Evaluate the effectiveness of policies meant to solve an
inflationary gap in the economy. [13]
The existence of an inflationary gap will still cause problems to
the economy hence the control of an inflationary gap is
economically justified. A deflationary fiscal policy, and monetary
policies are recommended. Above that, government can also use
a trade and exchange rate polies to do away with an inflationary
gap.
An increase in income taxation is necessary to solve an
inflationary gap. High income tax will cut disposable incomes.
Spenting ability in the economy will fall and aggregate demand in
the economy will fall. The fall in aggregate demand together with
the operation of the multiplier effect will reduce national income
to full employment and the deflationary gap will offset.
A cut in government expenditure is also recommended as a
measure to do away with an inflationary gap. Government can
cut own expenditures through reducing the civil service,
removing some social grants and privatization of government
firms. Since government is the single largest consumer in the
economy, a fall in government expenditure will cut aggregate
demand. The fall in aggregate demand together with the
operation of the multiplier effect will reduce national income to
full employment and the inflationary gap will be closed.
However, the effectiveness of fiscal policy is limited by
downward inflexibility nature of government expenditure.
Government expenditure is sticky downwards. This is because in
most cases, government expenditures are in the form of long
term agreed contracts. Trying to reverse downwards will attracts
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legal costs. In addition, most governments are reluctant to cut
government expenditures in fear of associated political costs.
The fiscal policy is also affected by time lags. It takes time for the
government to appreciate the economic situation and decide on
cost of action and implement. Sometimes the fiscal policy will
work at the wrong time.
Increase in interest rates is necessary when solving an
inflationary gap. High interest rates will discourage borrowing of
both consumption and investment nature. This is because at high
interest rates, very few investments project will remain
profitable. A fall in private investments and private consumption
will cut aggregate demand. The fall in aggregate demand
together with the operation of the multiplier principle will
reduce national income to full employment and the inflationary
gap will be offset.
Credit squeezing is also recommended in order to solve an
inflationary gap. Credit squeezing is when the central bank
reduces the ability of commercial banks to lend. This can be
achieved through increasing the reserve requirement. Credit
squeezing will depress borrowing levels in the economy.
Aggregate demand will fall since part of private consumption and
investments is financed through borrowing. The fall in aggregate
demand together with the operation of the multiplier effect will
reduce national income to full employment and the inflationary
gap will offset.
However, the effectiveness of the monetary policy lies on
expectations. If the business community is optimistic, high
interest rates will not deter people from borrowing. Aggregate
demand will remain high and the inflationary gap will persist.
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In addition, a deflationary monetary policy can fuel domestic
unemployment. According to the Philips curve, inflation and
unemployment trade-off. This means inflation is necessary to
keep unemployment low. A cut in aggregate demand can act as a
disincentive for increased production. Producers will scale down
in line with falling aggregate demand. jobs are lost and
unemployment will rise.
Currency revaluation is also a necessary measure when dealing
with an inflationary gap. Currency revaluation is increasing the
external value of the local currency. Currency revaluation will
make exports dearer. Assuming elastic export demand, export
volumes will fall by a greater percent than the price increase and
total export revenue will fall to cut aggregate demand. The fall in
aggregate demand together with the operation of the multiplier
effect will reduce national income towards full employment and
the inflationary gap will be offset.
However, currency revaluation can worsen the inflationary gap if
the Marshal-Lerner condition is not satisfied. If the sum of
import and export elasticity of demand is less than one, currency
revaluation will increase net exports and the inflationary gap will
widen.
The existence of an inflationary gap will conflict with other
macro-economic objectives. Inflation will erode the purchasing
power of money and standards of living will fall. Demand-pull
inflation will discourage foreign direct investments and economic
growth will be slowed. Although with limitations, the highlighted
policies are effective to a greater extent in solving an inflationary
gap. Government is recommended to adopt the policies.
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Call / Watsapp @ 0780911177 / 0716024769
