Question

Suppose that officials in Congress and the Federal Reserve become convinced that an economic recovery is occurring, in fact, there are fears that a strong recovery could lead to inflation. What can government do to prevent inflation? What are some of the advantages and disadvantages of these options? What policy would you recommend?

Answer 1

In the given scenario, the government can decrease the spending, take some austerity measures and or increase som taxes so that people have less money to spend as disposable income. It will cause decrease in AD and price level will decrease. It will help decrease inflation rate. Some of the advantages are its multiplier effect to maximize the impact of government action, less time to impact upon the aggregate demand and government's direct control over these initiatives. Though, there are some disadvantages as well in the forms of increase in unemployment rate, decrease in economic growth and poor labor market conditions.

The policy recommendation, will include austerity measures to reduce the spending, then reducing spending upon those programs that are non-developmental in nature or that cannot create revenue as well as increase in tax that is progressive in nature. It will make those to pay more who have high income or who are rich. For this, new tax can also be created so that it affects more to those who have more money and are rich. It will control the AD and inflation will be controlled.