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.
MONETARY POLICY - INTEREST RATES
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
interest rates reduce aggregate demand in three ways;
Discouraging borrowing by both households and
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
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.
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
Lower Government spending
A reduction in the amount the government sector
borrows each year (PSNCR)
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 OF THE EXCHANGE RATE
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.
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.
DIRECT WAGE CONTROLS - INCOMES POLICIES
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.
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
LABOUR MARKET REFORMS
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
in the labour market. If this does allow firms to control their
labour costs it may reduce cost push inflationary pressure.
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
SUPPLY SIDE REFORMS
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
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.
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