Evaluate Two Government Policies To Reduce Inflation

Intro

Inflation - a persistent increase in the price level over a period of time.

Inflation is costly to the economy - a fall in real income > loss of purchasing power discourages savings/investment harms export competitiveness.

Government must intervene to achieve a low and stable rate of inflation.

2:Deflationary monetary policy - increase in interest rate

Consider one cause of inflation that is demand pull inflation. As Keynesian perspective suggests, if the economy is operating at full employment, any increase in AD will be "purely inflationary".

How will higher IR curb demand? Use diagram to show leftward shift in AD leads to lower price level:

More incentive to save than spend

Increase the cost of borrowing and therefore investment will fall.

Lead to currency appreciation, import cheaper and export dearer.

Monetary policies are pre-emptive: prevents inflation before it actually occurs.

However

Time lags - IR changes take up to 18 months to have full effect. Due to fixed-rate interest rate, imperfect knowledge, etc....

Impact on different stakeholders: IR increase will have a more significant impact on someone who just entered the housing market with a high mortgage repayment (Unlike the elderly with a low mortgage).

Higher IR will discourage production and causes unemployment. Use Phillip (1958)`s inflation-unemployment trade-off debate.

3: A better solution - interventionist supply side policy

Interest rate changes are only effective as a temporary demand management policy. To curb inflation, especially cost-push inflation, the economy needs to increase its national output in the long term.

Example: improvement in the quality of labour can increase productivity, competition to lower prices and control inflation. Use AD/AS diagram to show rightward shift is AS and lower price level.

However

Increase in government spending > budget deficit > crowding out as the price of loanable funds (IR) becomes more expensive for businesses who wishes to invest. Classical economists argue that this is a significant problem of increased government spending and why the economy should be left to market forces.