Question

Analyse how fiscal policy and monetary policy could be used to solve the problem of deflation. Assess which policy is likely to be more effective. [12]

Deflation

[CIE AS level November 2018]

Answer

Tip : Evaluation on this question required a comparison of the advantages and disadvantages of each type of policy to arrive at a reasoned conclusion on which is likely to be more effective. A brief comment at the end of an essay NOT sufficient to receive a good mark for evaluation.

Step ➊: Define ‘fiscal policy’, ‘monetary policy’ and ‘deflation’ in the introduction.

Deflation is a general decline in prices for goods and services and can be a serious economic problem. Thus policymakers may make use of fiscal and monetary policy in an attempt to solve this problem. Fiscal policy is the use of taxation and government spending to manage aggregate demand in order to achieve the government’s macroeconomic aims. Monetary policy refers to any policy measures or instruments to influence the price or quantity of money. The three instruments of monetary policy are the interest rate, the money supply and the exchange rate. It should however be noted that there are several limitations to these policies.

Step ➋ : Discuss whether the expansionary fiscal policy can be used to solve the problem of deflation. Include the limitations of this policy.

Expansionary fiscal policy can help to solve the problem of deflation as it puts more money into consumers' and producer's hands to give them more purchasing power. It is designed to increase aggregate demand. This can be achieved in two ways.

➤ 2.1 Government spending can be increased.

An increase in public expenditure during deflation increases the aggregate demand for goods and services and leads to a large increase in income via the multiplier process.

Expenditure on public works creates demand for the products of private construction industries and helps in reviving them while expenditure on relief measures stimulates the demand for consumer goods industries. If the government increased investment in public work schemes, this government spending would create jobs, increase incomes and lead to greater aggregate demand.

➤ 2.2 The government can cut tax rates.

A reduction in taxes has the effect of raising disposable income thereby increasing consumption and investment expenditures.

Corporate tax cuts put more money into businesses' hands. They use it for new investment and employees. In that way, tax cuts create jobs. A decrease in taxes also means that households have more disposal income to spend. Higher disposal income increases consumption which increases the gross domestic product.

➤ 2.3 The effect of an effective expansionary fiscal policy is shown in the diagram below.

Initially, there is deflation and low levels of economic activity. The aggregate demand curve is represented by AD and the price level is at P. Aggregate demand (AD) consists of consumption (C), investment (I), government spending (G) and net exports (X-M). An increase in government spending and a cut in tax rates will stimulate the economy. This will shift the aggregate demand curve outwards from AD to AD1. The new price level will increase from P to P1. Consequently, the level of deflation is reduced.

➤ 2.4 It should also be noted that fiscal policy has several limitations.

There may be time lags. If the government plans to increase spending, this can take a long time to filter into the economy, and it may be too late. Spending plans are only set once a year. There is also a delay in implementing any changes to spending patterns.

If the government uses fiscal policy, its effectiveness will also depend upon the other components of AD, for example, if consumer confidence is very low, reducing taxes may not lead to an increase in consumer spending.

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Step ➌ : Discuss whether monetary policy can be used to solve the problem of deflation. Include the limitations of this policy.
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Monetary policy, like fiscal policy, seeks to influence aggregate demand. Again expansionary monetary policy is intended to increase aggregate demand. In this case, this may be achieved by a cut in the interest rate, an increase in the money supply and a reduction in the foreign exchange rate.

If the economy is suffering a recession, high unemployment and deflation, with output below potential GDP, expansionary monetary policy can help the economy return to potential GDP. This can be achieved in two ways.

➤ 3.1 If the central bank cut interest rates, it will tend to increase the overall demand in the economy. This will help to reduce deflation.

Lower interest rates make it cheaper to borrow, this encourages firms to invest and consumers to spend. It also reduces the cost of mortgage interest repayments. This gives households greater disposable income and encourages spending. Lower interest rates reduce the incentive to save. Furthermore, it reduces the value of the currency, making exports cheaper and increase export demand.

➤ 3.2 In addition to cutting interest rates, the Central Bank could pursue a policy of quantitative easing to increase the money supply and reduce long-term interest rates.

Under quantitative easing, the Central bank creates money. It then uses this created money to buy government bonds from commercial banks. In theory, this should increase the monetary base and cash reserves of banks, which should enable higher lending and reduce interest rates on bonds which should help investment.

The figure below illustrates this situation

The original equilibrium during a recession occurs at an output level of 600. An expansionary monetary policy will reduce interest rates and stimulate investment and consumer spending. This will cause the original aggregate demand curve AD to shift rightwards to AD1 so that the new equilibrium occurs at the higher potential GDP level of 700. The level of deflation has been reduced.

➤ 3.3 Monetary policy, however, is not always effective.

➤ 3.3.1 Cutting interest rates isn’t guaranteed to cause a strong economic recovery. Expansionary monetary policy may fail under certain conditions.

If confidence is very low, then people may not want to invest or spend, despite lower interest rates. In a credit crunch, banks may not have funds to lend, therefore although the Central Bank cuts base rates, it is still difficult to get a loan from a bank. Commercial banks may not pass the base rate cut on.

➤ 3.3.2 It's effectiveness also depends on other components of aggregate demand.

Expansionary monetary policy may boost consumer spending, however, if we are in a global recession, then there may be a strong fall in exports which outweighs the improvement in consumer spending.

There may be time lags. It can take up to 18 months for interest rate cuts to increase spending. For example, people may have a two-year fixed-rate mortgage. Therefore, they only see the impact of the rate cut when they remortgage.

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Step ➍ : Discuss which policy is more effective to solve deflation. (Evaluation)
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Fiscal policy may be more effective than monetary policy.

A rise in government spending may be more effective than reducing interest rates or increasing the money supply. This is because firms and households may be pessimistic during periods of deflation and so may not spend more even if their disposable incomes rise and it becomes cheaper to borrow.

In a deep recession causing deflation and liquidity trap, fiscal policy may be more effective than monetary policy because the government can pay for new investment schemes, creating jobs directly – rather than relying on monetary policy to indirectly encourage business to invest.

When the economy is in a recession and when business and consumer confidence is very low and perhaps where deflationary pressures are taking hold monetary policy may be ineffective in increasing current national spending and income. The problems experienced by the Japanese in trying to stimulate their economy through a zero-interest-rate policy might be mentioned here. In this case, fiscal policy might be more effective in stimulating demand.

It can thus be concluded that each policy has its respective advantages and disadvantages. However, in the case of deflation, fiscal policy has proven to be more effective than monetary policy.

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♕ Mark scheme
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For analysis of how expansionary monetary policy is designed to solve the problem of deflation with due reference to any weaknesses or disadvantages of this approach. (Up to 4 marks)

For analysis of how expansionary fiscal policy is designed to solve the problem of deflation with due reference to any weaknesses or disadvantages of this approach. (Up to 4 marks)

(AN: up to 8 marks)

For evaluative comment that compares the relative merits of each approach (3 marks) to arrive at a conclusion on which approach is most likely to be effective. (1 mark) (EV: up to 4 marks)

Policies to solve the problem of deflation include expansionary monetary policy and running a fiscal deficit. Whether either policy can be effective depends upon the extent to which consumers and businesses respond to the stimulus.

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♕ Examiner’s report
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Some good answers were provided here with sound analysis of both fiscal and monetary policy. Also, many candidates made good use of appropriate diagrams. The main weakness displayed by many responses was in their evaluation. Many pointed out the advantages and disadvantages of each type of policy, but this is an aspect of the analysis, not evaluation. Evaluation on this question required a comparison of the advantages and disadvantages of each type of policy to arrive at a reasoned conclusion on which is likely to be more effective. Many candidates appear to assume that a brief comment at the end of an essay is sufficient to receive a good mark for evaluation. It is not. Four marks are available for the display of this skill on the essay questions and a reasoned and considered assessment of the relative strengths and weaknesses of each type of policy to arrive at a relevant conclusion was essential here for a good mark.