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.