How Fiscal Policy control Inflation

In the situation of inflation there is a high price rise in the economy, this is due to increase in Aggregate Demand (AD). When there is an increase in AD beyond the full employment level, output remain constant since output cannot be increased as there is full employment, all resources are fully utilized, this leads to an increase the cost of production of existing factors of production and price rises. More and more rise in prices leads to a situation of inflation due to the situation of excess demand .

Below graph explains the inflationary gap

inflationary gap

AD: Aggregate demand at full employment

AD₁: Aggregate demand beyond full employment

AB: Excess demand = inflationary gap

OM: Full employment level of output

AD is Full employment Aggregate Demand. The intersection of AD curve with 45^◦ line at B gives us the equilibrium corresponding to full employment level of output M.

Now, suppose aggregate demand curve shifts upwards to AD₁ due to say, increase in government expenditure.The output will not rise since the economy is at full employment level of output. It will only cause a pressure of demand on the existing output which will leads to rise in prices. 

The economy faces a situation of inflation.Situation of excess demand is described as a situation of inflationary gap in the economy.

Inflationary gap = AD beyond full employment – AD at full employment = AB

Inflationary gap = AD₁  -  AD = AB

The high price rise will hamper the economy stability. Through the instruments of fiscal policy this gap will be reduced. Inflation is corrected when the government steps down its expenditure and ensures that there is less cash balance at the hands of the people, so that their demand reduces.

1) The government expenditure will be reduced. A reduction to the subsidies for producer so that they do not invest more in the economy.

2) Increase in tax burden on household and producers so that people are left with less money reducing their purchasing power.

3) Increase Public borrowings/ public debt by offering attractive rate of interest, reducing liquidity with the people.

4) Deficit financing is avoided.

By adopting all these Fiscal measures economy stability can be maintained.