Question

Assume that an economy experiences an adverse supply shock that causes stagflation (simultaneous decrease in output (increase in unemployment) and increase in prices). In your opinion, should the government use expansionary or contractionary fiscal policy to address the situation? Explain your answer, mentioning the tradeoffs that each of the policies involves?

Answer 1

Stagflation is situation also called as Catch22 situation wherein for example if the Government adopts expansionary fiscal policy by reducing taxes and inducing higher spending then the inflation rises which is drawback however real GDP growth also rises which is a plus.

Similarly, if the government adopts an contractionary fiscal policy by reducing spending and increasing taxes, then inflation drops as plus and real GDP also drops which is drawback.

So, in both situations we yield drawbacks.

Hence, here an out of box policy mix is required by which wr moderate out negatives from both.

Thus by taking an expansionary fiscal policy we induce higher GDP growth, and by taking contractionary monetary policy through interest rate rise and bond selling, we reduce inflation in market. Also curbing the imports and hedging crude oil to lowest prices can save import bill and forex reserves and also curb down the CPI And WPI Inflation drastically.

Here government can use forex reserves to boost supply and production so that prices come down eventually.

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