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Solving Deflation through Fiscal and Monetary Policy

Question

Analyse how fiscal policy and monetary policy could be used to solve the problem of deflation. Assess which policy is likely to be more effective. [12]

Category:

Macroeconomic Factors and Policies

[CIE AS level November 2018]

Preview Answer


Step ➊: Define ‘fiscal policy’, ‘monetary policy’ and ‘deflation’ in the introduction.


Deflation is a general decline in prices for goods and services and can be a serious economic problem. Thus policymakers may make use of fiscal and monetary policy in an attempt to solve this problem. Fiscal policy is the use of taxation and government spending to manage aggregate demand in order to achieve the government’s macroeconomic aims. Monetary policy refers to any policy measures or instruments to influence the price or quantity of money. The three instruments of monetary policy are the interest rate, the money supply and the exchange rate. It should however be noted that there are several limitations to these policies.


Step ➋ : Discuss whether the expansionary fiscal policy can be used to solve the problem of deflation. Include the limitations of this policy.


Expansionary fiscal policy can help to solve the problem of deflation as it puts more money into consumers' and producer's hands to give them more purchasing power. It is designed to increase aggregate demand. This can be achieved in two ways.

➤ 2.1 Government spending can be increased.

An increase in public expenditure during deflation increases the aggregate demand for goods and services and leads to a large increase in income via the multiplier process.

Expenditure on public works creates demand for the products of private construction industries and helps in reviving them while expenditure on relief measures stimulates the demand for consumer goods industries. If the government increased investment in public work schemes, this government spending would create jobs, increase incomes and lead to greater aggregate demand.

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