min read
· Posted on
February 21, 2024

Are interest rates the only way to tackle inflation? Part 2: Fiscal policy

Confused about why inflation is STILL high even with all these cash rate hikes? We'll take you through why and fiscal policy as another possible solution.

What's the key learning?

  • Part one recap: monetary policy and what's contributing to supply-side shocks to inflation
  • Fiscal policy
  • Why economists aren't that excited about fiscal policy

Note: This article is part two of a three-part series answering the question, ‘Are interest rates the only way to tackle inflation?’ If you haven’t yet read part one of this series on monetary policy, check that out first!

In part one of the ‘Are interest rates the only way to tackle inflation?’ series we looked at monetary policy (aka upping interest rates to tackle inflation) and how it theoretically reduces demand for goods and services. 

But, as monetary policy doesn’t really affect supply of goods and services (the major cause of inflation in Australia), it hasn’t been doing enough to bring inflation down.

So let’s take a look at one possible alternative or additional measure that can help bring down inflation.

It’s this thing called fiscal policy, which is the use of government spending and taxes to influence the economy.

How does fiscal policy work?

The theory is, if the government cuts down its spending (aka saves more), or increases taxes (aka earns more). Both of these measures separately (or together) would reduce the overall amount of money in circulation.

And with less money in the economy, people will spend less - ultimately would help bring down inflation. 

Now, there’s a fair reason to consider fiscal policy as an option. Let's be honest, government spending was pretty dang high during the pandemic. We’re talking, the introduction of Job Keeper, Job Seeker increases, and other government relief funds.

In fact, 38% of the 48 economists surveyed by The Economics Society of Australia believe that on top of hiking the cash rate, we should be winding back government spending.

And 17% of economists support an increase in income taxes, which can go towards making services cheaper.

Buttt, 38% in support isn’t actually that high. In other words, a number of these economists weren’t actually THAT hyped about the idea. 

How hyped the economists are right now...

Why aren’t economists hyped about this solution?

Well, over half of inflation at the moment is as a result of supply-side shocks meaning there’s lower supply globally of goods and services.

There are a tonne of reasons why but some of the main reasons are: 

  • The post-pandemic supply-chain issues 
  • China aiming for COVID-zero and shutting down much of its manufacturing
  • The Russia-Ukraine war disrupting the supply of essential goods and services, especially oil.

Because the majority of inflation is due to supply-side shocks, the economists surveyed reckon pushing demand down won’t actually be enough to tackle inflation.

Jump here to read part-three of the series, ‘Are interest rates the only way to tackle inflation?’ on the concept of delayed spending to curb inflation.

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