How Government Uses Monetary Policy to Reduce Inflation

1. Monetary Policy
In the UK and US, monetary policy is the most important tool for maintaining low inflation. In the UK, monetary policy is set by the MPC of the Bank of England. They are given an inflation target by the government. This inflation target is 2%+/-1 and the MPC use interest rates to try and achieve this target. The first step is for the MPC to try and predict future inflation. They look at various economic statistics and try to decide whether the economy is overheating. If inflation is forecast to increase above the target, the MPC will increase interest rates. Increased interest rates will help reduce the growth of Aggregate Demand in the economy. The slower growth will then lead to lower inflation. Higher interest rates reduce consumer spending because:

Increased interest rates increase the cost of borrowing, discouraging consumers from borrowing and spending. Increased interest rates make it more attractive to save money Increased interest rates reduce the disposable income of those with mortgages. Higher interest rates increased the value of the exchange rate leading to lower exports and more imports.

Diagram Showing Fall in American $ to Reduce Inflation

Base Rates and Inflation

Base interest rates were increased in the late 1980s / 1990 to try and control the rise in inflation.

2. Supply Side Policies

Supply side policies aim to increase long term competitiveness and productivity. For example, privatisation and deregulation were hoped to make firms more productive. Therefore, in the long run supply side policies can help reduce inflationary pressures. However, supply side policies work very much in the long term. They cannot be used to reduce sudden increases in the inflation rate.

Benefits of Supply Side Policies

i. Lower Inflation. Shifting AS to the right will cause a lower price level. By making the economy more efficient supply side policies will help reduce cost push inflation. ii. Lower Unemployment Supply side policies can help reduce structural, frictional and real wage unemployment and therefore help reduce the natural rate of unemployment.
iii. Improved trade and Balance of Payments. By making firms more productive and competitive they will be able to export more. This is important in light of the increased competition from S.E. Asia.

Diagram Showing effect of Supply Side Policies

Classical view of LRAS shifting to the right.

Keynesian view of LRAS shifting to the righ.

Supply Side Policies

Most supply side policies aim to enable the free market to work more efficiently by reducing government interference. i. Privatisation. This involves selling state owned assets to the private sector. It is argued that the private sector is more efficient in running business because they have a profit motive to reduce costs and develop better services. ii. Deregulation This involves reducing barriers to entry in order to make the market more competitive. For example BT used to be a Monopoly but now telecommunications is quite competitive. Competition tends to lead to lower prices and better quality of goods / service. iii. Reducing Income Taxes. It is argued that lower taxes (income and corporation) increase the incentives for people to work harder, leading to more output. However this is not necessarily true, lower taxes do not always increase work incentives (e.g. if income effect outweighs substitution effect) iv. Increased education and training Better education can improve labour productivity and increase aggregate supply. Often there is under-provision of education in a free market, leading to market failure. Therefore the government may need to subsidise suitable education and training schemes. However government intervention will cost money, requiring higher taxes, It will take time to have effect and government may subsidise the wrong types of training v. Reducing the power of Trades Unions This should a) Increase efficiency of firms e.g. less time lost to strikes b) Reduce unemployment (if labour markets are competitive) vi. Reducing State Welfare Benefits This may encourage unemployed to take jobs. vii. Providing better information about jobs This may also help reduce frictional unemployment

viii. Deregulate financial markets to allow more competition and lower borrowing costs for consumers and firms. ix. Lower Tariff barriers This will increase trade x. Removing unnecessary red tape and bureaucracy which add to a firms costs xi. Improving Transport and infrastructure. Due to market failure this is likely to need government intervention to improve transport and reduce congestion. This will help reduce firms costs. xii. Deregulate Labour Markets This is said to be an important objective for the EU to increase competitiveness. E.g. make it easier to hire and fire workers.

3. Fiscal Policy
This is another demand side policy, similar in effect to Monetary Policy. Fiscal policy involves the government changing tax and spending levels in order to influence the level of Aggregate Demand. To reduce inflationary pressures the government can increase tax and reduce government spending.

4. Exchange Rate Policy

In the late 1980s the UK joined the ERM, as a means to control inflation. It was felt that by keeping the value of the pound high, it would help reduce inflationary pressures. The policy did reduce inflation, but at the cost of a recession. To maintain the value of the . The government had to increase interest rates to 15%. The UK no longer uses this as an inflationary policy.

5. Wage Control
Wage growth is a key factor in determining inflation. If wages increase quickly it will cause high inflation. In the 1970s, there was a brief attempt at wage controls which tried to limit wage growth. However, it was effectively dropped because it was difficult to widely enforce.