Question

(a) How does the Government use its instruments of taxation and public expenditure during inflation? Support your answer with reasons.

(b) 1. Define price elasticity of demand.

2. Draw two demand curves to show relatively price elastic demand and perfectly price inelastic demand.

3. Explain the importance of elasticity of demand to the producer and the Government.

Answer 1

(a) Inflation is a state in which the value of money is falling i.e. price are rising. It is a fall in the external value of money as measured by foreign exchange rates, by the price of gold or indicated by excess demand for gold or foreign exchange at official rates. 

1. Public Expenditure: Public expenditure is an important component of aggregate demand. In order to control inflation it is essential that the government expenditure must be reduced. However, part of the government expenditure is of essential nature and hence, cannot be reduced. Therefore, what is important is that unproductive expenditure of the government, which is non-essential in nature, must be reduced. For example expenditure on defence arid unproductive works should be reduced. 

2. Taxation: The government may impose new taxes and raise the tax rate of existing taxes. This will reduce disposable income of individuals and thereby reduce the purchasing power with the individual and will lead to fall in consumption expenditure. At the same time, the tax system should be so evolved as to promote saving habits among the people and also provide incentives for undertaking productive investment. 

(b) 1. Price elasticity of demand is the responsiveness of change in quantity demanded in response to a given percentage change in the price of the commodity. 

It can be expressed as follows:

E_p = percentage change in quantity demand of commodity /percentage change in the price of the commodity

2. Relatively price elastic demand (Ed > 1)

Perfectly price inelastic demand (Ed = 0)

3. Elasticity of Demand useful to: 

1. The Government: The concept of elasticity of demand helps the government in fixing the rates of indirect taxes like sales tax. 

2. To the Producer: It helps him to take his decisions on the basis of the nature of elasticity of demand for his product. He will decide to. (1) Fix a higher price, and (2) Sell lesser quantity if the demand for his product is inelastic. Otherwise, if the demand is elastic, he may decide to (1) Fix a lower price, and (2) Sell larger quantity.