How does a Government Cure Inflation?

How does a Government Cure Inflation?

  1. Tightening fiscal policy. This is the classic Keynesian response. Basically, this involves reducing government spending and/or increasing taxation. Reducing government spending directly shifts the AD curve to the left, and increases in taxation do the same, but indirectly, through the reduction of consumers' disposable income, which leads to, reduced consumer spending.
  2. Tightening monetary policy. We will cover this in much more detail in the next section. Today this means increasing interest rates, which makes it more expensive for firms to invest and consumers to borrow and spend. Also, consumers mortgage payments rise, which leaves them less disposable income to spend. But as we have seen, the control of the money supply and the level of the exchange rate are linked. Governments can usually only control one of these three things at once (although some would say it is impossible to control the money supply). Higher interest rates tend to push the value of the £ up anyway, which helps keeps the price of imports down.
  1. Incomes policies. You will never hear a politician utter these words. Basically it involves controlling wage rises and so stopping the AS curve from shifting further to the left. This will make cost-push inflation less likely. This was used often in the 70s following the union inspired wage-price spirals. It was not very popular! This is obviously not something that monetarist economists (who like free markets) believe in, as it disrupts the free working of labour markets. Having said that, the last Conservative government did operate a pay freeze in the public sector (they have no control over the private sector, obviously). Of course, they didn't dare refer to it as an 'incomes policy'!
  2. Improving the supply side. In the topic called 'Aggregate demand and aggregate supply' we looked, in some depth, at ways in which the long run aggregate supply curve might shift to the right, increasing the productive potential of the economy and reducing the price level for a given aggregate demand curve (assuming the LRAS curve is vertical). Policies included improved education and training, privatisation and deregulation, control of the trade unions, increasing the flexibility of the labour market and incentives for firms to invest.

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