Question

What are the government’s fiscal policy options for ending severe demand-pull inflation?

Short answer

Reduced government spending and amplified taxes are the fiscal options to regulate demand-pull inflation.

Step-by-step solution

Effects of decreased government spending

Fiscal policy has two instruments that are government spending and taxes.A contractionary budgetary policy of the government reduces government spending.Lower government spending will directly shrink the aggregate expenditure of the economy.

As a result, a lower income will pull the demand down to a lower aggregate demand and supply model equilibrium. Hence, prices will fall, and inflation will be controlled or halted.

Effects of high taxes

Another part of a contractionary fiscal policy is high taxes.As taxes rise, the disposable income of consumers declines. Consequently, the consumption expenditure and saving in the economy also contracts. Less amount of consumption reduces the aggregate expenditure.

On the other hand, lower saving pulls down the gross investment as the economy is stable when saving matches the investment. Therefore, the consumption and investment expenditure falls, bringing the equilibrium GDP down. A lower GDP will reduce the aggregate demand, and the prices will fall. Hence, higher taxes will regulate demand-pull inflation.