Cambridge International as and a level Economics Ebook

2
Assess whether the scheme would have increased 
Th
ailand’s aggregate supply.
Policies to correct demand-pull inflation
To reduce demand-pull infl ation, governments employ 
defl ationary fi scal and defl ationary monetary policy 
measures. Income tax rates may be increased, the threshold 
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Cambridge International AS Level Economics

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at which people start paying the tax may be reduced and 
the tax base may be widened. Governments may cut their 
own spending and this may be the more favoured option 
in countries, such as Pakistan, where only a relatively small 
proportion of the population pay income tax.
In many countries, the main policy used to reduce 
demand-pull infl ation is monetary policy with the focus 
being on the interest rate. Indeed, many central banks 
are now given a target rate for infl ation and instructed to 
use interest rate changes to achieve it. If the infl ation rate 
is rising outside its target range, a central bank is likely 
to raise the rate of interest. Th
is form of defl ationary 
monetary policy may reduce demand-pull infl ation for a 
number of reasons. Th
e cost of borrowing is likely to rise 
which may discourage large-scale purchases including the 
purchase of houses and cars. Savings may be increased as 
the return from saving will rise. Th
e opportunity cost of 
saving is, of course, spending. A higher interest rate may 
also attract hot money which may increase the external 
value of a fl oating exchange rate. Th
is is likely to put 
downward pressure on domestic prices as domestic fi rms 
will face increased competitive pressure at home and 
abroad and lower imported raw material costs.
Monetarists argue that the only way to reduce 
infl ationary pressure is to lower the growth of the money 
supply. If increases in the money supply do not exceed 
increase in output, they suggest there will be no upward 
movement of the price level.
To reduce the risk of demand-pull infl ation in the 
longer term, governments use supply side policy measures. 
Over time aggregate demand tends to increase. If increases 
in aggregate supply can keep pace with higher aggregate 
demand, a country can enjoy higher output (higher real 
GDP) without experiencing infl ation. Th
is situation is 
shown in 
Figure 5.3
.