If inflation is too high in an economy the government will introduce policies to reduce the rate as a high rate can lead to disaster for a country. If the UK has excessively high inflation rates then they will not be able to compete on the exportation of goods against other countries as we will be charging higher prices which can then lead to a contraction on UK output and we become less efficient.
It is also disastrous for individuals as there will soon be a wage-inflation battle as wages need to increase with the inflation otherwise individuals will suffer a reduction in their real wage. Firms will have to constantly change their prices in order to keep up with the wage inflation which can be tricky if they use large catalogues to sell their products. This is why the government and the Bank of England try to keep the base rate of inflation at 2%.
If the inflation rate was above the desired 2% then the government could introduce contractionary fiscal policy which would cut the amount of government spending and raise direct taxation; causing aggregate demand to fall. This tactic will also increase the amount of leakages from the circular flow of income as more people are saving as well as decreasing the injections as the government is spending less money.
If the government was to decrease government spending and raise income tax there would be a dampener on the multiplier effect as less money will be spent by consumers as they have now got a lower real earnings as a larger proportion of their wages will be spent on income tax which means that they will cut their spending though purchasing less goods which in turns causes shops to have a reduction in their revenue so they begin to cut down their orders from their suppliers as they no longer have a strong enough demand for their goods.
The suppliers then cut down their output, which could be in the form of reducing their labour capital which can then lead to increased unemployment in the UK. Figure 1 – LRAS curve showing the effects of fiscal policy When inflation is too high in the UK, we will be operating at AD4 which has no benefit from operating at AD3 and is purely inflationary. This is a problem for the government as it causes us as a nation to become uncompetitive in our exports as we will be charging higher prices for the goods we produce.
The government could just wait and let the market sort itself out but that would be harsh as there would be a stark drop in demand when we become uncompetitive and cant export enough causing production to drop and workers to be laid off which can then in turn lead us into a recession. What the government want to do is to ease output and inflation back down to AD3 which is the best place to be as there is full employment but yet still a moderate inflation rate.
So to do this they introduce contractionary fiscal policy reduce our demand and to shift us leftwards on the LRAS curve. Another method which the government could use to reduce the inflation rate could be implementing tightening monetary policy. Tightening monetary policy is reducing the real supply of money and raising interest rates. Through raising interest rates it encourages consumers to save their money as it will yield them more money which is a leakage from the circular flow of income.
The opportunity cost of spending has increased and borrowing has become more expensive which therefore discourages firms to invest in capital. Furthermore, reducing the supply of money is deflationary as it becomes more valuable through there being less readily available. Figure 2 – Classical LRAS to show the effects of tightening monetary policy Figure 2 above shows the effects of tightening monetary policy. When the government cuts the supply of money and increase interest rates aggregate demand will drop from AD1 to AD2 as there is little incentive to spend anymore.
When interest rates increase there is little incentive to spend as projects which seemed feasible now look like they will note make profit as the cost of capital has risen as interest rates have risen which makes it seem like a better idea to save rather than spend at the moment. Alternatively, in the long run labour market reforms may be introduced to reduce inflation rates. The weakening of trade union power, the growth of part-time and temporary working along with the expansion of flexible working hours are all moves that have increased flexibility in the labour market.
If this does allow firms to control their labour costs it may reduce cost push inflationary pressure. In recent years the UK economy has not seen the acceleration in wage inflation normally associated with several years of sustained economic growth and falling inflation. One reason is that rising job insecurity inside a flexible labour market has meant that employers tend to have more power than the employees in modern times as firms tend to price setters than price takers.
In conclusion, I believe that fiscal policy is the most effect in the short term but it may not be so popular with governments as an increase in taxation angers consumers and governments which are fearful in losing their power would be hesitant in install this method. Furthermore, contractionary fiscal policy mustn’t be implemented at the same time as loosening monetary policy as they would cancel each other out and just end up as a waste of government time and money.