A2 Macroeconomics / International Economy

Fiscal Policy Effects

Fiscal policy decisions have a widespread effect on the everyday decisions and behaviour of
individual households and businesses – hence in this note we consider some of the
microeconomic effects of fiscal policy before considering the links between fiscal policy and
aggregate demand and key macroeconomic objectives.
The microeconomic effects of fiscal policy
Taxation and work incentives
Can changes in income taxes affect the incentive to work? This remains a controversial subject
in the economic literature!
Consider the impact of an increase in the basic rate of income tax or an increase in the rate of
national insurance contributions. The rise in direct tax has the effect of reducing the post-tax
income of those in work because for each hour of work taken the total net income is now
lower. This might encourage the individual to work more hours to maintain his/her target
income. Conversely, the effect might be to encourage less work since the higher tax might act
as a disincentive to work. Of course many workers have little flexibility in the hours that they
work. They will be contracted to work a certain number of hours, and changes in direct tax
rates will not alter that.
The government has introduced a lower starting rate of income tax for lower income earners.
This is designed to provide an incentive for people to work extra hours and keep more of what
they earn.
Changes to the tax and benefit system also seek to reduce the risk of the ‘poverty trap’ –
where households on low incomes see little net financial benefit from supplying extra hours of
their labour. If tax and benefit reforms can improve incentives and lead to an increase in the
labour supply, this will help to reduce the equilibrium rate of unemployment (the NAIRU) and
thereby increase the economy’s non-inflationary growth rate.
Taxation and the Pattern of Demand
Changes to indirect taxes in particular can have an effect on the pattern of demand for goods
and services. For example, the rising value of duty on cigarettes and alcohol is designed to
cause a substitution effect among consumers and thereby reduce the demand for what are
perceived as “de-merit goods”. In contrast, a government financial subsidy to producers has
the effect of reducing their costs of production, lowering the market price and encouraging an
expansion of demand.
The use of indirect taxation and subsidies is often justified on the grounds of instances
of market failure. But there might also be a justification based on achieving a
more equitable allocation of resources – e.g. providing basic state health care free at the
point of use.
Taxation and labour productivity
Some economists argue that taxes can have a significant effect on the intensity with which
people work and their overall efficiency and productivity. But there is little substantive
empirical evidence to support this view. Many factors contribute to improving productivity – tax
changes can play a role - but isolating the impact of tax cuts on productivity is extremely
difficult.

Taxation and business investment decisions

Lower rates of corporation tax and other business taxes can stimulate an increase in business
fixed capital investment spending. If planned investment increases, the nation’s capital stock
can rise and the capital stock per worker employed can rise.
The government might also use tax allowances to stimulate increases in research and
development and encourage more business start-ups. A favourable tax regime could also be
attractive to inflows of foreign direct investment – a stimulus to the economy that might
benefit both aggregate demand and supply. The Irish economy is often touted as an example
of how substantial cuts in the rate of corporation tax can act as a magnet for large amounts of
inward investment. The very low rates of company tax have been influential although it is not
the only factor that has underpinned the sensational rates of economic growth enjoyed by the
Irish economy over the last fifteen years.
Capital investment should not be seen solely in terms of the purchase of new machines.
Changes to the tax system and specific areas of government spending might also be used to
stimulate investment in technology, innovation, the skills of the labour force and social
infrastructure. A good example of this might be a substantial increase in real spending on the
transport infrastructure. Improvements in our transport system would add directly to
aggregate demand, but would also provide a boost to productivity and competitiveness.
Similarly increases in capital spending in education would have feedback effects in the long
term on the supply-side of the economy.
Fiscal Policy and Aggregate Demand
Traditionally fiscal policy has been seen as an instrument of demand management. This
means that changes in spending and taxation can be used “counter-cyclically” to help
smooth out some of the volatility of real national output particularly when the economy has
experienced an external shock.
Discretionary changes in fiscal policy and automatic stabilisers
Discretionary fiscal changes are deliberate changes in direct and indirect taxation and
govt spending – for example a decision by the government to increase total capital spending
on the road building budget or increase the allocation of resources going direct into the NHS.
Automatic fiscal changes are changes in tax revenues and government spending arising
automatically as the economy moves through different stages of the business cycle. These
changes are also known as theautomatic stabilisers of fiscal policy
Tax revenues: When the economy is expanding rapidly the amount of tax revenue increases
which takes money out of the circular flow of income and spending
Welfare spending: A growing economy means that the government does not have to spend
as much on means-tested welfare benefits such as income support and unemployment benefits
Budget balance and the circular flow: A fast-growing economy tends to lead to a net
outflow of money from the circular flow. Conversely during a slowdown or a recession, the
government normally ends up running a larger budget deficit.
Estimates from economists at the OECD have found that the effects of the automatic stabilisers
of fiscal policy can reduce the volatility of the economic cycle by up to 20%. In other words, if
the government is prepared to allow the automatic stabilisers to work through fully, the fiscal
policy can help to curb the excessive growth of demand during a boom, but also provide an
important support for income and demand during an economic downturn.
Measuring the fiscal stance
The fiscal stance is a term that is used to describe whether fiscal policy is being used to
actively expand demand and output in the economy (a reflationary or expansionary fiscal
stance) or conversely to take demand out of the circular flow (a deflationary fiscal stance).
A neutral fiscal stance might be shown if the government runs with a balanced budget where
government spending is equal to tax revenues. Adjusting for where the economy is in the
economic cycle, a neutral fiscal stance means that policy has no impact on the level of
economic activity
A reflationary fiscal stance happens when the government is running a large deficit budget
(i.e. G>T). Loosening the fiscal stance means the government borrows money to inject funds
into the economy so as to increase the level of aggregate demand and economic activity.
A deflationary fiscal stance happens when the government runs a budget surplus (i.e. G<T).
The government is injecting fewer funds into the economy than it is withdrawing through
taxes. The level of aggregate demand and economic activity falls.
The table below summarises the main changes in government spending and tax revenues and
government borrowing during recent years.
Govt Spending % of GDP Tax Revenues % of GDP Govt Borrowing % of GDP
1993 277.8 42.6 232.3 35.7 50.8 7.8
1997 318.5 38.8 308.7 37.6 10.2 1.2
2000 363.9 37.9 378.8 39.5 -14.9 -1.5
2004 488.0 41.4 454.0 38.5 34.1 2.9
From 2001-2004 there was a huge fiscal stimulus to the UK economy through substantial
increases in government spending on transport, and in particular heavier spending in the twin
areas of health and education. The real level of government spending grew from £364 billion in
2000 to £488 billion in 2004 – a rise of 34%. The share of GDP taken up by government
spending has also increased from 38% in 2000 to 41.4% in 2004. This significant increase in
government spending has helped to maintain Britain’s short-term economic growth at a time
when some components of AD (notably export demand and investment) have been weak.
The Keynesian school argues that fiscal policy can have powerful effects on aggregate
demand, output and employment when the economy is operating well below full capacity
national output, and where there is a need to provide a demand-stimulus to the economy.
Keynesians believe that there is a clear and justified role for the government to make active
use of fiscal policy measures to manage the level of aggregate demand.

Monetarist economists on the other hand believe that government spending and tax
changes can only have a temporary effect on aggregate demand, output and jobs and that
monetary policy is a more effective instrument for controlling demand and inflationary
pressure. They are much more sceptical about the wisdom of relying on fiscal policy as a
means of demand management. We will consider below some of the criticisms of using fiscal
policy as a tool of stabilising demand and output in the economy.
The multiplier effects of an expansionary fiscal policy depend on how much spare
productive capacity the economy has; how much of any increase in disposable income is spent
rather than saved or spent on imports. And also the effects of fiscal policy on variables such as
interest rates
Problems with Fiscal Policy as an Instrument of Demand Management
In theory a positive or negative output gap can be relatively easily overcome by the fine-tuning
of fiscal policy. However, in reality the situation is complex and many economists argue for
ignoring fiscal policy as a tool for managing aggregate demand focusing instead on the role
that monetary policy can play in stabilising demand and output.
Recognition lags and policy time lags
Inevitably, it takes time to for government policy-makers to recognise that AD is growing
either too quickly or too slowly and a need for some active discretionary changes in spending
or taxation
It then takes time to implement an appropriate policy response – government spending plans
are subject to a three year spending review and cannot be changed immediately. Likewise the
tax system is highly complex – for example – income tax can only normally be changed once a
year at the time of the Budget. Indirect taxes can be changed more quickly but they have less
of an effect on the level of aggregate demand
It then takes time for the change in fiscal policy to work, as the multiplier process on national
income, output and employment is not instantaneous.
The importance of the national income multiplier – imperfect information
Suppose a government wanted to eliminate a deflationary gap of £1000m. The increase
needed in government expenditure will depend on the size of the multiplier. The problem lies in
knowing the exact size of the multiplier. If the multiplier is 2, then government expenditure
would have to rise by £500m. However, if the multiplier was 4, a rise of only £250m would be
needed. Without knowing the precise value of the national income multiplier it is difficult to
fine-tune the economy accurately.
Fiscal Crowding-Out
The “crowding-out hypothesis” became popular in the 1970s and 1980s when free market
economists argued against the rising share of national income being taken by the public
sector. The essence of the crowding out view is that a rapid growth of government spending
leads to a transfer of scarce productive resources from the private sector to the public
sector. For example, if the government seeks to reflate AD by reducing taxation, or by
increasing government spending, then this may lead to a budget deficit. To finance the deficit
the government will have to sell debt to the private sector. Attracting individuals and
institutions to purchase the debt may require higher interest rates. A rise in interest rates may
crowd out private investment and consumption, offsetting the fiscal stimulus.
This type of crowding out is unlikely to make fiscal policy wholly ineffective – but large budget
deficits do require financing and in the long run, this requires a higher burden of taxation.
Higher taxes affect both businesses and households – neo-liberal economists believe that
higher taxation acts as a drag on business investment, labour market incentives and
productivity growth – all of which can have a negative effect on economic growth potential in
the long run.

The Keynesian response to the crowding-out hypothesis is that the probability of 100%
crowding-out is extremely remote, especially if the economy is operating well below its
productive capacity and if there is a plentiful supply of savings available that the government
can tap into when it needs to borrow money. There is no automatic relationship between the
level of government borrowing and the level of short term and long term interest rates. We can
see from the previous chart that there has been a downward trend in long term interest rates
over the last tent to twelve years. Indeed in 2003 the yield (rate of interest) on ten year
government bonds dipped below 4 per cent – one of the lowest long term interest rates in
recent history.
Reaction to Tax Cuts – Rational Expectations
According to a school of economic thought that believes in ‘rational expectations’, when the
government sells debt to fund a tax cut or an increase in expenditure, then a rational individual
will realise that at some future date he will face higher tax liabilities to pay for the interest
repayments. Thus, he should increase his savings as there has been no increase in his
permanent income. The implications are clear. Any change in fiscal policy will have no impact
on the economy if all individuals are rational. Fiscal policy in these circumstances may become
impotent.
Partly because of the limitations of fiscal policy as a tool of demand management, many
governments have switched the focus of fiscal policy towards using it to improve aggregate
supply as a means of creating the conditions for sustainable economic growth. This is certainly
the case with the current government.
Government borrowing
The level of government borrowing is an important part of fiscal policy and management of
aggregate demand in any economy. When the government is running a budget deficit, it
means that in a given year, total government expenditure exceeds total tax revenue. As a
result, the government has to borrow through the issue of debt such as Treasury Bills and
long-term government Bonds. The issue of debt is done by the central bank and involves
selling debt to the bond and bill markets.
Recent trends in UK government borrowing

Government finances have moved from surplus in the late 1990s to a deficit of over 2.5 % of
GDP in 2003-04. The emergence of a rising budget deficit has been due to a weaker economy
and the effects of substantial increases in government spending on priority areas such as
health, education, transport and defence. Both current and capital spending are rising sharply
in real terms. Critics of Gordon Brown argue that he risks losing control of the budget deficit if
tax revenues continue to come in below forecast whilst public sector spending remains high.
Gordon Brown’s reputation of fiscal prudence has come under pressure both before and after
the most recent election.
Does a budget deficit matter?
There is a consensus that a persistently large budget deficit can be a problem for the
government and the economy. Three of the reasons for this are as follows:
Financing a deficit: A budget deficit has to be financed and day-today, the issue of new
government debt to domestic or overseas investors can do this. In a world where financial
capital flows freely between countries, it can be relatively easy to finance a deficit. But it may
be that if the budget deficit rises to a high level, in the medium term the government may
have to offer higher interest rates to attract sufficient buyers of government debt. This in turn
will have a negative effect on economic growth
A government debt mountain? In the long run, government borrowing adds to the
accumulatedNational Debt. This means that the Government has to spend more each year in
debt-interest payments to holders of government bonds and other securities. There is
an opportunity cost involved here because this money might be used in more productive
ways, for example an increase in spending on health services or extra investment in education.
It also represents a transfer of income from people and businesses that pay taxes to those who
hold government debt and cause a redistribution of income and wealth in the economy
Crowding-out - the need for higher interest rates and higher taxes. Eventually the
budget deficit has to be reduced. This can be achieved by either by cutting back on public
sector spending or by raising the burden of taxation. If a larger budget deficit leads to higher
interest rates and taxation in the medium term and thereby has a negative effect on growth in
consumption and investment spending, then a process of ‘fiscal crowding-out’ is said to be
occurring.
Wasteful public spending: Neo-liberal economists are naturally opposed to a high level of
government spending. They believe that a rising share of GDP taken by the state sector has a
negative effect on the growth of the private sector of the economy. They are sceptical about
the benefits of higher spending believing that the scale of waste in the public sector is high –
money that would be better off being used by the private sector.

Potential benefits of a budget deficit

What are the main economic and social justifications for a higher level of government spending
and borrowing? Two main arguments stand out
Government borrowing can benefit economic growth: A budget deficit can have positive
macroeconomic effects in the long run if it is used to finance extra capital spending that leads
to an increase in the stock of national assets. For example, spending on the transport
infrastructure improves the supply-side capacity of the economy. And increased
investment in health and education can bring positive effects on productivity and
employment.
The budget deficit as a tool of demand management: Keynesian economists would
support the use of changing the level of government borrowing as a legitimate instrument of
managing aggregate demand. An increase in borrowing can be a useful stimulus to
demand when other sectors of the economy are suffering from weak or falling spending. The
fiscal stimulus given to the British economy during 2002-2004 has been important
in stabilizing demand and output at a time of global economic uncertainty. Perhaps
Keynesian fiscal demand management has once more come back into fashion! The argument is
that the government can and should use fiscal policy to keep real national output closer to
potential GDP so that we avoid a large negative output gap.
The current situation
Government borrowing in the UK has shot up to 3.4 percent of GDP in the last fiscal year, in
excess of the 3.0 percent limit set by Europe's Stability and Growth Pact. But as the UK is not
participating in the single currency, the UK is not bound by the terms of the fiscal stability pact
and this gives it more flexibility in terms of how much the UK government can borrow
The government has allowed the automatic stabilisers to work during the current cycle. In
other words, it has allowed an increase in government borrowing brought about by a slowdown
in domestic demand and output.
Gordon Brown has introduced his own fiscal rules – including the golden rule that
government spending on currently provided goods and services should be financed by taxation
over the course of the economic cycle. Government capital spending (public sector investment)
can be financed by borrowing because it results in the accumulation of capital which has long
term economic benefits for the country
Although government borrowing is currently high, there is little upward pressure on long-term
interest rates (indeed they are low). Financing the budget deficit is not a major problem for the
UK as it seems able to attract inflows of financial capital from overseas – and foreign investors
are happy to purchase new issues of government debt. This reduces the risk of the crowding
out effect taking place
Total government debt as a percentage of GDP remains low by historical standards (less than
40% of GDP). And with interest rates remaining low, the government is not facing up to a huge
cost of servicing this debt
It is difficult to forecast government borrowing with great accuracy. Firstly this is because
government tax revenue and spending is sensitive to changes in the economic cycle. Secondly,
we are dealing with huge numbers! Total government spending in 2003-04 is forecast to be
£459 billion and total tax receipts £422 billion (giving a forecast budget deficit of £37 billion).
It only takes government spending and tax revenues to be 1% or 2% different from current
forecasts for the budget deficit to change significantly
Inter-relationships between Fiscal & Monetary Policy
Fiscal policy should not be seen is isolation from monetary policy.
For most of the last thirty years, the operation of fiscal and monetary policy was in the hands
of just one person – the Chancellor of the Exchequer. However the degree of coordination the
two policies often left a lot to be desired. Even though the BoE has independence that allows it
to set interest rates, the decisions of the MPC are taken in full knowledge of the Government’s
fiscal policy stance. Indeed the Treasury has a non-voting representative at MPC meetings. The
government lets the MPC know of fiscal policy decisions that will appear in the budget.
Impact of fiscal policy on the composition of output
Monetary policy is often seen as something of a ‘blunt policy instrument’ – affecting all
sectors of the economy although in different ways and with a variable impact. Fiscal policy
changes can to a degree be targeted to affect certain groups (e.g. increases in means-tested
benefits for low income households, reductions in the rate of corporation tax for small-medium
sized enterprises and more generous investment allowances for businesses in certain regions)
Consider the effects of using either monetary or fiscal policy to achieve a given increase in
national income because actual GDP lies below potential GDP (i.e. there is a negative output
gap)
Monetary policy expansion: Lower interest rates will (ceteris paribus) lead to an increase in
both consumer and business capital spending both of which increases equilibrium national
income. Since investment spending results in a larger capital stock, then incomes in the future
will also be higher through the impact on LRAS.
Fiscal policy expansion: An expansionary fiscal policy (i.e. an increase in government
spending or lower taxes) adds directly to AD but if this is financed by higher borrowing, this
may result in higher interest rates and lower investment. The net result (by adjusting the
increase in G) is the same increase in current income. However, since investment spending is
lower, the capital stock is lower than it would have been, so that future incomes are lower.
Effectiveness of Monetary and Fiscal Policies
When the economy is in a recession, monetary policy may be ineffective in increasing spending
and income. In this case, fiscal policy might be more effective in stimulating demand. Other
economists disagree – they argue that changes in monetary policy can impact quite quickly
and strongly on consumer and business behaviour.
However, there may be factors which make fiscal policy ineffective aside from the usual
crowding out phenomena. Future-oriented consumption theories based round the concept of
rational expectations hold that individuals ‘undo’ government fiscal policy through changes in
their own behaviour – for example, if government spending and borrowing rises, people may
expect an increase in the tax burden in future years, and therefore increase their current
savings in anticipation of this
Differences in the Lags of Monetary and Fiscal Policies
Monetary and fiscal policies differ in the speed with which each takes effect the time lags are
variable
Monetary policy in the UK is flexible since interest rates can be changed by the Bank of
England each month and emergency rate changes can be made in between meetings of the
MPC, whereas changes in taxation take longer to organize and implement.
Because capital investment requires planning for the future, it may take some time before
decreases in interest rates are translated into increased investment spending. Typically it takes
six months – twelve months or more before the effects of changes in UK monetary policy are
felt. The impact of increased government spending is felt as soon as the spending takes place
and cuts in direct and indirect taxation feed through into the economy pretty quickly. However,
considerable time may pass between the decision to adopt a government spending programme
and its implementation. In recent years, the government has undershot on its planned
spending, partly because of problems in attracting sufficient extra staff into key public services
such as transport, education and health.

Author: Geoff Riley, Eton College, September 2006

nflation
Sunday, 19 September 2010 23:50 H.Lalnunmawia

INFLATION
Inflation may be defined as a persistent and appreciable rise in the general price level.
Inflation is statistically measured in terms of percentage increase in the price index over a
period of time usually a year or a month.
Inflationary gap: The inflationary gap is the amount by which aggregate demand exceeds
aggregate supply at the full employment level of income. The inflationary gap is explained
diagrammatically in the following figure.
In the figure YF is the full employment level of income, the 45˚ line represents aggregate
supply (AS), and the C + I + G line represent the aggregate demand (AD). The economy’s
aggregate demand curve (AD) intersects the aggregate supply curve (AS) at point E at the
income level OY1 which is greater than the full employment income level OYF. The amount by
which aggregate demand YFA exceeds the aggregate supply YFB at the full employment
income level is the inflationary gap. This is AB in the figure. Thus, the inflationary gap leads to
inflationary pressures in the economy which are the result of excess aggregate demand.
Types of Inflation
There are several types of inflation in the economy which are classified on different basis.
Some of the important types of inflation are discussed below.
Creeping, Walking, Running and Galloping Inflation:
(a) Creeping Inflation: When the rise in prices is very slow (less than 3% per annum) like
that of a snail or creeper, it is called creeping inflation. Such an increase in prices is regarded
safe and essential for economic growth.
(b) Walking or Trotting Inflation: When prices rise moderately and the annual inflation rate is
a single digit (3% - 10%), it is called walking or trotting inflation. Inflation at this rate is a
warning signal for the government to control it before it turns into running inflation.
(c) Running Inflation: When prices rise rapidly like the running of a horse at a rate of speed
of 10% - 20% per annum, it is called running inflation. Its control requires strong monetary
and fiscal measures, otherwise it leads to hyperinflation.
(d) Galloping or Hyperinflation: When prices rises between 20% to 100% per annum or even
more, it is called galloping or hyperinflation. Such a situation brings a total collapse of the
monetary system because of the continuous fall in the purchasing power of money.
Demand-Pull and Cost-Push Inflation:. Demand-pull inflation takes place when aggregate
demand is rising while the available supply of goods is less. The monetarists emphasize the
role of money as the principal cause of demand-pull inflation while the Keynesians emphasize
the increase in aggregate demand as the causes of inflation. On the other hand, Cost-push
inflation is caused by wage increases enforced by trade unions and profit increases by
employers.
Comprehensive and Sporadic Inflation: When the prices of all commodities in the economy
rise it is called comprehensive inflation. On the other hand, sporadic inflation is a sectoral
inflation in which the prices of a few commodities rise because of certain physical bottlenecks
which may impede any attempt to increase their production.
Open and Suppressed Inflation: Inflation is said to be open when the government takes no
steps to control the rise in the price level. Thus open inflation is the result of the uninterrupted
operation of the market mechanism. On the other hand, inflation is said to be suppressed
when the government actively intervenes to check the rise in the price level.
Mark-up Inflation: This type of inflation resulted from the peculiar method of pricing adopted
by the big business organizations. According to this method, the big business organizations
calculate their production costs first and then add to these costs a certain mark-up to yield the
targeted rate of profit.
Besides the above types of inflation, there are several other types of inflation which are
classified on the basis of time or the causes of inflation. On the basis of time there are
peacetime, wartime and postwar inflation. On the basis of factors causing inflation there are
credit inflation, deficit-induced inflation, scarcity-induced inflation etc.
Causes of Inflation
Broadly speaking inflation arises when the aggregate demand exceeds the aggregate supply
of goods and services. We analyse the factors which lead to increase in demand and the
shortage of supply.
Factors Causing Increase in Demand: Both Keynesians and monetarists believe that inflation
is caused by increase in the aggregate demand. Following are the factors which cause an
increase in the size of demand:
1. Increase in Money Supply: Inflation is caused by an increase in the supply of money
which leads to increase in aggregate demand. The higher the growth rate of nominal
money supply, the higher is the rate of inflation.
2. Increase in Disposable Income: When the disposable income of the people increases,
it raises their demand for goods and services. Disposable income may increase with the
rise in national income or reduction in taxes or reduction in the saving of the people.
3. Increase in Public Expenditure: In modern world government activities have been
expanding which resulted in increase government expenditure. This raised the
aggregate demand for goods and services, thereby causing inflation.
4. Increase in Consumer Spending: The demand for goods and services also increases
when consumer spending increases due to conspicuous consumption or demonstration
effect.
5. Cheap Monetary Policy: Cheap monetary policy or the policy of credit expansion also
leads to increase in the money supply which raises the demand for goods and services
in the economy thereby leading to inflation. This is also known as credit-induced
inflation.
6. Deficit Financing: In order to meet it’s mounting expenses, the government resorts to
deficit financing by borrowing from the public and even by printing more notes. This
raises aggregate demand in relation to aggregate supply, thereby leading to inflationary
rise in prices.
7. Increase in Exports: When the demand for domestically produced goods increases in
foreign countries, this raises the earnings of industries producing export commodities.
These, in turn, create more demand for goods and services within the economy.
Apart from the above factors, expansion of the private sector, existence of black money and
the repayment of public debt by the government also increases the aggregate demand for
goods and services in the economy.
Factors Causing Shortage of Supply: Following are the factor which result in a reduction in
the supply of goods and services:
1. Shortage of factors of production: When there is shortage of factors of production like
labour, capital, raw materials, etc. there is bound to be reduction in the production of
goods and services.
 2. Industrial Disputes: In countries where trade unions are powerful, they resort to
strikes and lock-outs which resulted in a fall in industrial production thereby reducing the
supply of goods.
3. Natural Calamities: Natural calamities like droughts, floods, etc. adversely affects the
supplies of agricultural products. This creates shortage of food products and raw
materials, thereby helping inflationary pressures.
4. Artificial Scarcities: Artificial scarcities are created by hoarders and speculators who
indulge in black marketing. Thus, they are instrumental in reducing supplies of goods
and raising their prices.
5. Increase in Exports: When the country produces more goods for exports than for
domestic consumption, this creates shortages of goods in the domestic market. This
leads to inflation in the economy.
6. Lop-sided production: If the stress is on the production of comforts, luxuries, or basic
products to the neglect of essential consumer goods in the country this creates
shortages of consumer goods. This again causes inflation.
7. Law of Diminishing Returns: If industries in the country are using old machine and
outmoded methods of production, the law of diminishing returns operates. This raises
cost per unit of production, thereby raising the prices of products.
International Factors: In modern times, inflation is a worldwide phenomenon. When prices rise
in major industrial countries, their effects spread to almost all countries with which they have
trade relations. Often the rise in price of a basic raw material like petrol in the international
market leads to rise in the price of all related commodities in a country.
Measures To Control Inflation
Inflation is caused by the failure of aggregate supply to equal the increase in aggregate
demand. Therefore, inflation can be controlled by increasing the supplies of goods and
reducing money income. The various measures to control inflation are discussed below.
Monetary Measures
The monetary measures to control inflation generally aims at reducing money incomes. These
are:
(a) Credit Control: The central bank could adopt a number of methods to control the quantity
and quality of credit to reduce the supply of money. For this purpose, it raises the bank rates,
sells securities in the open market, raises reserve ratio, and adopts a number of selective
credit control measures, such as raising margin requirements and regulating consumer credit.
(b) Demonetisation of Currency: Another monetary measure is to demonetise currency of
higher denominations. Such a measure is usually adopted when there is abundance of black
money in the country.
(c) Issue of New Currency: The most extreme monetary measure is the issue of new currency
in place of the old currency. Under this system, one new note is exchanged for a number of
the old currency. Such a measure is adopted when there is an excessive issue of notes and
there is hyperinflation in the economy.
Fiscal Measures
Monetary policy alone cannot control inflation. Therefore, it should be supplemented by fiscal
measures. The principal fiscal measures are discussed below.
(a) Reduction in Unnecessary Expenditure: The government should reduce unnecessary
expenditure on non-development activities in order to curb inflation.
(b) Increase in Taxes: To cut personal consumption expenditure, the rates of personal,
corporate and commodity taxes should be raised and even new taxes should be levied, but
the rates of taxes should not be too high as to discourage saving, investment and production.
(c) Increase in Savings: Another measure is to increase savings on the part of the people so
that their disposable income and purchasing power would be reduced. For this the
government should encourage savings by giving various incentives.
(d) Surplus Budgets: An important measure is to adopt anti-inflationary budgetary policy. For
this purpose, the government should give up deficit financing and instead have surplus
budgets. It means collecting more in revenues and spending less.
(e) Public Debt: In addition, the government should stop repayment of public debt and
postpone it to some future date till inflationary pressures are controlled. Instead, the
government should borrow more to reduce money supply with the public.
Other (Direct) Measures
Other measures to control inflation generally aims at increasing aggregate supply and
reducing aggregate demand directly. These are :-
(a) To Increase Production. The following measures should be adopted to increase
production:
(i) The government should encourage the production of essential consumer goods
like food, clothing, kerosene oil, sugar, vegetable oils, etc.
(ii) All possible help in the form of latest technology, raw materials, financial help,
subsidies, etc. should be provided to different consumer goods sectors to increase
production.
(b) Rational Wage Policy: Another important measure is to adopt a rational wage policy. The
best course for this is to link increase in wages to increase in productivity. This will have a
dual effect. It will control wage and at the same time increase production of goods in the
economy.
(c) Price Control: Price control and rationing is another measure of direct control to check
inflation. Price control means fixing an upper limit for the prices of essential consumer goods.
(d) Rationing: Rationing aims at distributing consumption of scarce goods so as to make them
available to a large number of consumers. It is applied to essential consumer goods such as
wheat, rice, sugar, kerosene oil, etc. It is meant to stabilize the prices of necessaries and
assure distributive justice.
Conclusion: From the various monetary, fiscal and other measures, discussed above, it
becomes clear that to control inflation, the government should adopt all measures
simultaneously.
Effects of Inflation
Inflation affects different people differently. When price rises or the value of money falls, some
groups of the society gain, some lose and some stand in between. Let us discuss the effects
of inflation on distribution of income and wealth, production, and on the society as a whole.

1. Effects of Inflation on Business Community: Inflation is welcomed by entrepreneurs

and businessmen because they stand to profit by rising prices. They find that the value
of their inventories and stock of goods is rising in money terms. They also find that prices
are rising faster than the costs of production, so that their profit is greatly enhanced.
2. Fixed Income Groups: Inflation hits wage-earners and salaried people very hard.
Although wage- earners, by the grace of trade unions, can chase galloping prices, they
seldom win the race. Since wages do not rise at the same rate and at the same time as
the general price level, the cost of living index rises, and the real income of the wage
earner decreases.
3. Farmers: Farmers usually gain during inflation, because they can get better prices for
their harvest during inflation
4. Investors: Those who invest in debentures and fixed-interest bearing securities,
bonds, etc, lose during inflation. However, investors in equities benefit because more
dividend is yielded on account of high profit made by joint-stock companies during
inflation.
5. Inflation will lead to deterioration of gross domestic savings and less capital formation
in the economy and less long term economic growth rate of the economy.