When economy approaches the inflationary window, the government should tax more and Federal Reserve should take a tight money policy to control the money supply in the circulation. .
There are four tools the government could use to intercept economy market including taxing, regulating, spending and borrowing. When economy approaches the inflationary window; the best fiscal tool government could use is more taxation. Increasing tax rate would discourage business investment, therefore, less job opportunities in the market and less money flows in the circulation. The total amount of money is fixed. According to the equation, AD=C+I+G+[X-M], if investment is depressed, money could flow to consumption, which will still cause the inflation. According to Keyness theory, the government should increase founds for infrastructure so that there wont be excessive money in the circulation. When less money is available in the market, the demand will go down and consequently prevent the inflation. If the government chose to borrow to spend more and compete with the private sector, it would crowd out the private sector and make the inflation rate even higher. .
There are three tools that the Federal Reserve could use for a tight money policy including raise reserve requirement, raise discount rate and sell treasure bill in the market. By raising the reserve requirement, there will be less money to multiply through the bank multiplier. By raising the discount rate, the interest rate goes up and banks need to take further consideration before making loans to customers. By selling treasure bill in the market, the Federal Reserve decreases the amount of money supply in the circulation. All of the three tools used by the Federal Reserve will increase the interest rate and decrease the business investment, therefore slow down the economic and create a soft landing. To slow down economy will generate victims.
