Inflation is generally controlled by the Central Bank and/or the government. The main policy used is monetary policy (changing interest rates). However, in theory, there are a variety of tools to control inflation including:
- Monetary policy
Higher interest rates reduce demand in the economy, leading to lower economic growth and lower inflation.
In a period of rapid economic growth, demand in the economy could be growing faster than its capacity to meet it. This leads to inflationary pressures as firms respond to shortages by putting up the price. We can term this demand-pull inflation. Therefore, reducing the growth of aggregate demand (AD) should reduce inflationary pressures.
The Central bank could increase interest rates. Higher rates make borrowing more expensive and saving more attractive. This should lead to lower growth in consumer spending and investment. See more on higher interest rates.
A higher interest rate should also lead to a higher exchange rate, which helps to reduce inflationary pressure by:
- Making imports cheaper. (lower price of imported goods)
- Reducing demand for exports.
- Increasing incentive for exporters to cut costs.
- Fiscal Policy
A higher rate of income tax could reduce spending, demand and inflationary pressures.
The government can increase taxes (such as income tax and VAT) and cut spending. This improves the government’s budget situation and helps to reduce demand in the economy.
Both these policies reduce inflation by reducing the growth of aggregate demand. If economic growth is rapid, reducing the growth of AD can reduce inflationary pressures without causing a recession.
If a country had high inflation and negative growth, then reducing aggregate demand would be more unpalatable as reducing inflation would lead to lower output and higher unemployment. They could still reduce inflation, but, it would be much more damaging to the economy.
- Control of money supply
Monetarists argue there is a close link between the money supply and inflation, therefore controlling money supply can control inflation.
The main way central banks control money supply is buying and selling government debt in the form of short term government bonds. Economists call this ‘open market operations’, because the central bank is selling bonds on the open market. Central banks usually own a big portion of their county’s debt. When they want to shrink the money supply, they can sell some that debt to banks or investors. People hand over money to buy the debt, and money is taken out of the economy, as money that used to be floating from person to person disappears into the central bank. When the central bank wants to add more money to the economy it can buy debt, taking government debt out of the economy and replacing it with new money.
All this bond buying and selling affects the interest rate too. By shifting the supply and demand for debt, central banks can move the interest rate to affect how many people take new loans. Changing the interest rate allows central banks to also impact the money supply indirectly, because each loan a bank makes actually creates money.
Central banks have other tools to indirectly control the money supply, like requiring banks to keep more money on hand (called reserve requirements), or changing the interest rate at which they lend money to private banks. In recent years central banks have also experimented with a new policy called quantitative easing—basically a turbocharged version of buying bonds.
- Supply-side policies
Supply-side policies are government attempts to increase productivity and increase efficiency in the economy. If successful, they will shift aggregate supply (AS) to the right and enable higher economic growth in the long-run.
There are two main types of supply-side policies.
- Free-market supply- Side policies involve policies to increase competitiveness and free-market efficiency. For example, privatisation, deregulation, lower income tax rates, and reduced power of trade unions.
- Interventionist supply- Side policies involve government intervention to overcome market failure. For example, higher government spending on transport, education and communication.
Benefits of Supply-Side Policies
In theory, supply-side policies should increase productivity and shift long-run aggregate supply (LRAS) to the right.
(a) Lower Inflation
Shifting AS to the right will cause a lower price level. By making the economy more efficient, supply-side policies will help reduce cost-push inflation. For example, if privatisation leads to more efficiency it can lead to lower prices.
(b) Lower Unemployment
Supply-side policies can contribute to reducing structural, frictional and real wage unemployment and therefore help reduce the natural rate of unemployment. See: Supply-side policies for reducing unemployment.
(c) Improved economic growth
Supply-side policies will increase the sustainable rate of economic growth by increasing LRAS; this enables a higher rate of economic growth without causing inflation.
(d) Improved trade and Balance of Payments
By making firms more productive and competitive, they will be able to export more. This is important in light of the increased competition from an increasingly globalised marketplace. See also: Economic Importance of Supply-Side Policies.
Limitations of supply-side policies
- Productivity growth depends largely on private enterprise and trends in technological innovation. There is a limit to which the government can accelerate the growth of technological change and improvements in working practices.
- Supply-side policies can be counter-productive. For example, flexible labour markets may reduce costs for business – but if they cause job-insecurity, workers may become demotivated and labour productivity stagnates. Since 2009, the UK has seen a fall in structural unemployment due to more flexible labour markets – but productivity growth is almost stagnant.
- In a recession, supply-side policies cannot tackle the fundamental problem which is lack of aggregate demand.
- All supply-side policies take a long time to have an effect. Some policies, such as education spending may not influence the economy for 20-30 years.