Cambridge International as and a level Economics Ebook

Policies to correct cost-push inflation
In the short term, a government may instruct its central 
bank to raise the exchange rate in a bid to reduce cost-
push infl ation. Such a measure may reduce raw material 
and capital costs and is likely to put pressure on domestic 
fi rms to fi nd ways to cut their costs.
Governments may also employ supply side policy 
measures to correct cost-push infl ation. For example, 
increased spending on training can raise labour productivity 
and so reduce labour costs or at least reduce the upward 
pressure on labour costs. Lower corporation tax may 
encourage fi rms to buy more effi
cient capital equipment, 
which can also put downward pressure on price rises.
A government may decide to provide subsidies to 
fi rms facing, for instance, higher fuel costs, so that 
they do not have to raise their prices. It may also hope 
that fi rms may use some of the subsidies to buy new 
capital equipment, which may lower prices in the 
longer term.
The eff ectiveness of policies to correct 
cost-push inflation
A rise in the exchange rate may not reduce infl ation, 
if foreign producers decide to keep the price of their 
exports unchanged in the country’s currency. Th
e 
country’s fi rms may also not respond to the increased 
competitive pressure to keep down their cost and 
price rises.
Increased spending on training may be successful in 
raising the skills of workers but if their pay rises by more 
than their productivity, costs of production will still rise. 
Lower corporation tax may not result in more investment 
if fi rms are pessimistic about the future.
Th
ere is also the risk that government subsidies 
may increase aggregate demand, through the rise in 
government spending, but may not increase aggregate 
supply if fi rms do not respond positively by using them to 
increase their effi
ciency.
TOP TIP
It is useful to draw on examples of policy measures used 
in your own country to correct balance of payments 
disequilibrium and inflation.