Policies to Control Inflation & Deflation (Cambridge (CIE) O Level Economics)
Revision Note
Written by: Steve Vorster
Reviewed by: Jenna Quinn
Policies to Tackle Inflation
Demand pull inflation is best addressed using contractionary demand side policies
Contractionary fiscal policy & contractionary monetary policy aim to reduce total (aggregate) demand in an economy
If total demand for goods/services decrease there will be a fall in the general price level thereby reducing the level of inflation
Total demand can be decreased through any policy which decreases one of the components of real gross domestic product (rGDP)
Examples of Demand-side Policies Which Are Likely To Reduce Demand Pull Inflation
Broad Policy Type | Specific Policy | Explanation |
|---|---|---|
Contractionary Fiscal Policy | Government increases corporation tax | Firms pay more tax → firms have less profit → firms invest less → rGDP falls → inflation decreases |
Contractionary Fiscal Policy | Government decreases expenditure on national defence | Government spending decreases → defence firms receive fewer orders from the government → national output falls → inflation decreases |
Contractionary Fiscal Policy | Government increases personal income tax | Households have less discretionary income → consumption decreases → national output falls → inflation decreases |
Contractionary Monetary Policy | The Central Bank increases interest rates | Household repayments on existing loans rise → households have less discretionary income → consumption decreases → national output falls → inflation decreases |
Contractionary Monetary Policy | The Central Bank decreases the money supply by stopping quantitative easing | Firms receive less money from the sale of bonds → investment decreases → national output falls → inflation decreases |
Demand-side policies are more effective in the short term at dealing with inflation caused by a rise in total (aggregate) demand
They are less effective at dealing with cost push inflation
One conflict caused by contractionary policy is that reducing demand pull inflation also reduces output & employment
Examples of Supply-side Policies Which Are Likely To Reduce Cost Push Inflation
Specific Supply-side Policy | Explanation |
|---|---|
The Government reduces regulation on the oil & banking industries | Regulations removed → costs of production decrease as firms no longer need to spend money meeting requirements → national output (total supply) rises → inflation reduces |
The Government changes migration policies to allow more workers into the country | More workers move into the country → the price of labour (wages) falls → costs of production reduce for firms → national output (total supply) rises → inflation reduces |
The Government builds a new rail network serving ports & airports | Speed & capacity of transport infrastructure is improved → costs of production decrease as firms benefit from the improvements → national output (total supply) rises → inflation reduces |
Supply-side policy tends to be long term, but highly effective in reducing price levels
They do not help deal with inflation caused by demand side issues
Policies To Tackle Deflation
Deflation caused by a fall in total demand (e.g. during a recession) is best addressed using expansionary demand-side policies
Expansionary fiscal policy & expansionary monetary policy aim to increase total (aggregate) demand in an economy
When total demand increases, general price levels also increase
This reduces or eliminates the deflation
Total demand can be increased through any policy which increases one of the components of real gross domestic product (rGDP)
Examples of Demand-side Policies Which Are Likely To Reduce Deflation
Broad Policy Type | Specific Policy | Explanation |
|---|---|---|
Expansionary Fiscal Policy | Government increases expenditure on national defence | Defence firms receive more orders from the government → total demand increases → deflation is improved/eliminated |
Expansionary Fiscal Policy | Government decreases personal income tax | Households have more discretionary income → consumption increases →total demand increases → deflation is improved/eliminated |
Expansionary Monetary Policy | The Central Bank lowers interest rates | Household repayments on existing loans fall → Households have more discretionary income → consumption increases → total demand increases → deflation is improved/eliminated |
Demand-side policies can very effective at dealing with deflation
Expansionary monetary policy tends to increase inequality in the distribution of income as the poor are usually unable to benefit from it (banks do not necessarily lend to the poorest households)
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