What this lesson teaches
I can describe the policies that control inflation and judge how well they work.
Syllabus K343, 4.7.5. Policies to control inflation: the range of policies available to control inflation and their effectiveness
Make a guess
Prices are rising because imported fuel and food cost more. Will raising interest rates fix the cause?
- Yes. Higher interest rates bring down any kind of inflation.
- Yes, because higher rates make imported fuel cheaper.
- Not really. It cuts demand but not import costs.
Show the answer
Not really. It cuts demand but not import costs.
This is cost-push inflation. Higher rates slow spending and may raise unemployment, but the cause is dearer imports. A stronger currency fits better.
Contractionary fiscal and monetary policies cut demand-pull inflation; supply-side policies and a stronger currency ease cost-push inflation.
For demand-pull inflation, the government can use contractionary fiscal policy: raise taxes or cut its spending. Total demand falls, easing the pressure on prices.
The central bank can raise interest rates or reduce the money supply. Borrowing becomes dearer and saving more rewarding, so spending falls. A rise in the exchange rate makes imports cheaper, which also lowers prices.
For cost-push inflation, cutting demand works less well and can raise unemployment. Supply-side policies that raise productivity lower costs per unit over time. A stronger currency reduces the cost of imported raw materials.
Each policy has costs. Cutting demand can slow growth and raise unemployment. Supply-side policies are slow. A stronger currency makes exports dearer.
- Demand-pull
- Raise interest rates, raise taxes, cut government spending.
- Cost-push
- Supply-side policy, stronger currency.
- Trade-off
- Cutting demand can raise unemployment and slow growth.
Worked example: Matching the policy to the cause
Compare two inflation problems.
- Country A: a spending boom near full employment is pushing prices up. Raising interest rates or taxes to cool demand fits this demand-pull inflation.
- Country B: imported fuel and food prices are rising sharply. Cutting demand would cost jobs without fixing the cause.
- For country B, a stronger currency to cheapen imports, plus help for firms to raise productivity, fits cost-push inflation better.
Watch out for this
Raising interest rates is always the best way to fight inflation.
It works well against demand-pull inflation. Against cost-push inflation it can push up unemployment without tackling the rise in costs.
Check your understanding
Which policy best tackles cost-push inflation over the long run?
- Raising government spending on projects
- Cutting interest rates to lift spending
- Raising productivity through training
Show the answer
Raising productivity through training
Right. Higher output per worker lowers cost per unit, easing the pressure on prices.
Check your understanding
Which policy is most likely to reduce demand-pull inflation?
- Raising government spending
- Cutting income tax
- Raising interest rates
- Letting the currency fall in value
Show the answer
Raising interest rates
Right. Dearer borrowing cuts spending, which eases the pressure of demand on prices.