Policies to correct deflation
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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.
Aggregate demand can be increased in two ways:
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.
The government can cut tax rates.
A reduction in taxes has the effect of raising disposable income thereby increasing consumption and investment expenditures.
x 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.
Limitations of fiscal policy to correct deflation
There may be time lags.
If the government plans to increase spending, this can take a long time to filter into the economy, and it may be too late. Spending plans are only set once a year. There is also a delay in implementing any changes to spending patterns.
The effectiveness of fiscal policy will also depend upon the other components of Aggregate demand.
For example, if consumer confidence is very low, reducing taxes may not lead to an increase in consumer spending.