Policies to reduce inflation

• Macro objective for inflation


  Low and stable inflation, specifically to hit an inflation target (e.g. 2% in the UK)
• Inflation is beyond the target rate

  Policies could be used to bring that rate down
• Demand-pull inflation


  Inflation pushing the inflation rate beyond the target rate
• Policies to bring down demand-pull inflation


  1. Contractionary demand-side policies

  2. Contractionary monetary policy via an increase in interest rates

  3. Contractionary fiscal policy via a cut in government spending or increases in taxation
• Contractionary fiscal policy to target inflation is very unlikely, as it is the central bank's job to use monetary policy to bring inflation towards target
• Monetary policy


  More suited to targeting inflation due to the monetary policy transmission mechanism
• Central banks are independent from the government and therefore more transparent, maybe more trustworthy, and more successful in getting to the inflation target
• Contractionary monetary policy via an increase in interest rates


  Aggregate demand shifts to the left, reducing demand-pull inflation
• Evaluation of contractionary monetary policy


  • Trade-offs with macro objectives (lower economic growth, higher unemployment, potential recession)
  • Impact on investment (high interest rates deter investment, lower productivity, worsening competitiveness)
  • Impact on the indebted (households and businesses may default on loans)
  • Potential strengthening of the exchange rate and widening of the current account deficit
• Cost-push inflation


  Inflation pushing the inflation rate beyond the target rate
• Policies to bring down cost-push inflation


  1. Implement or reduce an inflation target to limit wage rises

  2. Reduce VAT or subsidise firms to reduce their cost of production
• Subsidies to all firms to reduce cost of production is a ludicrous idea, as governments would not do this due to the significant cost and worsening of government finances
• Intervening in foreign exchange markets to strengthen the exchange rate and reduce cost-push inflation is ludicrous, as many countries have freely floating exchange rates
• Evaluation of policies for cost-push inflation


  • Cost-push inflation is often short-term, so we don't need to worry about it as much
  • Can't do anything about some causes of cost-push inflation (e.g. high raw material prices), so we shouldn't implement policies with horrible side effects
• Long-term high inflation rates


  Caused by the economy not having enough spare capacity
• Policies to bring down long-term high inflation rates


  Supply-side policies to increase the productive capacity of the economy and long-run economic growth
• Evaluation of supply-side policies


  • No guarantee of success in boosting long-run aggregate supply
  • Interventionist supply-side policies can be expensive
  • Time lag before policies work in shifting long-run aggregate supply
  • Negative stakeholder impact of market-based supply-side policies
• It is very hard to know exactly what type of inflation is dominating, so a range of policies may be needed to control inflation overall
• If inflation is already low and stable, we don't need policies to reduce it, as the objective is low and stable inflation