Cures for inflation

Cures for demand-pull inflation 

Short-run policy: Aim to bring down Aggregate Demand

1.Contractionary monetary policy (Rise in the interest rate)

The government will raise the interest rate in order to reduce the money supply. A rise in the interest rate will cause a rise in the opportunity cost of consumption and therefore reduce it. Also, the higher interest rate lowers the expected net return on investment, hence lowering the level of investment. As consumption and investment fall, the aggregate demand falls in turn and therefore demand-pull inflation is reduced.

Limitation:

When investment and consumption are interest-inelastic due to optimism of investors and consumers, expected return may rise as the increase in revenue outstrips the increase in cost. A rise in interest rate may not be sufficient in curbing rising investment and “inrational exuberance” of consumers.

2.Contractionary fiscal policy

The government will reduce government spending or increase taxes. Reducing government spending will directly cause the aggregate demand to fall. A rise in income tax reduces disposable income and hence reduces consumption. A rise in corporate tax reduces the post-tax returns on investments, hence reducing the level of investment. These two will also drag down the aggregate demand. As the aggregate demand falls, the demand pull inflation is reduced.

Limitation:

In reality, contractionary fiscal policies such as raising direct taxes and reducing government spending will have adverse long term supply-side effects and conflict with other macroeconomic goals of growth and employment. Much of government expenditure is tied to long term contracts, such as education and healthcare, such as construction of roads and hospitals. Therefore, contractionary fiscal policy does not help to cure demand-pull inflation in the long run.

Long-run policy: supply-side policy

As the demand-pull inflation is the consequence of the actual growth outstripping the potential growth, cures can be slow down the actual growth as well as increase the productive capacity of the economy using supply-side policies. As long as LRAS grows as the same pace with aggregate demand, the economy will achieve non-inflationary growth.

Cures for Import-price-push inflation and cost-push inflation due to negative supply shocks

Short-run policy: price ceiling

The government can implement price controls to prevent cost-push inflation from entering the domestic market. The price ceilings on basic essentials such as food and fuel are to ensure the basic survival of the people.

Long-run policy: Find or develop cheaper alternatives

Economies which are heavily dependent on imports may be easily subject to an increase in the price of imported goods. One way to reduce the cost-push inflation is to reduce the overdependence on trade by finding or developing cheaper alternatives through the use of R&D.

Limitation: 

R&D is usually expensive and time-consuming and no one can be sure of its success. Moreover, the opportunity cost of it is high since resources may be diverted away from other key developments in education, defense, healthcare, and other aspects of the economy.

Cures for profit-push inflation

Short-run policy: Price controls

Profit-push inflation is caused by monopolies in the market. To control monopoly power, governments can adopt short-run policies that include price controls such as marginal-cost-pricing and average-cost-pricing.

Limitations:

As monopoly powers are usually international corporates, the price control policy may lead those transnational companies give up this area and it is people suffer from loss of job and of access to their goods.

Long-run policy: legislation and deregulation

Legislation is regulation set by government to balance between the profits incentives that make industries efficient as well as the costs of living and business costs. One example is Energy Market Authority of Singapore.

Deregulation is a pro-competition policy that allows for more players into a particular industry or a sector of the economy. Deregulation encourages more competition in the supply of goods and services. Increased competition can lead to increased efficiency, more consumer choice and lower prices, therefore reducing the profit-push inflation.