Answer to Question #198856 in Economics of Enterprise for Keitu

Question

3.1Explain the difference between demand-pull and cost-push inflation,and discuss two ways in which inflation can be managed. (10)

3.2Describe how the South African government could use discretionary fiscal policy to stimulate the economy. Be sure to advise the government on possible pitfalls of using this type of fiscal policy.(10)

 

Answer 1

3.1) Cost push inflation is caused by the rise in the cost of inputs required for production. Due to rise in price of inputs , the cost of production rises. This leads to the leftward shift in AS curve . As a result , output fall below potential , unemployment rises and price level also rises. There is negative output gap in economy in this case.

Demand pull inflation is caused when there is excess money or capacity in economy and purchasing power rises. This lead to rise in AD showing the rightward shift. The price level rises and real GDP rises and goes beyond potential creating inflationary gap in economy. This is positive output gap.

Ways in which inflation can be managed

I). Monetary Measures

Monetary policy of the Central Bank should be employed. Most central banks use high interest rates as the traditional way to fight or prevent inflation.

II). Fiscal Measures

Fiscal measures to control inflation include taxation, government expenditure and public borrowings. The government should also ban exportation of essential items such as oils and cereals which can play a significant role in managing inflation.

3.2) the South African government can use discretionary fiscal policy to stimulate the economy especially if it is in a recession by lowering taxes and increase spending while the Fed enacts an expansionary monetary policy. In addition, it can be done by lowering the fed funds rate or through quantitative easing.

However, employing discretionary fiscal policy to stimulate the economy can attract unpredictable political behavior. Therefore, the government should first agree with economists the terms and conditions requires in implementing the policy.