If inflation is too high in an economy the government will introduce policies to reduce the rate as a high rate can lead to disaster for a country. If the UK has excessively high inflation rates then they will not be able to compete on the exportation of goods against other countries as we will be charging higher prices which can then lead to a contraction on UK output and we become less efficient. It is also disastrous for individuals as there will soon be a wage-inflation battle as wages need to increase with the inflation otherwise individuals will suffer a reduction in their real wage. Firms will have to constantly change their prices in order to keep up with the wage inflation which can be tricky if they use large catalogues to sell their products. This is why the government and the Bank of England try to keep the base rate of inflation at 2%. 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 income tax there would be a dampener on the multiplier effect as less money will be spent by consumers as they have now got a lower real earnings as a larger proportion of their wages will be spent on income tax which means that they will cut their spending though purchasing less goods which in turns causes shops to have a reduction in their revenue so they begin to cut down their orders from their suppliers as they no longer have a strong enough demand for their goods. The suppliers then cut down their output, which could be in the form of reducing their labour capital which can then lead to increased unemployment in the UK.
Figure 1 – LRAS...
Please join StudyMode to read the full document