Readers Question: what are the economic policies that lead to low inflation in an economy?
1. Monetary Policy
In the UK and US, monetary policy is the most important tool for maintaining low inflation. In the UK, monetary policy is set by the MPC of the Bank of England. They are given an inflation target by the government. This inflation target is 2%+/-1 and the MPC use interest rates to try and achieve this target.
The first step is for the MPC to try and predict future inflation. They look at various economic statistics and try to decide whether the economy is overheating. If inflation is forecast to increase above the target, the MPC will increase interest rates.
Increased interest rates will help reduce the growth of Aggregate Demand in the economy. The slower growth will then lead to lower inflation. Higher interest rates reduce consumer spending because:
- Increased interest rates increase the cost of borrowing, discouraging consumers from borrowing and spending.
- Increased interest rates make it more attractive to save money
- Increased interest rates reduce the disposable income of those with mortgages.
- Higher interest rates increased the value of the exchange rate leading to lower exports and more imports.
Diagram Showing Fall in AD to Reduce Inflation
Base Rates and Inflation
Base interest rates were increased in the late 1980s / 1990 to try and control the rise in inflation.
2. Supply Side Policies
Supply side policies aim to increase long term competitiveness and productivity. For example, privatisation and deregulation were hoped to make firms more productive. Therefore, in the long run supply side policies can help reduce inflationary pressures. However, supply side policies work very much in the long term. They cannot be used to reduce sudden increases in the inflation rate. Supply side policies
3. Fiscal Policy
This is another demand side policy, similar in effect to Monetary Policy. Fiscal policy involves the government changing tax and spending levels in order to influence the level of Aggregate Demand. To reduce inflationary pressures the government can increase tax and reduce government spending. This will reduce AD.
4. Exchange Rate Policy
In the late 1980s the UK joined the ERM, as a means to control inflation. It was felt that by keeping the value of the pound high, it would help reduce inflationary pressures. The policy did reduce inflation, but at the cost of a recession. To maintain the value of the £ against the DM, the government had to increase interest rates to 15%. The UK no longer uses this as an inflationary policy.
5. Wage Control
Wage growth is a key factor in determining inflation. If wages increase quickly it will cause high inflation. In the 1970s, there was a brief attempt at wage controls which tried to limit wage growth. However, it was effectively dropped because it was difficult to widely enforce.