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Economic policies to control inflation

The control of inflation has become one of the dominant objectives of government economics

policy in many countries. Effective policies to control inflation need to focus on the underlyingcauses of inflation in the economy. For example if the main cause is excess demand for goods an

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.

1) MONETARY POLICYThe central bank has mandate in the setting of official interest rates in most of the countries.

They set interest rates with the aim of keeping inflation under control over the years. Monetarypolicy can control the growth of demand through an increase in interest rates and a contraction in

the real money supply. For example, in the elate 1980s, interest rates in the UL went to 15%

because of the excessive growth in the economy and contributed to the recession of the early1990s.

The effects of higher interest rates.

Higher interest rates effects aggregate demand in the following ways.

y Discouraging borrowing by both households and companies.y Increasing the rate of saving (the opportunity cost of spending has increased)y The rise in mortgage interest payments will reduce homeowners real effective disposable

income and their ability to spend. . Increased mortgage costs will also reduce marketdemand in the housing market.

y Business investment may also fall, as the cost of borrowing funds will increase. Someplanned investment projects will now become unprofitable and as a result, aggregatedemand will fall.

y Higher interest rates could also be used to limit monetary inflation. A rise in real interestrates should reduce the demand for lending and therefore reduce the growth of broad

money.

2) FISCAL POLICYFiscal policy effects aggregate demand in the following ways.

y Higher direct taxes ( causing a fall in disposable income resulting into reduced aggregatedemand)

y Lower government spending. Lower payments to people causing lower demandy A reduction in the amount the government sector borrows each year reduces amount of

money resulting into lower demand.

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The fiscal policy increase the rate of leakages from the circular flow and reduce injections intothe circular flow of income and will reduce demand pull-inflation at the cost of slower growth

and unemployment.

3) AN APPRECIATIONOF EXCHANGE RATEAn appreciation in the rupee makes Pakistani exports more expensive and should reduce thevolume of exports ad aggregate demand. It also provides Pakistani firms an incentive to keep

costs down to remain competitive in the world market. A stronger rupee reduces import prices.And this makes firms raw materials and components cheaper, therefore helping them control

costs. A rise in the value of the exchange rates might be achieved by an increase in interest ratesor through the sale of foreign exchange by the central bank intervention in the foreign exchange

markets.

4) DI

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Income policies( or direct wage controls) set limits on the rate of growth of wages and have the

potential to reduce cost inflation . the governments normally does not use such a policy, but itcan try to influence wage growth by restricting pay rise in the public sector and by setting cash

limits for the pay of public sector employees.

In the private sector the government may try moral suasion to persuade firms and employees toexercise moderation in the wage negotiations. This is rarely sufficient on its own. Wage inflation

normally falls when the economy is heading into recession and unemployment starts to rise. Thiscauses greater job insecurity and some workers may trade off lower pay claims for some degree

of employment protection.