Figure 1:
As we see in Figure 1, the government spending will increase output to Q2 and reduce the price to P2. The amount per unit of the subsidy is given by the vertical distance between the two supply curves and the total cost of the subsidy is given by the shaded area. This is an effective method of price control because the money given to the firms by the government allows them to price products lower without losing profit. The Indian government finds it necessary to implement these policies to firstly, improve quality of living as the essentials will cost less and secondly to reduce the rate of inflation. Inflation is defined as “a rise in the general level of prices of goods and services in an economy over a period of time.” It is desirable to maintain a reasonably low rate as inflation erodes international competitiveness making exports cost more abroad. This can cause a decrease in demand for exports. This would result in less revenue for many firms, and less money coming into the country.
Last week in Hong Kong, authorities turned to a different method of price control. This includes waving public-housing rents for two months and providing residents with cash handouts of 6000 Hong Kong dollars (US$770.) By doing so, Hong Kong hopes that by cutting costs of accommodation, and giving handouts, residents will have more money to spend on the necessities as prices increase. However there are two fundamental flaws in this policy. The first is that this is only a short-term fix. Rent is only waived for two months and the handouts are a one-time payment, instead of ideally making it easier for the savings to be sustainable. As prices continue to go up, the situation will worsen as the extra cash runs out. The second problem is that this policy does not address the problem of inflation. Inflation can affect the demand for their exports and firms may suffer, and people on fixed incomes (as many do in developing countries) will be spending higher fractions of their salary on essentials.
These demand-side policies are popular with governments because they can temporarily prevent inflation from acceleration further. Middle Eastern countries such as Jordan, Algeria and Morocco are all using similar policies to maintain low food prices. However subsidies and handouts let governments avoid more painful moves, such as big interest-rate increases, which many governments fear will slow growth. Frederic Neumann, and economist at HSBC in Hong Kong says, “…subsidies and price controls are counterproductive.” He also says that “giving people more money to spend through subsidies and handouts is the last thing governments should be doing when prices are rising.” What he means, is that by enable more consumer spending, the governments are increasing aggregate demand. This is known as demand-pull inflation. Which is shown in figure 2 and defined as “when aggregate demand in an economy outpaces aggregate supply”
Figure 2
As we see here in figure 2, as demand shifts right, price goes from P1 to P2. This is what Frederic Neumann fears will happen in to the countries that have recently turned to demand side policy. Overall, although handouts and subsidies are an effective short-term fix, which improve quality of life, they may prove costly in the long run.
