Macroeconomics IA South Korea inflation at threeyear high on food price jump

High inflation is very bad for the people, since they have a lower purchasing power, meaning that if, for example, before they could buy 2 kilos of apples for two euros, now they can only buy one and a half kilo. This is especially a problem for people on fixed incomes, whose income does not change as inflation increases. To reduce inflation the government can use contractionary demand-side policies that are used to manage the economy. They could use either the contractionary Fiscal Policy to lower price level or the contractionary Monetary Policy. The tools of the Monetary Policy are interest rates, which is the amount charged by a lender to a borrower (usually the bank to its customer) for the use of assets. As interest rates get higher, consumption goes down since people have less money to spend, and so inflation decreases as well. However, the article states that “The bank of Korea has raised interest rates three times this year in a bid to control rising consumer prices” and therefore they don't want to raise them again- “It will therefore be tough for the Bank of Korea to raise interest rates this month”. This can be explained by the fact that even though raising interest rates lowers inflation it worsens the economic growth of a country, as we can see in the Figure 2 below:

Figure 2: Effect of increased interest rates on Korean economy

We can clearly see why the Bank of Korea does not want to increase interest rates again. It will push Aggregate Demand inward even further, from AD to AD1, which will improve the inflation by lowering it from P to P1, but cause economical problems, since GDP decreases from X to X1. And so Korean authorities struggle, because they want to lower inflation, but also they want to “ boost domestic demand”. Therefore, it is unlikely that the bank of Korea will “exercise monetary policy at the risk of further slowdown”.

Another policy that the government could use is the Fiscal Policy. Its tools are taxation and government spending. If the government needs to lower inflation, they could increase taxes or decrease government spending, which would shift the aggregate demand curve inwards and thus reduce Price Level. However, this policy has the same negative effect on the economy as the monetary policy, because even though it lowers inflation, it also lowers GDP. This effect can be observed in Figure 3 below.

Figure 3: Effect of contractionary Fiscal Policy on Korean economy:

Here, we can see that the Fiscal Policy will shift the aggregate demand curve in from AD to AD1, which will lead to the desired effect of a fall in price level from P to P1, however, it will also reduce GDP from X to X1, and this means that economic growth decreases, which is rather bad for an economy.

Overall, the use of the Fiscal or Monetary Policy could lower the price level and thus inflation, however it also lowers GDP, which could lead to a decrease in standards of living, spending, and employment, which could be considered a negative multiplier effect and could possible initiate a recession of the economic growth of Korea. Therefore, the authorities should consider imposing Supply Side Policies, which will not harm the economy and therefore be more convenient. The goal of a Supply Side Policy is to increase the output of the economy by bringing about an improvement in the factors that affect production. For example, the government could grant subsidies to firms dedicated to food production and other simple commodities in Korea. This would have the positive effect illustrated in Figure 4.

Figure 4: Effect of subsidy on food or essential commodities market:

On this diagram we can observe that if the government would use a supply side policy and for example grant subsidies to Korean food and commodity producers, the aggregate supply curve would shift outward form AS to AS1, which would lower the price level from P to P1, but at the same time economic growth keeps occurring, as X moves to X1. Therefore, it would be highly suggestible for the Korean government to subsidize those firms who produce the goods whose prices have been rising. Another way to shift the aggregate supply curve outward would be by allowing them a tax reduction, which would have the same positive effect on the economy.

In conclusion, as “fighting rising prices is one of their (Korean government’s) top priorities” they should stop concentrating on the monetary policy and instead use the Supply Side Policy, which will not only lower inflation but also serve economic growth.

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