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Success of Supply-Side Policy vs. Fiscal Policy in Inflation

Discuss whether supply side policy is more likely to be successful than fiscal policy when an economy is faced with inflation

Category:

Macroeconomic Factors and Policies

[CIE A level May June 2017]

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Answer

Explain how fiscal policily and supply side policy can't be used to tackle inflation. Do not forgot to compare the relative strengths and weaknesses of each approach and to reach a conclusion concerning which policy is more likely to be successful.


Step ➊ : Define ‘fiscal policy’, ‘supply-side policy’, and ‘inflation’ in the introduction.


Inflation is the general increase in the prices of goods and services over time. Inflation can be very damaging to an economy and thus the government may adopt several policies to solve this problem, for example, fiscal policy and supply-side policy. Fiscal policy refers to the use of government spending and tax policies to influence economic conditions, including demand for goods and services, employment, inflation and economic growth. Supply-side policy includes any policy that improves an economy’s productive potential and its ability to produce. Before concluding which of these two policies is likely to be more successful to tackle inflation, several points must be considered. We will discuss how these policies can be implemented and evaluate whether they are always successful.


Step ➋ : Discuss whether fiscal policy can be effective to solve inflation.

Deflationary fiscal policy can be used in an attempt to reduce 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. Income tax rates may be increased, the threshold at which people start paying the tax may be reduced and the tax base may be widened. Governments may cut their own spending, for example, by providing fewer benefits. Higher-income tax reduces disposable income and therefore reduces consumer spending. This also happens when the government cuts subsidies or transfer payments. The main aim of deflationary fiscal policy is to reduce aggregate demand.

➤ 2.1 The diagram below shows the effect of tight fiscal policy.

A cut in government spending or an increase in tax rates will reduce consumer spending, as a result, the aggregate demand curve will shift inward from AD to AD1. This will result in a fall in the general price level from P to P1 as well as a fall in GDP from Y to Y1.

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➤ 2.2 Fiscal policy may not always be successful.

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, as noted earlier, 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. Reduced government expenditure may cause social unrest.

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Step ➌ : Discuss whether supply-side policy can be effective to solve inflation.
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To reduce the risk of demand-pull inflation in the longer term, governments use supply-side policy measures. Over time aggregate demand tends to increase. If increases in aggregate supply can keep pace with higher aggregate demand, a country can enjoy higher output (higher real GDP) without experiencing inflation.

➤ 3.1 Governments may also employ supply side policy measures to correct cost-push inflation.

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. Firms may also use some of the subsidies to buy new capital equipment, which may lower costs and prices in the longer term.

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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 general price level from P to P1.

➤ 3.2 Supply-side policy may not always successful

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. There is also the risk that government subsidies may increase aggregate demand, through the rise in government spending, but may not increase aggregate supply if firms do not respond positively by using them to increase their efficiency. Another disadvantage of supply-side policies is that they are costly and there is a time lag before it takes effect.

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Step ➍ : Conclude which policy is more effective (evaluation)
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To conclude, supply-side policies can be considered as the most effective policy compared to fiscal policy in order to tackle inflation. 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 policy is used to reduce aggregate demand, there is the risk this may cause unemployment and low economic growth. Furthermore, fiscal policy is less effective if the economy is not operating close to, or at full capacity.

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♕ Examiner’s report
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Although most candidates provided a clear explanation of how fiscal policy could be used to deal with inflation many were unable to provide an equally successful explanation of supply-side policy. There were many examples of the policy instruments that are considered as supply-side measures, but it was not always clear how these might be used to deal with inflation. The instruments of supply-side policy were often described, but the overall aim of the policy when an economy was faced with inflation was often absent. This weakness in these approaches also undermined the candidates’ assessment of which policy was more likely to be successful and low marks were often awarded for evaluation as a result.

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♕ Mark scheme
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For analysis
• of how supply-side policy can be applied to correct inflation in an economy with due consideration of the likely success of this approach. (Up to 6 marks)
• of how fiscal policy can be applied to correct inflation in an economy with due consideration of the likely success of this approach. (Up to 6 marks)

(8 marks maximum)

For evaluation that assesses and compares
• the relative strengths and weaknesses of each approach (3 marks)
• to reach a conclusion concerning which policy is more likely to be successful (1 mark)

(4 marks maximum)

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♕ Guidance
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The term ‘supply-side policy’ refers to any action taken by governments to influence aggregate supply. This could include action such as improving education and training, changing tax rates to affect economic activity and improving infrastructure. A shift in the aggregate supply curve to the right reduces inflationary pressure as aggregate demand can be satisfied with an increase in real output rather than an increase in prices.
Contractionary fiscal policy will shift the aggregate demand curve to the left and reduce inflationary pressure.
The weaknesses of supply-side policy include the pressure on the government budget and the long-time period before it takes effect. The weakness of fiscal policy is that higher tax rates can provide a disincentive effect and reduced government expenditure may cause social unrest.

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