Policies to Control Inflation (Cambridge International IGCSE Economics)
Policies to manage inflation
Spec point — the range of policies available to control inflation and their effectiveness
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Demand-pull inflation is best addressed using contractionary demand-side policies
- Contractionary fiscal policy and contractionary monetary policy aim to reduce total (aggregate) demand in an economy
- If total demand for goods and services decreases, there will be a fall in the general price level, thereby reducing the level of inflation
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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 used to reduce demand-pull inflation
| Broad policy type | Specific policy | Explanation |
|---|---|---|
| Contractionary fiscal policy | - The government increases corporation tax | - Firms pay more tax → firms have less profit → firms invest less → rGDP falls → inflation decreases |
| Contractionary fiscal policy | - The 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 | - The 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 |
The effectiveness of demand-side policies
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Demand-side policies are more effective in the short term at dealing with inflation caused by a rise in total (aggregate) demand
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They are less effective at dealing with cost-push inflation
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One conflict caused by contractionary policy is that reducing demand-pull inflation also reduces output and employment
- This could increase unemployment
Examples of supply-side policies used to reduce cost-push inflation
| Specific supply-side policy | Explanation |
|---|---|
| The government reduces regulation on the oil and 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 and airports | - Speed and capacity of transport infrastructure is improved → costs of production decrease as firms benefit from the improvements → national output (total supply) rises → inflation reduces |
The effectiveness of supply-side policies
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Supply-side policy tends to be long-term and is highly effective in reducing price levels in the long run
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They do not help deal with inflation caused by demand-side issues
- Not useful for short-term inflation – if prices are rising quickly due to demand-side pressures (e.g., after a stimulus), supply-side policies are too slow to help
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They can be expensive to implement – as they can require high government spending in the short term (e.g. for investment or subsidies)
Exam Hint When answering questions on inflation, say that supply-side policies help reduce inflation in the long run, but they are not a quick fix. For short-term inflation, monetary policy is usually more effective
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