Government will issue policies aiming to reduce aggregate demand and lower costs to tackle inflation. These policies to control causes of inflation will seriously impact on businesses and their strategy.
- Increase TAXes. Higher TAXes will reduce consumer demand because people will have less disposable income to spend. If TAXes are increased, there could be a shift away from luxury products into normal and inferior products. So, businesses may change their Marketing Mix to offer more cheaper goods and services.
- Raise interest rates. The country’s central bank, for example The FED in the US., will most likely raise interest rates, and maintain high-interest-rate environment for a longer period of time. High interest rates will discourage business borrowing and investment. Interest rate increases will lower customer demand as borrowing money from a bank is now more expensive, so people will spend less. Businesses may cancel pre-planned investment projects. Consumer credit will also be discouraged. This will reduce the overall demand in the economy, especially for expensive goods.
- Lower government spending. Lower government spending will negatively affect certain industries, e.g. defense and military equipment suppliers, hospital equipment producers, school suppliers such as book publishers and school uniform manufacturers, etc. These firms may attempt to export more of their products abroad and/or enter foreign markets in order to gain lost customers.
- Maintain high exchange rate. Government may also strengthen domestic currency by requesting the central bank to buy back local currency from the market through a reverse repo. Therefore, to lower the supply of domestic currency. With lower currency supply, exchange rate will increase. The high exchange rate after appreciation will make exports less competitive. Businesses could switch to concentrating more on selling to the domestic market.
- Set wage ceilings. Government can use public sector workers as an example to introduce caps on the maximum amount of wages and salaries which employees can earn. Discouraging high wage settlements could work in countries with dominant public sector in the economy such as China. However, private businesses are unlikely to be influenced by government attempts to regulate wage settlements. It is because for-profit companies in private sector of the economy will pay what is needed to attract and keep the best employees to remain competitive and profitable.
TIP: A repo mechanism results in injecting more money into the economy.
TIP: A reverse repo mechanism dries up the money supply.
Essentially, it is accepted that prices rise because businesses are forced to increase them since their costs are rising, and customers drive demand higher trying to fulfill more and more of their wants. However, the government will try to keep inflation low and stable. The government will usually set the target inflation rate at around 2% annual growth. Any increases above that number will most likely kickstart a series of governmental policies to tackle inflation.
