long term. They can reduce inflationary pressure, raise economic growth, lower unemployment, stabilise an exchange rate, reduce a current account deficit and promote development. In contrast, when fiscal and monetary policy is used to reduce aggregate demand, there is the risk of unemployment and low economic growth. This effect will be worst if the economy is not operating close to, or at full capacity.

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♕ Mark scheme
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A range of policies are available such as contractionary fiscal or monetary policy that are designed to reduce aggregate demand, or supply-side policies that are designed to shift aggregate supply to the right to match the excess aggregate demand. Supply-side policies might also be used to solve the problem of cost-push inflation. This type of inflation might also be solved by other policies such as support for the exchange rate.

For analysis explaining the policies available and how each is designed to solve the problem of inflation. For an explanation of any policy designed to solve the problem of inflation. (Up to 4 marks)

8 marks maximum
For evaluative comment on the most effective policy. This might include a consideration of the strengths and weaknesses of each policy and whether the policy is appropriate given the type of inflation that is present. A concluding comment on which policy is most likely to be effective is essential for full marks.
4 marks maximum

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♕ Examiner's report
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Candidates produced a number of very good, thoughtful answers to this question, containing well explained and appropriate analysis together with thoughtful evaluation. However, a large number of candidates scored low marks because their answers were poorly directed at the question set. Many provided over-long introductions focusing upon the causes, types and consequences of inflation and these were often accompanied with only a brief explanation of policies. The result was that answers were often unbalanced with only superficial analysis of possible policy options. This undermined attempts to evaluative the effectiveness of the policies and marks were not scored as a result.

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