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 .

Deficient Demand

Deficient demand refers to the situation when aggregate demand (AD) is in short of aggregate supply (AS) corresponding to fullemployment in the economy.

AD < AS : Corresponding to full employment.

Desired AD in the economy happens to be short of its full employment level. 

It implies that desired AD does not permit production at the full employment, due to deficient demand, equilibrium between desired AD and desired AS is struck at a level lower than full employment in the economy, this is a situation of underemployment equilibrium. 

Deficient demand may be caused by decrease in the value of various components of aggregate demand

i.e.

AD = C + I + G + (X - M)

Thus, deficient demand may be caused by the following factors:

1) Decrease in the consumption expenditure by the household due to increase in the propensity to save and reduction in propensity to consume.

2) Decrease in private investment expenditure.

3) Decrease in government expenditure this may be due to losses in public enterprises. In such a situation, instead of making fresh investment, the government may resort to disinvestment, implying a cut in AD. 

4) Decline in export, owing to lower domestic demand in rest of the world.

5) Rise in imports, owing to lower international prices compared with domestic prices. A rise in import implies a cut in AD as imports are negative components of AD.

6) An increase in tax rates leaving lesser disposable income with the people. This leads to reduction in their capacity to spend

7) Decrease in money supply due to reduction of credit facilities by the commercial banks. 

Below figure illustrates the situation of deficient demand.

deficient demand

AD: Aggregate demand at full employment

AD₁: Aggregate demand corresponding to underemployment

FC: deficient demand

OM: Full employment level of output

ON: equilibrium output owing to underemployment

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

Now, suppose aggregate demand curve shifts downwards to AD₁ due to say, decrease in government expenditure.

At the full employment level of income, the aggregate supply is OM or FM. This is greater than aggregate demand of CM.

The deficient demand at the full employment income is FC 

Deficient demand = FC = AD - AD₁  (FM – CM)

Inflationary gap

Inflationary gap is the excess of Aggregate Demand over and above its level required to maintain full employment equilibrium in the economy.

When there is a situation of excess demand, the level of output does not rise since factors are already fully employed.

Output level remains constant corresponding to full employment. A high level of aggregate spending relative to full employment level of output will generate shortages of goods in the economy, which would push up prices and causes inflation.

A situation of inflationary pressure emerges in the economy.

Inflationary pressure is proportionate to excess demand i.e. inflationary gap is a measure of the amount of excess demand in the economy.

Greater the excess demand, greater the inflationary pressure.

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

Excess Demand

Excess demand refers to the situation when aggregate demand (AD) is in excess and its components of aggregate supply (AS) corresponding to full employment in the economy.

AD > AS : Corresponding to full employment. 

Desired AD in the economy happens to exceed its full employment level.

As it is a situation of full employment, resources are all fully utilized so aggregate supply cannot be raised, increase in demand implies greater pressure on the available goods and services in the economy.

Accordingly, price of existing goods and services tends to rise.

Excess demand may be caused by increase in the value of various components of aggregate demand.

i.e.

AD = C + I + G + (X - M) 

Thus, excess demand may be caused by the following factors: 

1) Increase in the consumption expenditure by the household due to increase in the propensity to consume.

2) Increase in private investment expenditure.

3) Increase in government expenditure, owing to its active participation in the process of growth and social welfare.

4) Increase in export, owing to lower domestic prices in relation to international prices.

5) Decrease in imports, owing to higher international prices compared with domestic prices.

6) A cut in tax rates leaving higher disposable income with the people.

Full Employment

Full employment refers to a situation when all those who are able to work and are willing to work (at the existing wage rate) are getting work. It is a situation when, corresponding to a given wage rate, demand for labor force is equal to supply of labor force, and the labor market is cleared (it is in a state of equilibrium).

Two situations must be noted in this definition:

1) Full employment does not mean that everyone is employed. People who are voluntarily unemployed, such as ‘idle rich’, are not employed because they are not willing to work. They are not treated as unemployed.

2) There might be some amount of frictional unemployment owing to technological improvements, decrease in demand for the product of some industries, or because some person may be changing jobs or because of structural changes in the economy. It may take some time for these persons to get a new job. So, these people may remain temporarily unemployed.