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Using Monetary or Fiscal Policy to Solve Deflation


Discuss whether a government should use monetary policy or fiscal policy to solve the problem of deflation in an economy

(12 marks)


Macroeconomic Factors and Policies

CIE AS Level June 2021

Preview Answer

(Step 1: Define deflation)

Deflation is a general decline in prices for goods and services and can be a serious economic problem. Policymakers attempt to solve deflation by making use of fiscal policy and monetary policy.

(Step 2: Explain how fiscal policy can be used to solve deflation)

Fiscal policy involves the use of government spending, taxation and borrowing to affect the level and growth of aggregate demand, output and jobs.

Expansionary fiscal policy can help to solve the problem of deflation as it puts more money into consumers' and producers' hands to give them more purchasing power. It is designed to increase aggregate demand. This can be achieved in two ways. First, government spending can be increased. Second, the government can cut tax rates.

🪙The government can solve deflation by cutting taxes.

A reduction in taxes has the effect of raising disposable income thereby increasing consumption and investment expenditures. Corporate tax cuts put more money into businesses' hands. They use it for new investments and employees. In that way, tax cuts create jobs. A decrease in taxes also means that households have more disposable income to spend. Higher disposal income increases consumption which increases the gross domestic product. On the expenditure side, the government maintains all public projects and obligations.

🪙 The government can solve deflation by increasing spending.

The government may even embark on new public projects for the purpose of providing jobs in order to keep aggregate demand strong.

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.

The effect of an effective expansionary fiscal policy is shown in the diagram below.

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