➤ 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.

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.