Inflation refers to the rise in the prices of most goods and services of daily or common use, such as food, clothing, housing, recreation, transport, consumer staples, etc.
Inflation is indicative of the decrease in the purchasing power of a unit of a country’s currency.
Inflation occurs when spending on goods and services outstrips production.
Tools to control inflation:
1. Monetary policy – Higher interest rates reduce demand in the economy, leading to lower economic growth and lower inflation.
2. Control of money supply – Monetarists argue there is a close link between the money supply and inflation, therefore controlling money supply can control inflation.
3. Supply-side policies – policies to increase the competitiveness and efficiency of the economy, putting downward pressure on long-term costs.
4. Fiscal policy – a higher rate of income tax could reduce spending, demand and inflationary pressures.
5. Wage/price controls – trying to control wages and prices could, in theory, help to reduce inflationary pressures. However, they are rarely used because they are not usually effective.
Policies to Reduce Inflation
1. Reduce expectations: A key determinant of inflation over time is inflation expectations. If people expect inflation next year, firms will put up prices and workers will demand higher wages. This expectation tends to cause higher inflation. If the Central Bank and government can effectively reduce expectations by making credible threats to bring inflation under control, this will make their job easier.
2. Price controls: With inflation, we will see firms trying to increase prices as much as they can to maintain profitability and deal with rising costs. One way to try to avoid this ‘profit-push’ inflation is to introduce price controls. This is where the government sets limits on price increases.
3. Wage Control: If inflation is caused by wage inflation (e.g. powerful unions bargaining for higher real wages), then limiting wage growth can help to moderate inflation. Lower wage growth will reduce the costs for firms and lead to less excess demand in the economy.
4. Monetarism: Monetarism seeks to control inflation by controlling the money supply. Monetarists believe there is a strong link between the money supply and inflation. If you can control the growth of the money supply, then you should be able to bring inflation under control. Monetarists would stress policies such as:
7. Control of money being created by the government (Helicopter Money)
8. Supply-Side Policies: Often inflation is caused by persistent uncompetitiveness and rising costs. Supply-side policies may enable the economy to become more competitive and help to moderate inflationary pressures. For example, more flexible labour markets may help reduce inflationary pressure. However, supply-side policies can take a long time, and cannot deal with inflation caused by rising demand.
9. Exchange rate policy: A country may seek to keep inflation low by joining a fixed exchange rate mechanism. The argument is that if the value of a currency is fixed (or semi-fixed) then this creates a discipline to keep inflation low. If inflation rises, the currency would become uncompetitive and start to fall. In the late 1980s, the UK joined the European Exchange Rate Mechanism (ERM) partly to bring inflation under control.
10. Ways to Reduce Hyperinflation – change currency: In a period of hyperinflation, conventional policies may be unsuitable. Expectations of future inflation may be hard to change. When people have lost confidence in a currency, it may be necessary to introduce a new currency or use another like the dollar (e.g. Zimbabwe hyperinflation).