POLICIES TO REDUCE INFLATION AND THEIR EFFECTIVENESS
For an economy that is in macroeconomic equilibrium, there are two ways in
which prices can begin to increase. First, there could be a leftward shift in the
aggregate supply curve. Second, there could be a rightward shift in aggregate
demand.
Anti-inflationary policy
The appropriate policies to reduce inflation depend on the type of inflation.
Given that demand-pull inflation is due to excess aggregate demand, then an
appropriate policy would be to reduce aggregate demand. Thus the government
could use deflationary fiscal policy (increase taxes and lower government
spending) and/or deflationary monetary policy (raise interest rates and reduce
the money supply).
Evaluation of Anti-inflationary policies
1.From a political standpoint, such policies are highly unpopular. Looking first at
fiscal policy, a voting population is unlikely to be happy to accept higher taxes as
it reduces disposable income and the level of consumption. A reduction in
government spending will affect the vulnerable groups such as the unemployed
pensioners and low-income earners in the economy and this may result in less
support for the government.
2. Govts and central banks make estimates of future inflation rates. Forecasts
are more uncertain for inflation rates in the long run.
3.It takes a long time for a government to bring about a change in its fiscal policy.
Budgets are developed over a long period and changes need to go through
lengthy legislative procedures where there may be great opposition to any
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budget cuts. Therefore, there would be a long time lag involved in using
contractionary policy to bring about a decrease in aggregate demand
There are 3 types of time lags in the case of a number of policy tools. There is a
i. Recognition lag. It takes time to identify the economic problem, for
instance, inflation.
ii. Implementation lag. It takes time to make and introduce policies, for
instance, a rise in income tax.
iii. Behavioural lag. It takes time for the policy tool to influence the behaviour
of household and firms.
By the time a policy tool does have an impact on economic behaviour, the
economic problem may have changed, from inflation to recession. This would
make the policy tool inappropriate. Thus in many cases policy tools may act
counter-cyclically, that is, going against the fluctuations in economic activity.
There is the possibility that household, workers and firms may not respond in
the expected way, for instance, during an inflationary period a rise in interest
rate will not cause a rise in saving and discourage borrowing if household,
workers and firms are optimistic about the future.
4.Nowadays, monetary policy is considered to be the most effective way of
managing aggregate demand in the economy and changes in interest rates are
considered the best weapon in the fight against inflation. Fiscal policy is not seen
to be as effective as monetary policy in battling demand-pull inflation. It would
be very difficult for governments to reduce their spending because of their
commitments to the public. Moreover, even if governments could reduce their
spending, it would take a long time for the cuts to have any effect on the price
level.
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5.Inflation may be caused by excessive growth in money supply. But it can be
difficult for govt to control the growth in money supply if commercial banks
continue to increase their loans by getting around any limits on bank lending.
6. There are limits on the policy tools a govt can use.
• If a country is a member of an economic and monetary union, it will not
be able to set its own interest rate.
• A country may be reluctant to raise the income tax rate if this will lead to
emigration of workers and discourage the setting up of multinationals in
the country.
• A govt may want to spend more on infrastructure to reduce cost-push
inflation but finance for taxes revenue and borrowing may not be
available.
7. If inflation is of a cost-push nature, then deflationary demand-side policies
may bring down the price level, but they will result in lower national output and
are likely to cause unemployment to rise. Thus, demand-side policies are
ineffective and supply-side policies are the appropriate policies to deal with
cost-push inflation. However, when inflation does occur, it is difficult to
distinguish the demand-pull from the cost-push inflation and so policymakers
are likely to use a mix of solutions.
8.A significant problem facing governments is the possible trade-off between
their different policy objectives. They may want to fight inflation by bringing
about a decrease in aggregate demand, but this might result in a higher level of
unemployment. If they try to fight unemployment and increase economic
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output (achieve economic growth) by increasing aggregate demand, it might
create inflationary pressure.
9. Some types of policies may reduce both demand-pull and cost-push inflation.
• For example, an increase in govt spending on education and training may
increase demand-pull inflation in the short run. However, in the long run
it may reduce cost-push inflation by raising productivity and lowering cost
of production. It could also allow the economy to sustain larger increases
in AD without experiencing inflation.
10. There is no guarantee that higher spending on education and training will
reduce cost-push inflation
• Firms may not have the necessary capital equipment to take full
advantage of workers’ new skills. Thus, rise in productivity of workers will
be less than rise in wage rates and costs of production will rise. This will
result in higher cost-push inflation.
