If the inflation rate was above the desired 2% then the government could introduce contractionary fiscal policy which would cut the amount of government spending and raise direct taxation; causing aggregate demand to fall. This tactic will also increase the amount of leakages from the circular flow of income as more people are saving as well as decreasing the injections as the government is spending less money. If the government was to decrease government spending and raise …show more content…
Tightening monetary policy is reducing the real supply of money and raising interest rates. Through raising interest rates it encourages consumers to save their money as it will yield them more money which is a leakage from the circular flow of income. The opportunity cost of spending has increased and borrowing has become more expensive which therefore discourages firms to invest in capital. Furthermore, reducing the supply of money is deflationary as it becomes more valuable through there being less readily