Policies to Control Inflation & Deflation (Cambridge (CIE) O Level Economics)

Revision Note

Reviewed by: Jenna Quinn

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

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)

Last updated: 22 June 2024

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