Reducing Inflation Without Interest Rates

Readers Question From: Economic Policies to Reduce Inflation. What about a case were there is inflation and government needs central bank to print more money to spend and does not want to increase tax or interest rate. What can policies should the central bank adopt on this case.

If the Central Bank is printing more money, then the increase in the Money Supply is likely to cause inflation. Monetarist theory suggests inflation will occur if the money supply grows faster than Real Output.

If the government does not want to increase tax or increase interest rates, it is going to be difficult to reduce inflation.

They could reduce government spending. This will help to reduce the growth of AD. Government spending is a component of AD (C+I+G+X-M). This lower government spending will help reduce demand pull inflation. Although, it may be difficult to find areas of government spending to cut. One thing the government like to focus on is maintaining ‘wage restraint’ in the public sector. What this means is that public sector workers will get low wage increases. This will help reduce cost push and demand pull inflation.

The other option is to use Supply side policies. For example, reducing power of trades unions may help reduce wage inflation. Privatisation and deregulation may increase competitiveness and reduce inflation. However, at best, supply side policies will take a long time to have an effect. They will not be able to meet the immediate need.

One final policy is having a fixed (and high exchange rate) like the UK in the ERM 1990. However, this may require high interest rates to keep exchange rate high.