Inflation can be reduced by policies that slow down the growth of AD and/or boost the rate of growth of aggregate supply (AS)
- Controlling aggregate demand is important if inflation is to be controlled. If the government believes that AD is too high, it may choose to ‘tighten fiscal policy’ by reducing its own spending on public and merit goods or welfare payments
- It can choose to raise direct taxes, leading to a reduction in real disposable income
- The consequence may be that demand and output are lower which has a negative effect on jobs and real economic growth in the short-term
- A ‘tightening of monetary policy’ involves the central bank introducing a period of higher interest rates to reduce consumer and investment spending
- Higher interest rates may cause the exchange rate to appreciate in value bringing about a fall in the cost of imported goods and services and also a fall in demand for exports (X)
Supply side economic policies:
- Supply side policies seek to increase productivity, competition and innovation – all of which can maintain lower prices. These are ways of controlling inflation in the medium term
i.A reduction in company taxes to encourage greater investment
ii.A reduction in taxes which increases risk-taking and incentives to work – a cut in income taxes can be considered both a fiscal and a supply-side policy
iii.Policies to open a market to more competition to increase supply and lower prices
Rising productivity will cause an outward shift of aggregate supply
Direct controls - a government might choose to introduce direct controls on some prices and wages
- Public sector pay awards – the annual increase in government sector pay might be tightly controlled or even froze (this means a real wage decrease).
- The prices of some utilities such as water bills are subject to regulatory control – if the price capping regime changes, this can have a short-term effect on the rate of inflation
Evaluation points – how best can inflation be controlled?
- The most appropriate way to control inflation in the short term is for the government and the central bank to keep control of aggregate demand to a level consistent with our productive capacity
- AD is probably better controlled through the use of monetary policy rather than an over-reliance on using fiscal policy as an instrument of demand-management
- Controlling demand to limit inflation is likely to be ineffective in the short run if the main causes are due to external shocks such as high world food and energy prices
- The UK is an open economy in which inflation is strongly affected by events in the rest of the world
- In the long run, it is the growth of a country’s supply-side productive potential that gives an economy the flexibility to grow without suffering from acceleration in cost and price inflation.