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 AD 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.
See also:

An evaluation of Monetary Policy in controlling inflation

Inflation notes

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. Supply side policies
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. This will reduce AD.
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 against the DM, 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.
Deflation means a fall in prices (a negative inflation rate). Policy makers should generally be
concerned if there is an inflation rate of less than the target of 2%.
For example, in the Eurozone Jan 2015, the headline inflation rate is -0.2%. Even if we strip
away volatile prices like oil, core inflation is 0.8%. This is a very low rate of inflation.
There are many serious potential problems of low inflation / deflation

Higher debt burdens,

Decline in spending,

Higher unemployment.

See costs of deflation for more detail.

What options are available to overcome deflation?
Monetary policy

The traditional tool of monetary policy is interest rates. If inflation is too low, the Central Bank
can try to cut interest rates. In theory, this should boost spending and aggregate demand. For
example, lower rates reduce cost of mortgage payments, giving people more to spend.

A simple theory
to increase inflation cut interest rates, boost AD and increase the PL

However, there are times when cutting interest rates are not sufficient. In a liquidity trap zero
interest rates may not encourage sufficient spending. For example, after the credit crunch lower
interest rates failed to boost demand sufficiently. Lower interest rates failed to solve low inflation
for many reasons:

People preferred to save,

People took opportunity to pay off debts

Banks didnt want to lend, so firms couldnt get loans despite low rates

Banks didnt pass the full base rate cut onto consumers.

Unconventional monetary policy

With a failure of interest rates, the traditional tool of monetary policy, Central Banks have need
to consider unconventional monetary policy. Some of these policies are relatively untried.
Helicopter drop print money

In theory, creating inflation should be the easiest thing just print money and according to the
quantity theory of money we should get inflation. A particular policy for printing money is

termed the helicopter drop where the Central Bank gives newly created money to consumers
directly. Central Banks have been reluctant to pursue this strategy, presumably because it goes
against the mentality of serious Central Bankers and their inflation fighting credentials. But, it
would be a solution to deflation. The most challenging aspect would be knowing about much
money to print, to get the right amount of inflation.
Quantitative easing

There are different variations of quantitative easing, but the one used by the UK and US,
involves the Central Bank creating money and using this to buy government bonds. This should
reduce bond yields, and increase the money supply. But, since the introduction of Q.E. the
impact has been fairly limited. Banks havent been so keen to lend out the money they received
from selling bonds. However, Q.E. may explain why UK and US have higher inflation rates and
higher growth than the Eurozone, which until Jan 15 avoided real Q.E.
Change inflation expectations

One of the biggest challenges to overcome deflation is to change inflation expectations. When
people expect deflation firms will not give wage rises, consumers wont pay higher prices. But,
if people do expect inflation, then firms are more willing to increase wages and consumers will
be more willing to pay higher prices. Expectations are often self-fulfilling. This is why the ECB
announced a bigger than expected Q.E. package they were trying to influence expectations of
inflation, which will make it easier to solve deflation.
Devaluation

Another option to increase inflation is to pursue devaluation attempting to reduce the value of
the currency, through selling domestic currency and / or increasing the money supply to try and
devalue the currency. Devaluation will help increase inflation and inflation expectations, through
boost to domestic exports and higher import prices. The difficulty is that in an era of general
deflation many countries may be trying to do the same thing, leading to competitive
devaluation. Also, it will reduce living standards by making imports more expensive.
Fiscal Policy

When monetary policy is ineffective, many economists suggest fiscal policy should play a
greater role. If the private sector wants to save, the government should borrow from the private
sector and stimulate economic activity through higher infrastructure spending. This expansionary
fiscal policy can help to kick-start the economy and hopefully create a positive multiplier effect
to create more normal levels of economic growth and reach the inflation target.
Some fear that in an economic downturn, there is no room for the government to borrow because
they are already exceeding debt limits (e.g. growth and stability pact) In this case, the

government could fund expansionary fiscal policy through Q.E. Central Bank creating money
and buying the debt the government creates.
The fear is that if governments spend financed through money creation it will lead to inflation.
But, in a period of deflation that is the aim.
Why is it so hard to overcome deflation?

In theory it may seem easy to overcome deflation people are always warning of the dangers of
inflation. Yet, in many cases (Japan 90s and 00s. Europe since 10 deflation can be dangerously
persistent. Part of the reason is deflation expectations can get entrenched and the other part is
that Central Banks are so used to fighting inflation they become fearful about doing too much
to solve deflation. Therefore, inflation fighting policies often tend to err on the cautious side.
But, there are real costs in failing to overcome deflation.

Six Ways to Create Economic Growth

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Why are politicians ignoring the math and the desire of the American public? A recent Gallup
pollfound that out of a list of 12 policy issues, Americans cited restoring a strong economy and
job market as the number one priority for President Obama in his second term. The economy,
jobs and the role of government were the central issue in the government election, yet listening
to the Presidents big government Inauguration speech, the deficit and jobs were barely
mentioned. I expected more given four years of stunted job growth, rising debt, and a January
2013 Government Accountability Report starkly declaring that absent policy changes the
federal government continues to face an unsustainable path.
What can be done to fix our current economic downturn and cut the deficit? Congress will have
to lead on the big issues. The Simpson Bowles Commission, created by President Obama,
proposed a reasonable set of shared pain proposals that are a great starting point for debate. But
even without Simpson Bowles, here are a few common-sense proposals which would reverse the
new normal with policies focused on economic growth.
1. Promote economic growth through innovation. Just as we saw at the 2013 International
CES, innovation and start-ups fuel our economic growth. They are the ultimate job creators
who start with ingenious ideas, take risks and create value for the American consumer. Our
nation has been built by encouraging entrepreneurship and innovation. Especially in our current
economic downturn, it is crucial that we pursue national policies that promote innovation to
ensure that there will be enough prosperity to carry on into the next generation.

2. Strategic immigration reform. As other countries aggressively reach out to skilled

immigrants, we have made it more difficult for foreign entrepreneurs to come to and stay in
America. Our refusal to let more highly skilled immigrants into America is costing jobs, delaying
economic recovery and harming our international leadership in innovation and entrepreneurship.
We should grant automatic green cards to STEM graduate students from U.S. universities and
pass the Dream Act to allow law-abiding people brought to the U.S. as children to become
citizens. The Startup Act is another common sense measure that would create green cards for
immigrants who register through a business and meet employment and investment benchmarks
in the U.S. We should work to expand and remove the country caps on H1-B visas and fix the
EB-5 program, which would give visas to immigrants who invest at least $500,000 and create at
least 10 jobs.
3. End the war on drugs. We have spent billions, incarcerated millions and made the situation
worse. Why not follow Spains lead and treat the addicted and decriminalize and tax marijuana?
Evidence shows that legalization does not add to drug use and can generate large revenues.
Economists have estimated that legalizing marijuana would save the government $7.7 billion per
year on enforcement. Of this savings, $5.3 billion would go to state and local governments, while
$2.4 billion would be accrued to the federal government. Two states who voted recently to
legalize marijuana, Colorado and Washington, are expected to bring in $550 million in revenue
combined.
4. Require unemployed workers to volunteer. We encourage unemployment by rewarding the
unemployed. All research shows the longer the unemployment payments the longer the jobless
stay jobless. By shortening the duration of unemployment insurance and requiring those
receiving checks to volunteer at a non-profit, both parties can benefit. By contributing to society,
they can gain skills, contacts and references that will help them be successful in the next job they
attain and in turn, we would see fewer people claiming unemployment.
5. Cut health care costs. Lets be honest about our ability to afford Social Security and
Medicare and means test based on wealth including assets. We simply cant afford to pay for
these any more. We can stop incentivizing doctors to use the most expensive drugs. Many
doctors are paid a percentage of the cost of the drugs they use. If we ban drug company rebates
to doctors and pay by the injection rather than the cost of the drugs, then we will cut Medicare
spending. We must also allow Americans to buy prescription drugs from overseas. Thanks to the
deal that the White House cut with drug companies, we have a wall around our nation for
imported drugs and every nation in the world pays a lot less for the same drugs. We will save
billions if we can pay what any other country pays.
6. Remove unnecessary and unclear laws. Industries often set international standards for
testing and measurement, but the Department of Energy (DoE), flush with cash, seems intent on
hiring consultants to create new and redundant test procedures. For example, there are industry

standards for measuring energy usage in TVs and cable set-top boxes. Current DoE rulemakings
waste taxpayer money reinventing the wheel. In addition, these new laws can also be ambiguous,
making it harder for businesses to know if they are violating the laws. Government prosecutors
have made their reputation at the agencies like the National Labor Relations Board (NLRB), the
Federal Trade Commission (FTC) and the Fish and Wildlife Service by threatening legal action
against great companies like Boeing, Gibson and Google. Unfair laws like these waste
government resources and hurt the competitiveness of U.S. companies.

DEFINITION of 'Fiscal Policy'

Government spending policies that influence macroeconomic conditions. Through fiscal policy,
regulators attempt to improve unemployment rates, control inflation, stabilize business cycles
and influence interest rates in an effort to control the economy. Fiscal policy is largely based on
the ideas of British economist John Maynard Keynes (18831946), who believed governments
could change economic performance by adjusting tax rates and government spending.

DEFINITION of 'Monetary Policy'

The actions of a central bank, currency board or other regulatory committee that determine the
size and rate of growth of the money supply, which in turn affects interest rates. Monetary policy
is maintained through actions such as increasing the interest rate, or changing the amount of
money banks need to keep in the vault (bank reserves).

Trade policy defines standards, goals, rules and regulations that pertain to trade
relations between countries. These policies are specific to each country and are
formulated by its public officials. Their aim is to boost the nations international
trade. A countrys trade policy includes taxes imposed on import and export,
inspection regulations, and tariffs and quotas.

Types of Trade Policy

National trade policy: Every country formulates this policy to safeguard the best interest of its
trade and citizens. This policy is always in consonance with the national foreign policy.
Bilateral trade policy: This policy is formed between two nations to regulate the trade and
business relations with each other. The national trade policies of both the nations and their
negotiations under the trade agreement are considered while formulating bilateral trade policy.
International trade policy: International economic organizations, such as Organization for
Economic Co-operation and Development (OECD), World Trade Organization (WTO) and
International Monetary Fund (IMF), define the international trade policy under their charter. The
policies uphold the best interests of both developed and developing nations. The best example is
the Doha Development Agenda which was formulated by the WTO.