Question

Which of the following policy would reduce the inflation rate? please explain B and D in detail, many thanks!

(a) reduction of the personal income tax rate

(b) reduction of transfer payment

(c) increase of government expense

(d) reduction of money supply

Answer 1

Part a.

A reduction in Personal Income tax will mean that household will now have more income at their disposal thereby increasing demand for goods and services. A spur in demand increase the prices further. Therefore a reduction in Personal Income tax will not help in reducing inflation rate.

Part b.

A reduction in transfer payments from government will mean a decrease in cash transfers done to households. A decrease in transfers reduces the households' disposable income which reduces the demand for goods and services which leads to fall in prices. Therefore a reduction in transfer payments will help in reducing inflation.

Part c.

An increase in Government spending will first increase the demand for goods and services and secondly it will lead to generation of income (Government spending multiplier). Both of which will result in increased demand for goods and services and thereby increasing prices. Therefore an increase in Government spending will not help in reducing inflation.

Part d.

A reduction in money supply in supply will create a shortage of currency in the economy, at a given supply of goods and services already produced. This reduction in money supply will lead to demand going down since people will have less cash as a result prices will go down. Therefore a reduction in money supply will lead to a reduction in inflation.