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Economic Polices To Control Inflation 


Policies to control inflation need to focus on the underlying causes of inflation in the economy. For example if the main cause is excess demand for goods and services, then government policy should look to reduce the level of aggregate demand.  If cost-push inflation is the root cause, production costs need to be controlled for the problem to be reduced.



Since May 1997, the Bank of England has had operational independence in the setting of official interest rates in the United Kingdom. They set interest rates with the aim of keeping inflation under control over the next two years.


Monetary policy can control the growth of demand through an increase in interest rates and a contraction in the real money supply. For example, in the late 1980s, interest rates went up to 15% because of the excessive growth in the economy and contributed to the recession of the early 1990s. This is shown in the chart above


Higher interest rates reduce aggregate demand in three ways;

        Discouraging borrowing by both households and companies

        Increasing the rate of saving (the opportunity cost of spending has increased)

        The rise in mortgage interest payments will reduce homeowners' real 'effective' disposable income and their ability to spend. Increased mortgage costs will also reduce market demand in the housing market


Business investment may also fall, as the cost of borrowing funds will increase. Some planned investment projects will now become unprofitable and, as a result, aggregate demand will fall.


Higher interest rates could also be used to limit monetary inflation. A rise in real interest rates should reduce the demand for lending and therefore reduce the growth of broad money.



        Higher direct taxes (causing a fall in disposable income)

        Lower Government spending

        A reduction in the amount the government sector borrows each year (PSNCR)


These fiscal policies increase the rate of leakages from the circular flow and reduce injections into the circular flow of income and will reduce demand pull inflation at the cost of slower growth and unemployment.



An appreciation in the pound sterling makes British exports more expensive and should reduce the volume of exports and aggregate demand. It also provides UK firms with an incentive to keep costs down to remain competitive in the world market. A stronger pound reduces import prices. And this makes firms' raw materials and components cheaper; therefore helping them control costs.


A rise in the value of the exchange rate might be achieved by an increase in interest rates or through the purchase of sterling via Central Bank intervention in the foreign exchange markets.



Incomes policies (or direct wage controls) set limits on the rate of growth of wages and have the potential to reduce cost inflation. The Government has not used such a policy since the late 1970s, but it does still try to influence wage growth by restricting pay rises in the public sector and by setting cash limits for the pay of public sector employees.


In the private sector the government may try moral suasion to persuade firms and employees to exercise moderation in wage negotiations. This is rarely sufficient on its own. Wage inflation normally falls when the economy is heading into recession and unemployment starts to rise. This causes greater job insecurity and some workers may trade off lower pay claims for some degree of employment protection.


Long-Term Policies To Control Inflation


The weakening of trade union power, the growth of part-time and temporary working along with the expansion of flexible working hours are all moves that have increased flexibility in the labour market. If this does allow firms to control their labour costs it may reduce cost push inflationary pressure.


Certainly in recent years the UK economy has not seen the acceleration in wage inflation normally associated with several years of sustained economic growth and falling inflation. One reason is that rising job insecurity inside a flexible labour market has tilted the balance of power away from employees towards employers.



If a greater output can be produced at a lower cost per unit, then the economy can achieve sustained economic growth without inflation. An increase in aggregate supply is often a key long term objective of Government economic policy. In the diagram below we see the benefits of an outward shift in the short run aggregate supply curve. The equilibrium level of real national income increases and the average price level falls.


Supply side reforms seek to increase the productive capacity of the economy in the long run and raise the trend rate of growth of labour and capital productivity. A number of supply-side policies have been introduced into the British economy in recent years.  Productivity gains help to control unit labour costs (an important cause of cost-push inflation) and put less pressure on producers to raise their prices.


The key to controlling inflation in the long run is for the authorities to keep control of aggregate demand (through fiscal and monetary policy) and at the same time seek to achieve improvements to the supply side of the economy. The credibility of inflation control policies can often be enhanced by the introduction of inflation targets.



E-mail Steve Margetts