Reducing inflation

Match the policy to the cause

1. Demand-pull inflation comes from excess aggregate demand, so demand-reducing policies (higher rates, tighter fiscal policy) suit it.
2. Cost-push inflation comes from rising costs, so supply-side and cost-reducing measures suit it.
3. Diagnosing the cause first is essential, because the wrong policy can worsen the problem: cutting aggregate demand against cost-push inflation deepens a recession without curing the price rises.

Contractionary monetary policy

1. Raising the policy interest rate is the main tool.
2. Higher rates raise the cost of borrowing and reward saving → consumption and investment fall → aggregate demand falls → demand-pull pressure on the price level eases.
3. The central bank can also cut the money supply or use quantitative tightening to withdraw liquidity.
4. Higher rates attract capital inflows and appreciate the currency, which lowers import prices and eases imported inflation.

Contractionary fiscal policy

1. The government can raise direct or indirect taxes, reducing disposable income and spending.
2. It can cut government spending, reducing aggregate demand directly.
3. A smaller budget deficit reduces the injection into the circular flow of income, lowering aggregate demand and demand-pull inflation.
4. The trade-off is slower growth and higher unemployment, and raising indirect taxes can even push measured prices up in the short run.

Supply-side policies

1. Supply-side measures raise productivity and capacity, shifting long-run aggregate supply to the right → a lower price level for any given aggregate demand.
2. Lower business taxes or energy costs directly reduce firms' costs, easing cost-push inflation.
3. Training, deregulation and competition policy work over the long run to hold down costs and prices.
4. Their advantage is reducing inflation without sacrificing growth or employment; their drawback is that they are slow and do little in the short run.

Exchange rate and direct measures

1. Allowing or engineering a stronger exchange rate lowers the price of imports, easing imported and cost-push inflation.
2. Prices and incomes policies try to limit wage and price rises directly.
3. Direct controls are hard to enforce and can create shortages and distortions, so they tend to fail once relaxed.

How effective are they

1. These policies can bring inflation back to target when applied credibly.
2. Time lags mean the effects arrive slowly, so policy can overshoot and cause an unnecessary downturn.
3. Contractionary policy risks higher unemployment and slower growth, the short-run inflation–unemployment trade-off.
4. Supply-side measures are slow and costly and do little in the short run.
5. Effectiveness ultimately depends on the cause of inflation, the output cost society will accept, and whether expectations are anchored by a credible, independent central bank.