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Inflation » Policies to Control Inflation

What you'll learn this session

Study time: 30 minutes

Cambridge spec: 4.7.5

The main policies a government can use to control inflation
How to match each policy to demand-pull or cost-push inflation
How effective each policy is, and how long it takes to work
The side effects of these policies on other macroeconomic aims

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Choosing the right cure

You have met the two causes of inflation: demand-pull and cost-push. The key idea in this lesson is that the best policy depends on the cause. A policy that works well for one type may do little for the other, and almost every policy has a price to pay somewhere else in the economy.

Governments usually aim for low, stable inflation, not zero inflation. Controlling inflation means slowing it down so that prices rise slowly and predictably.

Key terms:

Time lag: the delay between a policy being introduced and its full effect being felt in the economy.

Policies for demand-pull inflation

Demand-pull inflation happens when total demand grows faster than output. The cure is to slow spending down, so that demand grows more slowly than the economy's ability to produce. Two policies do this.

💰 Contractionary fiscal policy

Higher taxes leave households and firms with less to spend. Cuts in government spending reduce demand directly.

🏦 Contractionary monetary policy

A rise in interest rates makes borrowing dearer and saving more attractive, so consumers and firms spend and invest less.

How effective? These policies fit demand-pull inflation well, because they attack its cause: too much spending. Monetary policy can be changed quickly, but there is a time lag before it works fully, because households and firms may have loans that do not change at once. Fiscal policy can be targeted, but tax rises are unpopular and spending cuts can hurt public services.

Side effects. Lower spending also means lower output. Firms sell less, so they may cut jobs, and economic growth slows. This is the conflict between stable prices and full employment that you studied earlier. Higher interest rates also raise costs for firms that borrow, which can reduce investment. Higher taxes can also reduce the incentive to work.

Policies for cost-push inflation

Cost-push inflation happens when firms' costs rise, for example wages or the price of imported raw materials. Cutting demand is a poor cure here, because spending was not the problem. Two policies are more suitable.

🏭 Supply-side policy

Training, better infrastructure and less red tape help firms to produce more at lower cost, which reduces the pressure on prices.

💱 A higher exchange rate

When the currency is worth more, imported materials and goods cost less in the home currency, so firms' costs and shop prices fall.

How can a government raise the exchange rate? One way is to raise interest rates. Higher rates attract savers from abroad, who need the home currency to deposit their money, so demand for the currency rises and it becomes worth more.

How effective? Supply-side policy is very effective in the long run, because it increases output and lowers costs at the same time, so it can help to control both types of inflation. But it is slow and can be expensive, as a training programme or a new road takes years to complete. A higher exchange rate can bring quick relief when imports are a large part of firms' costs, but it makes the country's exports dearer for foreign buyers.

Side effects. A higher exchange rate can reduce export sales and jobs in export industries. It may also worsen the balance of payments, as imports become cheaper and exports dearer. Supply-side policy has few direct harmful effects on spending and jobs in the short run, but it is slow and costly for the government budget.

A higher exchange rate also helps with demand-pull inflation, because dearer exports and cheaper imports reduce net exports and so lower total demand. In that case the same policy works through a different route.

Matching policy to the cause

Policy	Best for	Main weakness or side effect
Contractionary fiscal policy	Demand-pull	Higher unemployment, slower growth, unpopular
Contractionary monetary policy	Demand-pull	Time lag, less investment, slower growth
Supply-side policy	Both, especially cost-push	Slow and costly
Higher exchange rate	Cost-push from imports	Exports become dearer, jobs in exporting firms at risk

The policies in the table work as you studied in the lessons on fiscal policy, monetary policy and supply-side policy. Here the new skill is choosing the right one and judging how well it will work.

Worked example

Palvera has factories working flat out after a surge in export orders and a fall in interest rates, and prices are rising by 7% a year. Hendral also has inflation of 7%, but the cause is a rise in the price of the metal its firms import to make machinery.

Palvera: this is demand-pull inflation, so the best policy is contractionary fiscal or monetary policy, such as a rise in the interest rate. It cuts spending, so demand grows more slowly. The cost is slower growth and possibly higher unemployment.

Hendral: this is cost-push inflation. Raising interest rates would cut spending but would not make the metal cheaper, and it would slow the economy. A higher exchange rate would make the imported metal cheaper, and supply-side policy could help firms find ways to cut costs over time.

Common mistakes

Using one policy for every type of inflation. Always link the policy to the cause.
Saying a policy "stops" inflation. It usually slows it down.
Forgetting the side effects, such as unemployment or slower growth.
Listing policies with no comment on effectiveness or time lags.

Exam-style question

Marvenia has had cost-push inflation for two years. Firms import most of their raw materials, and the value of the currency has been falling. The government is thinking about raising interest rates, or taking steps to raise the value of the currency.

(a) State two policies a government could use to control inflation. [2 marks]

(b) Explain why a higher exchange rate might reduce inflation in Marvenia. [3 marks]

Model answer

(a) Contractionary fiscal policy (1). Contractionary monetary policy (1). (Supply-side policy or a higher exchange rate also gain the marks.)

(b) A higher exchange rate means each unit of the home currency buys more foreign currency (1). Imported raw materials therefore cost firms less in the home currency (1). Firms' costs fall, so they can charge lower prices and inflation slows (1).

(c) Raising interest rates would make borrowing dearer and cut spending (1). This is the right cure for demand-pull inflation, but Marvenia has cost-push inflation, so it does not tackle the cause (1). Lower demand could also cause unemployment and slower growth (1). It may help a little, as a higher interest rate can attract foreign savers and raise the value of the currency, which lowers import costs (1). However, supply-side policy to reduce firms' costs would be a better fit in the long run (1). So raising interest rates is not the best single policy, although it might support other measures (1).

Exam tip

In a "Discuss" question, name the cause of inflation first, then say whether the policy attacks that cause. Finish with a judgement and one side effect.

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