Reflationary policies and Deflationary policies

Reflationary policies and Deflationary policies

Keynesians - Policies                                  

The other sections about Keynesians show that they believe that the economy can settle at any equilibrium. This means that they recommend that the government gets actively involved in the economy to manage the level of demand. You will then be stunned to learn that these policies are known as demand-management policies.

Demand management means adjusting the level of demand to try to ensure that the economy arrives at full employment equilibrium. If there is a shortfall in demand, such as in a recession (a deflationary gap) then the government will need to reflate the economy. If there is an excess of demand, such as in a boom, then the government will need to deflate the economy.

Reflationary policies

Reflationary policies to boost the level of economic activity might include:

    * Increasing the level of government expenditure

    * Cutting taxation (either direct or indirect) to encourage spending

    * Cutting interest rates to encourage saving

    * Allowing some money supply growth

The first two policies would be considered expansionary fiscal policies, while the second two are expansionary monetary policies. The impact of them should be to reduce aggregate demand and therefore the level of output. The diagram below shows this:

[Reflationary policies] 

The reflationary policies have boosted the level of output from Q1 to Q2. The impact on the price level has been small, though if demand increased any more it may well be inflationary.

Deflationary policies

Deflationary policies to dampen down the level of economic activity might include:

    * Reducing the level of government expenditure

    * Increasing taxation (either direct or indirect) to discourage spending

    * Increasing interest rates to discourage saving

    * Reducing money supply growth

The first two policies would be considered contractionary fiscal policies, while the second two are contractionary monetary policies. The impact of them should be to reduce aggregate demand and therefore the level of output. The diagram below shows this:

[Deflationary policies] 

The initial level of aggregate demand was inflationary - prices were increasing rapidly.  However, the deflationary policies have reduced demand to AD2 and thus reduced the level of inflation.