The policy response to inflation

Overview

Contractionary fiscal policy be used against inflation, how supply-side policy can reduce inflation and interest rate described as a blunt instrument for controlling inflation.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Explain how a rise in the policy interest rate reduces demand-pull inflation, using AD–AS analysis.

   Model answer

   A higher policy rate feeds through to the rates charged on mortgages, consumer credit and business loans, and to the return on saving. Households facing higher borrowing costs cut spending on durables and housing, and higher returns make saving more attractive, so consumption falls. Firms find that fewer investment projects cover their cost of finance, so investment falls. Higher rates also tend to attract capital inflows, appreciating the currency and reducing net exports. On a diagram with the general price level on the vertical axis and real national output on the horizontal axis, the AD curve shifts to the left. At the new equilibrium the price level is lower than it would otherwise have been and real output is lower, so inflation falls at the cost of slower growth and higher unemployment.

2. 2

   How can contractionary fiscal policy be used against inflation, and what is its main drawback?

   Model answer

   Raising income tax reduces households' disposable income and therefore consumption, while cutting government spending reduces that component of aggregate demand directly. The AD curve shifts left, so at the new equilibrium the price level and real output are both lower and inflationary pressure is reduced. The main drawback is that the reduction in demand falls on output and employment as well as on prices, and cuts to government investment in infrastructure or education also reduce the economy's future productive capacity, shifting long-run aggregate supply left and worsening the inflation problem in later years.

3. 3

   Analyse how supply-side policy can reduce inflation, and explain why the effect differs from that of demand-side policy.

   Model answer

   Supply-side measures act on the economy's capacity to produce: improved education and training raise the productivity of labour, investment in infrastructure lowers transport and distribution costs, and measures that increase competition force firms to cut costs and margins. On a diagram with the general price level on the vertical axis and real national output on the horizontal axis, these shift the aggregate supply curve to the right. At the new equilibrium the price level is lower and real output is higher. The contrast with demand-side policy is fundamental: reducing aggregate demand lowers prices by lowering output, so it buys lower inflation with lost production and jobs, whereas shifting aggregate supply lowers prices while raising output, so nothing is sacrificed. The offsetting weakness is timing, since supply-side measures take years to work and cannot address an inflation problem that is present now, and several of them require public spending that adds to demand before the capacity arrives.

4. 4

   Why is the interest rate described as a blunt instrument for controlling inflation?

   Model answer

   It acts on the whole economy simultaneously and cannot be aimed at the source of the pressure, so a rate rise intended to cool an overheating region or sector also contracts activity everywhere else. Its burden falls very unevenly, hitting households with variable-rate mortgages and firms dependent on borrowing hard, while leaving those without debt largely untouched. It also works with a long and uncertain lag, so the effect arrives when conditions may have changed. These features mean the instrument achieves its target only by imposing costs well beyond the activity causing the inflation.

5. 5

   Why do time lags complicate the use of monetary policy against inflation?

   Model answer

   Data on prices and output arrive with a delay and are subsequently revised, so the current position is never known with certainty at the moment a decision is taken. Once the interest rate changes, it takes time for borrowing costs, spending and then prices to respond, with the full effect on inflation commonly taking well over a year. Policy must therefore be set on a forecast of where inflation will be when the action bites, not on today's figure. If the lag is misjudged, a tightening intended to cool an overheating economy can land during a downturn and deepen it.

6. 6

   Analyse the policy options available to an economy experiencing deflation.

   Model answer

   Monetary policy is the first line: cutting the policy rate lowers borrowing costs and raises consumption and investment, shifting aggregate demand right so that at the new equilibrium the price level and real output are both higher. The difficulty is that deflation usually arrives when rates are already near zero, so this route is quickly exhausted, and with prices falling the real interest rate remains positive even at a zero nominal rate. Unconventional monetary measures, notably large-scale purchases of assets to lower longer-term yields and raise asset prices, can extend the reach of monetary policy, though their effect is less certain and they tend to raise wealth inequality by inflating asset values. Fiscal expansion is more reliable in these conditions, because increased government spending raises aggregate demand directly rather than depending on households and firms choosing to borrow, and it works even when interest rates cannot fall. Its constraint is the effect on government borrowing. Alongside these, credible commitment to a positive inflation target matters, because deflation persists largely through expectations, and convincing households that prices will rise removes the reason to postpone spending.

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