What Actions Might a Government Take in Order to Reduce the Rate of Inflation in the Economy?
The control of inflation has become one of the dominant objectives of government economic policy in many countries. Effective 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.
Monetary Policy
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.
The effects of higher interest rates
Higher interest rates reduce aggregate demand in three main 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.
Fiscal Policy
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
Monetary Policy
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.
The effects of higher interest rates
Higher interest rates reduce aggregate demand in three main 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.
Fiscal Policy
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
Bibliography: http://www.tutor2u.net/economics/content/topics/inflation/controlling_inflation.htm