Governments may employ supply-side policy to correct cost-push inflation.
Cost-push inflation occurs when prices are pushed up by increases in the cost of production.
Supply-side policies increase the productive potential of the economy, they help to prevent the general price level from rising beyond control.
Using supply-side policies to tackle inflation
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.
Reducing the power of unions and/or firms (for example, by the use of anti-monopoly legislation) may encourage more competition in the supply of labour and/or goods.
Effectiveness of supply-side policies
In the short run, some supply-side policy measures may actually contribute to inflation. For instance, cuts in income tax may increase aggregate demand before they increase aggregate supply.
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.
Supply-side policies will increase productivity and lower costs of production,
This will lead to a shift in the aggregate supply curve from AS to AS1.
This will result in a fall in the price level from P to P1. The level of inflation is reduced.