IB Economics HL Essay

Evaluate government policies to deal with inflation.
(15 marks)
Inflation is a sustained increase in average price level and it includes demand-pull inflation and
cost-push inflation. Demand-push inflation is caused by increase in aggregate demand, in turn
brought about by changes in any of the determinants of aggregate demand. Cost-push inflation is
caused by increases in cost of production or supply-side shocks like earthquakes. The policies
include the demand-side policy which contains fiscal policy and monetary policy and the
supply-side policy which contains interventionist policy and market-based policy.
For the demand-pull inflation, for example, the business are optimistic that the future market will
grow better and so increase investment spending. As investment is one of the components of AD,
when investment increases, AD1 shifts to AD2, then the PL1 increases to PL2, real output increases
from Y1 to Y2, and cause the inflation.
For the cost-push inflation, for example the government increases the minimum wage, when the
Wmin increases, it means the cost of production increases. In order to maintain certain amount of
profit, companies may reduce the supply or increase the price of the products, the the SRAS1
shifts to the SRAS2, PL1 increases to PL2, Y1 decreases to Y2, and cause the inflation.
To solve the demand-pull inflation, government will use the demand-side policy, which means
the contractionary fiscal policy and tight monetary policy. The contractionary fiscal policy is to
increase the tax rate and decrease the government spending. As the government spending is one
of the component of the AD, reducing government spending cause the AD decreases.
When the tax rate increases, consumers have less disposable income, companies have less profit
after tax, the they have less ability to consume or do investment. Thus, the consumption and
investment decrease, AD curve shifts to the left, PL1 decreases to PL2, solve the inflation.
The fiscal policy has several advantages, for example the automatic stabilizer, which means
factors that automatically without any action by government authorities work toward
establishing the economy by reducing the short-term fluctuations of the business cycle. When
output increases a lot, the average income increases with the increasing tax rate, then the
disposable income increases at a smaller percentage due to the progression system. Hence, the
consumption will increase at a slower speed, and reduce the upward of fluctuation of the
economy. Therefore, it can slow down or solve inflation.
And also, it’s very effective and direct in dealing with the rapid inflation, because the
contractionary fiscal policy is to decrease the government spending which can directly let the AD
shifts to left and solve the inflation. In addition, it’s targeted, it means that the government can
reduce spending on products with particularly high inflation.
However, it also has a lot of disadvantages. It has time lag, because the government need to take
time to recognize the problem, design policies and take effect. And when put the contractionary
fiscal policy, it has political constrains because higher interest affect political popularity.
The tight monetary policy is to increase the interest rate, when the interest rate increases, gain
from saving increases, cost for borrowing increases, then both the consumers and firms will save
more and borrow less, thus they have less money to consume or do investment. Therefore, the
consumption and investment decreases, which cause the AD1 decreases to AD2, PL1 decreases to
PL2, solve the inflation.
The tight monetary has shorter time length than fiscal policy because the central bank needs less
time to design the policy. The government needs to submit proposals at one level for review, but
the central bank needs only a few meetings to formulate policies. And it has no political
constrains because the central bank just consider the economic situation, it’s not be controlled by
the government. Moreover, the central bank can adjust interest rate incrementally. It can set the
rate step to step, more than one in a year, wait time to see the effects whether needs a new
policy to solve the inflation. However, it also has a lot of disadvantages, for example, The
monetary policy is ineffective during the rapid inflation, because it will be influenced by the
confidence. And it still has the time lag.
To solve the cost-push inflation, the government can both use the demand-side policy and
supply-side policy. But for the demand-side policy, it can let price level decrease but may lead to
cyclical unemployment. And also the supply-side policy depends on situations. It’s hard to solve
the cost-push inflation. The example I mentioned above can be solved by reduce the minimum
wage or the power of trade union. When reduce the Wmin, the cost for labor decreases, and the
firms have more profits then charge lower prices. When reduce the power of trade union, it has
weaker power to argue for higher wages and other benefits for workers, then output increases
and PL decreases, solve the inflation.
For the market-based policy, it has the advantage, for example, it plays an important role in
increasing the potential output, as mentioned above, it can reduce the nature employment and
increase the potential output. It also increase the efficiency of resources allocation because when
the cost of labour decreases, the demand for labor will increase, then leads the society allocate
efficiently. However, it still has disadvantages such as the longer time lag compared to
demand-side policy because it has longest time to take effect, and also may reduce poverty’s
living standard and widen the income disparity because of the decreasing minimum wage.
In other situations, like the supply shock which the hazards like earthquakes interrupt the supply,
we can use inflation-targeting to solve. Inflation targeting is a central banking policy that revolves
around meeting preset, publicly displayed targets for the annual rate of inflation. The advantage
of this policy is to keep a lower rate of inflation, a more stable rate of inflation can let firms
better predict future price and have more certainty. Then, blind investment will be reduced and
replaced by planned and mature investment. In addition, with the rise of price level, the interest
rate will also increase, which can control the inflation within a certain range. It’s a kind of better
coordination between monetary and fiscal policy. But this policy reduced ability to purse other
macroeconomic objectives because it only target the inflation. Furthermore, it’s hard to find an
appropriate inflation target.

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Evaluate government policies to deal with inflation.

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