Government Aims and Fiscal Policy: Question 5
Syllabus 4.1, 4.2
A government is experiencing demand-pull inflation and decides to use fiscal policy, rather than monetary policy, to bring the inflation rate down.
Which action is most likely to achieve this aim?
Show worked solution Hide worked solution
Worked solution
Step 1: Recall how fiscal policy tackles demand-pull inflation
Demand-pull inflation happens when total (aggregate) demand grows faster than the economy’s ability to produce output. Using fiscal policy to reduce it means using taxation and government spending to reduce total demand, raising taxes and/or cutting government spending, sometimes called a contractionary or deflationary fiscal stance.
Step 2: Test each option against this rule
- A: cutting corporation tax lowers the cost, to firms, of taxing their profits, encouraging more investment spending. This raises total demand rather than lowering it.
- B: more government spending on motorway construction is itself an increase in government demand for resources, adding to inflationary pressure rather than easing it.
- C: raising the basic rate of income tax reduces households’ disposable income, so consumption spending falls. This directly reduces total demand, easing demand-pull inflation.
- D: cutting the tax on imported goods lowers their price, but it also increases households’ real spending power, which tends to raise total demand rather than reduce it, and does not target domestic total demand the way a change in income tax does.
Step 3: Confirm the answer
Only raising income tax withdraws spending power from the economy, directly reducing total demand and helping to ease demand-pull inflation.
Final answer
Raising the basic rate of income tax, option C.