Inflation is a general rise in the prices of commodities and services within a specific time, leading to a decline in the value of money. In other words, Inflation lowers the currency’s value and raises the cost of living. An increase in the money supply is the most common cause of Inflation. This essay explains what Inflation is and its importance to governments and evaluates whether monetary Policy is the best method for reducing It. It also compares and contrasts monetary Policy with other policies that can be used to mitigate Inflation. Lastly, it describes what Policy would be more effective in dealing with Inflation in the country.
Inflation reduces the buying power of a currency so that a given sum of money may purchase fewer products and services. Many causes can contribute to Inflation, including a rise in the money supply, more significant production costs, and increasing demand for goods and services. Zimbabwe, Venezuela, and Argentina are examples of nations that have historically had considerable inflation rates. In November 2008, Zimbabwe’s hyperinflation peaked at 89.7 sextillion percent, leading to a fast depreciation of the country’s currency and considerable economic misery. Inflation rates in Venezuela exceeded 65,000% in 2018, causing food and medication shortages and widespread flight (Saymeh et al., 2013). In recent years, Argentina has also seen inflation spells reaching 40 percent.
Demand-pull Inflation happens when an economy’s demand for products and services exceeds its supply. As a result, the price of products and services rises because buyers are prepared to pay more to get scarce items. While it may initially improve productivity and employment, it can also raise production costs, culminating in a wage-price circle. It can be advantageous in the short run since it increases economic growth and reduces unemployment (Saymeh and Orabi, 2013). But, in the long run, it might lead to a drop in efficiency and a decline in real production, resulting in stagflation.
Cost-push Inflation arises whenever the cost of manufacturing rises, causing the prices of products and services to increase. This may be the result of an increase in labor, raw supplies, or taxes. It may increase the price level and reduce output and employment (Saymeh and Orabi, 2013). Cost-push Inflation may be transient and caused by supply-side causes like natural disasters or geopolitical conflicts. Conversely, it might decrease output and employment if enduring reasons like wage rises or structural inefficiencies bring it on.
Policies used to mitigate Inflation in a country.
Monetary Policy refers to the acts done by a central bank to regulate the money supply and interest rates in an economy to achieve specific economic objectives, such as inflation control (Coibion et al., 2022). Typically, the central bank employs a restrictive monetary policy, which attempts to lower the amount of money in circulation and increase interest rates to reduce Inflation.
The central bank may sell government assets on the open market to lower the money supply. When the central bank sells assets, it takes money out of circulation, which can diminish the money supply and cause interest rates to rise. Higher interest rates can restrict borrowing and spending, reducing demand-pull Inflation (Coibion et al., 2022). Increasing banks’ reserve requirements is a different instrument the central bank may employ to combat Inflation. When reserve requirements are increased, banks are compelled to retain more of their reserve deposits, reducing the amount of money that may be loaned. As a result, the money supply drops, which can assist in alleviating inflationary pressures.
The central bank can also raise the discount rate, which is the rate at which banks can directly borrow money from the central bank. As the discount rate increases, borrowing becomes more expensive, which might cause banks to lend less money. This can aid in reducing the money supply and Inflation. In addition, the central bank can utilize forward guidance to affect future interest rate expectations (Coibion et al., 2022). Indicating that the central bank intends to raise interest rates in the future can anchor inflation expectations and limit demand-pull Inflation. This is because firms and individuals may curtail spending in anticipation of future increases in borrowing costs, reducing inflationary pressures.
Consequently, the effectiveness of monetary policy in managing Inflation is limited. Inflation driven by supply-side reasons, such as a rapid rise in manufacturing prices, may resist contractionary monetary Policy. However, if interest rates are already low, the central bank may need more flexibility to reduce the money supply and raise rates. In addition, contractionary monetary Policy can negatively affect the economy by lowering investment and economic growth. Thus, a mix of monetary and fiscal measures may be required to combat Inflation successfully and mitigate the negative impacts of policy interventions. For example, As the UK has an open economy, global events significantly impact Inflation. Therefore the government uses the monetary Policy in blend with the fiscal Policy to reduce Inflation in the country.
Fiscal Policy in mitigating Inflation.
The government’s use of taxation and expenditure to affect the economy is known as fiscal Policy. Fiscal Policy can lower aggregate demand, which can aid in reducing demand-pull Inflation to lower Inflation (Hansen, 2013). The government’s use of taxation and expenditure to affect the economy is known as fiscal Policy. Fiscal Policy can reduce aggregate demand, which can aid in reducing demand-pull Inflation to lower Inflation.
Cutting back on expenditure is one way the government may use fiscal policy to lower Inflation. Less demand for goods and services due to decreased government spending can assist in easing inflationary pressures. However, implementing it can be challenging because cutting government expenditure can be politically contentious and harm particular companies or sectors (Hansen, 2013). Tax increases are another method the government may use fiscal Policy to fight Inflation. As a result of higher taxes, consumers have less money to spend, which can help reduce demand-pull Inflation. This strategy, meanwhile, can be politically risky and might have a detrimental impact on consumer spending and economic expansion.
To lower Inflation, the government may also make targeted payments or subsidies to particular groups or individuals. For instance, the government may provide subsidies to help customers balance the rising expenses if a sharp increase in energy prices causes Inflation. In the short run, this can assist in lowering inflationary pressures, but it might not be sustainable in the long run.
Both benefits and drawbacks might be associated with employing fiscal Policy to lower Inflation. One advantage is that fiscal Policy may be more precisely targeted than monetary Policy since it can be applied to specific industries or demographic groupings. Since changes in government spending or taxes may be enacted more swiftly than changes in interest rates, fiscal Policy can also immediately influence the economy. Nonetheless, there are drawbacks to employing fiscal Policy to lower Inflation. Fiscal Policy may be politically problematic since it may necessitate making tough choices, either budget reductions or tax hikes. Fiscal Pharmative impacts economic growth since it can reduce consumer spending and investment by raising taxes or cutting government spending.
The government boosted the economy’s efficiency and productivity through supply-side policies. Instead of encouraging demand through increased government expenditure, these policies often aim to stimulate economic development by expanding the market’s supply of products and services (Fernández et al., 2014, pp 248). Some examples of supply-side policies include:
- Tax cuts: A decrease in the taxes paid by individuals and incentivize incentives for people to work and invest, which can ultimately lead to a rise in output and productivity.
- Deregulation: Getting rid of regulations on businesses that are not necessary can help cut costs and improve efficiency, which ultimately results in increased output and productivity.
- Investment in infrastructure: Investing in infrastructure such as roads, bridges, and public transportation can improve the efficiency of transportation and communication, making it easier for businesses to transport goods and services.
With all these policies, the government can reduce Inflation by improving its productivity while lowering the high demand for supplies which may lead to Inflation due to scarcity of commodities (Fernández et al., 2014, pp 248). The supply-side Policy can be used to improve people’s lives and promote the general development of a nation within a period. However, one of the significant drawbacks of supply-side strategies is that they are only effective in the long run; hence, they cannot be utilized to mitigate unexpected spikes in the inflation rate. In addition, there is no assurance that the government’s supply-side initiatives would successfully lower Inflation. Additional details on Supply-side policies
To sum up, Inflation is an essential economic concept that refers to the general growth
of prices through time. It can substantially affect the economy, including decreased purchasing. Power, reduced savings, and more significant uncertainty. Thus, governments and central banks frequently view inflation control as a primary policy priority. The monetary, Fiscal, and supply-side policies can be used to mitigate the inflation rate in any country. Therefore, they have advantages and disadvantages and seek alternate measures to achieve their macroeconomic objectives.
Coibion O., Gorodnichenko, Y., & Weber, M. (2022). Monetary policy communications and their effects on household inflation expectations. Journal of Political Economy, 130(6), 1537-1584.
Fernández-Villaverde, J., Guerrón-Quintana, P. and Rubio-Ramírez, J.F., 2014. Supply-side policies and the zero lower bound. IMF Economic Review, 62(2), pp.248-260.
Hansen, A.H., (2013). Fiscal Policy & business cycles. Routledge.
Saymeh, A.A.F. and Orabi, M.M.A., 2013. The effect of interest rate, inflation rate, and GDP on real economic growth rate in Jordan. Asian Economic and Financial Review, 3(3), pp.341-354.