Remedies for inflation

Remedies for inflation

1. Dd-pull inflation: dd-side policies (contractionary) focuses on lowering AD

   • 1. Fiscal Policy (FP)
     • Deliberate reduction in govt expenditure
       • on goods & services (eg: on defence/education)
         • Reduce G, hence AD; GPL falls
       • on transfer payments: Money given by govt to its citizens/firms w/o any goods & services exchanged in return
         • influences consumers' ability to consumer/ firms' ability to invest
           • Reduce C/I (not G)
     • Adjusting tax rates
       • Raising direct tax rate: tax levied on income
         • Personal income tax
           • Decrease disposable income, lower purchasing power, reduce C
         • Corporate income tax
           • lower profit, reduce I
       • Lowering indirect tax rate: tax levied on goods & services
         • Increase dd for foreign goods at e expense of domestic goods
     • LIMITATION:
       • Size of multiplier
       • Rigidity/inflexibility of govt spending
       • Political consideration
       • Time lag
   • 2. Monetary Policy on i/r
     • Reduce money supply in an economy (by raising cash ratio/ selling govt bond)
       • i/r increase
         • cost of borrowing rises; Expected profitability on investment reduces, so I falls
         • Higher cost of borrowing to purchase on credit, savings become more attractive, so C falls
     • LIMITATION
       • Effectiveness of MP Tools
         • Monetary authority must be able to control MS by altering tools of MP
         • MS difficult to control when
           • economy is 'open' (judged by size of foreign trade sector)
             • Large free flow of funds in & out of e country
           • Economy is highly undeveloped
             • large non-monetised sector
             • practice of barter trade (mutual exchange of goods & services w/o use of money)
       • Interest elasticity of investments & consumptions
         • Effectiveness of MP depends on steepness of MEI curve (sensitivity of investments to i/r)
   • 3. Monetary Policy on ER
     • Appreciate the country's currency (by buying its currency in e int'l foreign exchange market/sell foreign currency)
       • Rise in domestic ER
         • Exports dearer in foreign market
           • Domestic country's exports more ex in terms of foreign currency (as px of exports terms of domestic currency remains unchanged)
             • Demand for ecports falls, fall in X
         • Imports cheaper in home market
           • foreign goods less expensive in domestic currency
             • Rise in M
     • Limitation
       • PED of Imports
         • Appreciating ER is feasible only if PED of import > 1
           • A fall in import px leads to a more than proportionate increase in its Qd
       • Availability of Foreign Exchange
         • Govt need to have a sizeable amt of funds for exchange
           • To appreciate domestic ER, govt must have sufficient foreign currency reserves (to dd domestic currency)
   • 4. Income & Px Policy
     • lowering disposable income of consumers
       • Reduce induced consumption
         • Eg: In Sg, raise employee's CPF contribution rate, savings increase
     • Voluntary & statutory restraints on wage increase
       • wage ceiling
         • persuade trade unions to practise a wage restraint policy, prevent excessive wage increases
     • LIMITATION
       • Increased borrowing, consumers can cont. to spend
       • Decrease in standard of living, esp for fixed income earners
       • Poor response to wage guidelines
         • Trade unions & employers not keen to cut wages as dd-pull inflation associated w tight labour market, provide higher wage to woo scarce labour

2. Cost-push inflation: ss-side policies reduces COP to increase AS

   • Short-term ss-side policy: Reduce COP, productive capacity unchanged; sets limits to the returns to factor inputs
     • 1. Fiscal policy
       • Reducing (import) tariffs, eg. on imported raw materials
       • Reducing govt fees & rentals
       • Govt subsidies for FOP; eg, Jobs Credit Scheme 2009
       • LIMITATION
         • Time lags
         • Increased risk of budget deficit & increased govt debt
           • govt either increase expenditure on transfer payment / reduce its revenue/ both
     • 2. Monetary policy on ER
       • Appreciate domestic currency
         • firms purchase imported raw materials at lower px
       • LIMITATION
         • Proportion of imported input
           • Appreciation has sig. impact for countries heavily reliant on imported FOP; VS reliant on domestic FOP
           • Greater effect on country dominated by a large secondary (manufacturing) sector; VS tertiary (service) oriented country
         • Loss in export & investment competitiveness
           • reduce export competitiveness
           • deter foreign direct investment, as more capital (in their currency) needed for investment
             • I falls, actual & potential EG affected
         • Availability of foreign exchange
     • 3. Income & Px Policy: Reduce COP via controlling cost of FOP
       • Voluntary & statutory wage restraints (eg: on wages)
       • Controlling factor cost by setting px ceiling for FOP, producers/ factor owners unable to increase px according to their own wish
       • Lowering wages
         • In Sg, reduce employers' CPF contribution rate; save cost for firms
       • LIMITATION
         • Problems with wage restraints, hard for trade unions to cooperate w govt as both serve diff objectives
         • Decreased savings
           • households use income to makeup for e shortfall in CPF monthly contribution to finance housing loan
             • further lower household's disposable income
         • Px controls & black market
           • Creation of shortages, produces turn to black market & pay higer px to secure resources, higher costs passed to consumers as higher px
   • Long-term ss-side policy: Raise productive capacity by improving firms' efficiency & increasing quality & qty of FOP
     • GPL falls