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

(12 marks)

Initially, there is deflation and low levels of economic activity. The aggregate demand curve is represented by AD and the price level is at P. Aggregate demand (AD) consists of consumption (C), investment (I), government spending (G) and net exports (X-M). An increase in government spending and a cut in tax rates will stimulate the economy. This will shift the aggregate demand curve outwards from AD to AD1. The new price level will increase from P to P1. Consequently, the level of deflation is reduced.




(Step 3: Explain the weaknesses of fiscal policy to solve deflation)




The effectiveness of fiscal policy measures largely depends on the availability of accurate key data. Usually the key data on the economy is often delayed and is subject to revisions and making reflationary fiscal policy less effective.

A more serious problem faced by the government when using fiscal policy is financing a budget deficit. The government will have to spend more than it collects.

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.




(Step 4: Explain how monetary policy can be used to solve deflation)




Expansionary monetary policy is intended to increase aggregate demand. This may be achieved by a cut in the interest rate or/and an increase in the money supply.

🪙 Cutting interest rates can help to solve deflation.

Lower interest rates stimulate consumer consumption spending by making it more attractive to take out loans to buy things such as cars and houses. This will increase the overall demand in the economy and help to reduce deflation.

🪙 Increasing the money supply can help solve deflation.

The Central Bank could pursue a policy of quantitative easing to increase the money supply and reduce long-term interest rates. Under quantitative easing, the Central bank creates money. It then uses this created money to buy government bonds from commercial banks. In theory, this should increase the monetary base and cash reserves of banks, which should enable higher lending and reduce interest rates on bonds which should help investment.


(Step 5: Discuss the weaknesses of monetary policy)

Expansionary monetary policy may fail under certain conditions. If confidence is very low, then people may not want to invest or spend, despite lower interest rates. In a credit crunch, banks may not have funds to lend, therefore although the Central Bank cuts base rates, it is still difficult to get a loan from a bank. Commercial banks may not pass the base rate cut on.

We cannot predict with great accuracy the extent to which a change in interest rates will achieve the desired I planned economic effects.

Moreover when it comes to solving deflation there are many factors affecting prices and most of these arc outside of the central bank’s direct control. For example, low confidence of consumers and businesses and changes in international commodity prices.



(Step 6: Discuss which policy is more effective to solve deflation.)




Fiscal policy may be more effective than monetary policy.

A rise in government spending may be more effective than reducing interest rates or increasing the money supply. This is because firms and households may be pessimistic during periods of deflation and so may not spend more even if their disposable incomes rise and it becomes cheaper to borrow.

In a deep recession causing deflation and liquidity trap, fiscal policy may be more effective than monetary policy because the government can pay for new investment schemes, creating jobs directly – rather than relying on monetary policy to indirectly encourage business to invest.

When the economy is in a recession and when business and consumer confidence is very low and perhaps where deflationary pressures are taking hold monetary policy may be ineffective in increasing current national spending and income. The problems experienced by the Japanese in trying to stimulate their economy through a zero-interest-rate policy might be mentioned here. In this case, fiscal policy might be more effective in stimulating demand.

It can thus be concluded that each policy has its respective advantages and disadvantages. However, in the case of deflation, fiscal policy has proven to be more effective than monetary policy.






>MARKING SCHEME<

For analysis that explains how monetary policy can be used to stimulate
aggregate demand With due reference to the strengths and weaknesses Of
this approach. Maximum 3 marks if only strengths or weaknesses are
explained
(up to 4 marks)
For analysis that explains how fiscal policy can be used to stimulate
aggregate demand With due reference to the strengths and weaknesses Of
this approach. Maximum 3 marks if only strengths or weaknesses are
explained
(up to 4 marks)
And for evaluation that clearly compares the use Of each policy to sowe the
problem Of deflation (3 marks) that leads to a reasoned conclusion as to
Which policy may be the most appropriate (I mark)