The government can reduce inflation via monetary policy, fiscal policy or exchange rate policy. These are the major counter inflation policies.
Counter inflationary policies
Let’s evaluate the various counter inflationary policies. Governments attempt to control inflation through the following tools:
- Monetary policy.
- Fiscal policy.
- Exchange rate policy.
1. Counter inflationary policy – Monetary policy
Monetary policy can have an effect on aggregate demand; deflationary monetary policy will cause an inward shift of Aggregate Demand (AD) curve. If inflation is high or is expected to increase, interest rates can be increased. Then:
- Companies withhold investment.
- Mortgage costs increase reducing households’ disposable income.
- Consumer durables requiring credit become more expensive so demand falls.
- Saving is more profitable, so people are encouraged to save more.
The money supply can also be reduced. A central bank may refuse to satisfy the demand for money. More likely they will restrict the amount of credit available by:
- Increasing the cash ratio.
- Limiting the amount of loans and mortgages within a fixed time period, e.g. one month.
- Increasing or imposing a minimum deposit or down-payment on certain purchases.
2. Counter inflationary policy – Fiscal policy
Governments use fiscal policy to have an effect on aggregate demand. Governments can directly have an effect by reducing their own spending on an economy. Lower government expenditure causes an inward shift of Aggregate Demand (AD) curve, lessening demand-pull inflationary pressures. This is also an opportunity for a government to have a negative Public Sector Net Cash Requirement (PSNCR) and repay some national debt.
Governments are able to increase in Direct TAXes such as Income TAX and Corporate TAX, which are TAXes on households earnings’ and firms’ profits, in order to reduce both disposable income and retained profit. This in turn will lead to a fall in the consumption of households and the investment planned by firms causing an inward shift of the aggregate demand curve.
Finally a decrease in Sales TAX which is an Indirect TAX will reduce the cost to industry, lowering the average price level causing an outward shift of the Short-Run Aggregate Supply (SRAS) curve and assist in combating cost-push inflation.
3. Counter inflationary policy – Exchange Rate Policy
Exchange rates can be used to control inflation, in two main ways:
- A higher exchange rate which means stronger currency will make imports cheaper, so imports will increase causing Aggregate Demand (AD) to decrease, thus reducing the price level.
- A higher exchange rate which means stronger currency will lead to a fall in exports as they will become relatively more expensive; again this leads to a fall in Aggregate Demand (AD), bringing down price levels.
Summary about methods of fighting high inflation
Governments can use interest rates, their own budget and exchange rates as a means of controlling inflation.
