Inflation is a period of rising prices. Most Central Banks target low inflation. If inflation rises above this inflation target, there are several economic policies, such as monetary policy to reduce the inflation rate.
Summary of policies to reduce inflation
- Monetary policy – Higher interest rates. This increases the cost of borrowing and discourages spending. This leads to lower economic growth and lower inflation.
- Tight fiscal policy – Higher income tax and/or lower government spending, will reduce aggregate demand, leading to lower growth and less demand pull inflation
- Supply side policies – These aim to increase long-term competitiveness, e.g. privatisation and deregulation may help reduce costs of business, leading to lower inflation.
Policies to reduce inflation in more details
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 are likely to 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. See also:
2. Supply Side Policies
Supply side policies aim to increase long term competitiveness and productivity. For example, it was hoped that privatisation and deregulation would make firms more productive and competitive. 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. Also, there is no guarantee government supply side policies will be successful in reducing inflation More details at: 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.
- A stronger Pound makes imports cheaper (lower cost-push inflation)
- Stronger Pound reduces domestic demand, leading to less demand-pull inflation.
- A stronger Pound creates incentives for firms to cut costs in order to remain competitive.
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%, and this contributed to the recession.
See: ERM crisis 1992
The UK no longer uses this as an anti-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 enforce widely.
6. Targeting Money Supply (Monetarism) In the early 1980s, the UK adopted a form of monetarism, where the government sought to control inflation through controlling the money supply. To control the money supply, the government adopted higher interest rates and reduced budget deficit. It did bring inflation down but at expense of deep recession. Monetarism was effectively abandoned because the link between money supply and inflation was weaker than expected. See: UK economy 1979-84
Difficult types of inflation to control
- Cost-push inflation
In 2008 and 2011/12, the UK experienced cost-push inflation of 5% – above the target of CPI = 2%. However, the Bank of England didn’t alter its monetary policy. This was because:
- The inflation was expected to be temporary – caused by rising oil prices, rising tax rates and impact of devaluation.
- Economy in recession. With the economy in recession, the Bank of England didn’t want to reduce aggregate demand because it felt it was more important to boost economic growth.
In these cases of cost-push inflation, it is harder to reduce inflation, and it is maybe better to let the temporary inflation factors come to an end.