Question: Evaluate 3 policies that can be used to control inflation.
If inflation is too high, the monetary authorities could use tight monetary policy to bring inflation back down to the target level. This would mean an increase in interest rates and a rise in the cost of borrowing, making it more expensive for consumers and firms to take out loans. So consumption and investment will both fall, AD will decrease and there will be demand-pull deflation as the price level falls, as shown in the diagram.
But, the effects will not be instantaneous because there are time lags involved. For instance, an interest rate change could take roughly up to 2 years to exert its full effect on AD and inflation. Also, LRAS must be inelastic (or perfectly inelastic) otherwise the reduction in AD will not impact much on inflation, instead it will cause a significant decrease in real GDP.
Another policy that could be used to control inflation, this time by the government, is contractionary fiscal policy. If inflation is too high then the government may reduce government spending and/or increase taxation. This will mean more leakages from the circular flow of income, AD will fall and, again, there will be demand-pull deflation.
However, this may be too politically difficult to carry out. If the economy is in a recession or if an election is approaching, the government will, arguably, not want to decrease AD and incomes because the general public may be unlikely to vote for the incumbent government. Additionally, if the cuts in government spending are on the infrastructure then, in the long-run, inflation will rise again as the economy becomes less efficient and LRAS shifts leftwards.
Alternatively, the government could use supply-side policies to bring inflation under control. If inflation is too high, the government could, for example, increase spending on education to improve the economy’s human capital. This will make workers more efficient, shift LRAS rightwards and lead to cost-push deflation.
Although, a supply-side policy such as education spending may actually be counter-productive to controlling high inflation in the short-run. Although the long-run effect will likely see a rightwards shift of LRAS and fall in inflation, the short-run effect of higher government spending will create demand-pull inflation. Perhaps a supply-side policy such as education spending could be used in tandem with a tight monetary policy to control inflation in both the short-run and long-run.