Fiscal Policy to Combat Inflation

When Keynes developed his landmark economic theory in the mid-1930s, his main concern was unemployment. The remedy he prescribed was an expansionary fiscal policy that would increase government spending or reduce taxes to get the economy moving. But Keynes realized that fiscal policy could also serve to combat inflation. If society attempts to purchase more goods and services than the economy is capable of producing, a reduction in government spending or an increase in taxes will help reduce inflationary pressures.

If the government spends less, one component of total spending (G) is reduced directly, and consumption spending (C) is reduced indirectly through the multiplier effect. A tax increase has a different impact. Consumers who pay higher taxes find themselves with less disposable income; this forces them to reduce their consumption spending. Either way, total spending is reduced.

As you might expect, the fiscal policy used to fight inflation is considerably less popular than the policy used to combat unemployment. The prescriptions for dealing with unemployment—reducing taxes and increasing government spending—are generally applauded. Inflation-fighting measures usually meet with less widespread approval.