AS Macro Revision: Policies to Control Inflation

This revision blog focuses on policies that can be used to control the rate of inflation. Our starting point is that inflation comes from more than one source. Rising prices are not simply the result of increasing aggregate demand but also from higher costs of production and the direct and indirect effects of changes in government policies. It is also important to note that many inflationary impulses come from outside the domestic economy - namely from external shocks in the global economic system - many of which an individual country has no control to change.

Thinking about the domestic economy, inflation can be reduced by policies that
(i) slow down the growth of AD or
(ii) boost the rate of growth of aggregate supply (AS)

The main anti-inflation controls available to a government are:

Fiscal policy: 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. Or 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 an effect on jobs and real economic growth in the short-term. A fiscal tightening will have the effect of reducing the size of the budget deficit.

Monetary policy: A ‘tightening of monetary policy’ involves the central bank introducing a period of higher policy interest rates to reduce consumer and investment spending. Monetary policy is designed mainly to control demand-pull inflationary pressures. But it also has an effect on costs, not least through the effect of changes in interest rates on the value of the currency. Make sure that you understand the ways in which interest rates feed through to affect the components of aggregate demand, output and inflationary pressures.

Supply side economic policies: Supply side policies include those that seek to increase productivity, competition and innovation – all of which can maintain lower prices. These are important ways of controlling inflation in the medium term. If the economy can raise its underlying growth rate, then a higher level of aggregate demand can be sustained without leading to an acceleration in the rate of inflation.

The most appropriate way to control inflation in the short term is for the government and the central bank to operate fiscal and monetary policy to keep control of aggregate demand to a level consistent with our productive capacity.

The standard consensus among economists (until recently) has been that 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. But 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.

Will UK interest rates have to rise?

Interest rates in the UK have been a ultra low levels in the last couple of years because of the financial and economic crisis and fears of a depression and price deflation. But this phase of near-zero interest rates may be coming to an end. In news reports in May 2010 it was claimed that the UK must raise interest rates this year to control inflation. The Organisation of Economic Cooperation and Development are worried about a rise in inflation expectations and that the Bank of England’s policy of £220bn worth of quantitative easing (the printing of new money in order to increase liquidity in the economy) may have a sizeable potential inflationary impact.

Key inflation concepts:

1. Consumer price index: A measure of the average cost of living. The CPI is based on a “basket” of food and other consumer goods such as furniture.
2. Deflation: A sustained fall in the price level. This means that, on average, the prices of products in an economy are going down over time
3. Inflation target: The Government sets the Bank of England a CPI inflation target, which is currently 2 per cent.
4. Inflationary pressures: Occurrences likely to lead to price rises. These can come from both the demand and the supply-side.
5. Retail Price Index (RPI): The RPI is broadly similar to the CPI but includes mortgage repayments and some taxes, and excludes the top 4 per cent of earners. It is used to calculate increases in wages, state benefits and pensions.
6. Stagflation: A combination of slow growth and rising inflation, can lead to stagflation. The most recent period of stagflation occurred during the 1970s, when world oil prices rose, and inflation rose at one point to nearly 30 per cent.
7. Wage price spiral: A situation where workers bid for higher wages because they have seen their real income eroded by rising prices. This can lead to a further burst of cost-push inflation in an economy.