Tuesday, August 26, 2008

How Effective Is Fiscal Policy In Countering Inflation?

Fiscal policy is the manipulation of government expenditure & level of taxation to influence the movement of AD & overall level of economic activity

The government can choose to execute either or both of these

How fiscal policy helps to counter inflation?

(1) Fall in G. When government spends lesser on public services such as on infrastructure, transport, education & health, this directly means a fall in G which also translates to leftward movement of AD curve. Therefore there will be lesser inflationary pressure in the economy

(2) Fall in G which affects C. As government spends lesser into the economy, in the way of lesser development projects, there will be lesser job opportunities too & income may fall. As such overall household spending into the economy will decline & this is followed by leftward movement of AD.

(3) Fall in G which affects I. When there are lesser projects, it may adversely affect profitability of firms or contractors engaged to run it. As profits are lower, these firms will be less willing to invest in R&D, capital goods & business expansion resulting in the fall of I. As such it will ease the inflationary pressure in economy

(4) Increase in income tax. Working people will have lower disposable income & this translates to lower level of spending into the economy. Fall in C will cause AD to shift left

(5) Increase in corporation tax
. Firms will have lower level of retained profits & this will discourage investment. Fall in I will be followed by leftward movement of AD


(1) The task to manage the inflation so that it falls within the target range of CPI 2% +/- 1% is the premier role of Monetary Policy Committee (MPC). The main aim of fiscal policy is to ensure economic growth & low unemployment in economy. Combating inflation may be viewed as ‘secondary goal’

(2) Monetary policy is more effective than fiscal policy in combating inflation as it does not suffer from implementation lags. BOE is independent from UK government since May 1997 & therefore any decisions can be executed immediately with minimal or no political intervention. Furthermore meetings are held every month. Unlike fiscal policy, policies may take months to years to be instituted. By then economic circumstance may have changed & the policy is futile

(3) Fiscal policy is able to ease inflationary pressure but at the expense of lower economic growth. As such supply side policy is the best since there is no inflationary pressure & yet higher output can be attained

(4) Fiscal policy is more suitable to counter demand-pull inflation. If the inflation is due to rising costs of input, supply side policy would be more favourable

(5) Fiscal policy will not be an effective mean to counter inflation if the tax reduction or cut government spending is not significant. Having said that, it must be exercised with great caution too as strong tightening policy may cause deflation to UK economy which is normally followed by contracting economic growth

(6) If the UK economy is near to full employment, tightening policy would be able to bring price level down significantly without much damage to economic growth

(7) Reduction in government spending such as on health & education will have an adverse effect on price level in the long run. In the short run, the government is able to ease inflationary pressure. But since productive capacity is affected too, AS will shift backward in the long run causing price level to climb back

No comments: