Governments and central banks would have to undertake a tight monetary and fiscal policy to combat demand pull inflation. Increasing the interest rate, reducing government spending, or boosting taxes are all examples. Consumers would spend less on durable goods and homes if the interest rate were to rise. It would also raise corporations’ and businesses’ investment spending. Because Aggregate Demand D is rising too quickly in demand pull inflation, these contractionary actions would slow the rise, implying that inflation would still occur but at a slower rate.
How may demand-pull inflation be managed in two ways?
The Central Bank and/or the government are in charge of inflation. The most common policy is monetary policy (changing interest rates). However, there are a number of measures that can be used to control inflation in theory, including:
- Higher interest rates in the economy restrict demand, resulting in slower economic development and lower inflation.
- Limiting the money supply – Monetarists say that because the money supply and inflation are so closely linked, controlling the money supply can help control inflation.
- Supply-side strategies are those that aim to boost the economy’s competitiveness and efficiency while also lowering long-term expenses.
- A higher income tax rate could diminish expenditure, demand, and inflationary pressures.
- Wage limits – attempting to keep wages under control could theoretically assist to lessen inflationary pressures. However, it has only been used a few times since the 1970s.
Monetary Policy
During a period of high economic expansion, the economy’s demand may outpace its capacity to meet it. Firms respond to shortages by raising prices, resulting in inflationary pressures. This is referred to as demand-pull inflation. As a result, cutting aggregate demand (AD) growth should lessen inflationary pressures.
The Bank of England may raise interest rates. Borrowing becomes more expensive as interest rates rise, while saving becomes more appealing. Consumer spending and investment should expand at a slower pace as a result of this. More information about increasing interest rates can be found here.
A higher interest rate should result in a higher exchange rate, which reduces inflationary pressure by:
In the late 1980s and early 1990s, interest rates were raised in an attempt to keep inflation under control.
Inflation target
Many countries have an inflation target as part of their monetary policy (for example, the UK’s inflation target of 2%, +/-1). The premise is that if people believe the inflation objective is credible, inflation expectations will be reduced. It is simpler to manage inflation when inflation expectations are low.
Countries have also delegated monetary policymaking authority to the central bank. An independent Central Bank, the reasoning goes, will be free of political influences to set low interest rates ahead of an election.
Fiscal Policy
The government has the ability to raise taxes (such as income tax and VAT) while also reducing spending. This serves to lessen demand in the economy while also improving the government’s budget condition.
Both of these measures cut inflation by lowering aggregate demand growth. Reduced AD growth can lessen inflationary pressures without producing a recession if economic growth is rapid.
Reduced aggregate demand would be more unpleasant if a country had high inflation and negative growth, as lower inflation would lead to lower output and increased unemployment. They could still lower inflation, but at a considerably higher cost to the economy.
Wage Control
Limiting pay growth can help to lower inflation if wage inflation is the source (e.g., powerful unions bargaining for higher real wages). Lower wage growth serves to mitigate demand-pull inflation by reducing cost-push inflation.
However, as the United Kingdom realized in the 1970s, controlling inflation through income measures can be difficult, especially if labor unions are prominent.
Monetarism
Monetarism aims to keep inflation under control by limiting the money supply. Monetarists think that the money supply and inflation are inextricably linked. You should be able to bring inflation under control if you can manage the expansion of the money supply. Monetarists would emphasize policies like:
In fact, however, the link between money supply and inflation is weaker.
Supply Side Policies
Inflation is frequently caused by growing costs and ongoing uncompetitiveness. Supply-side initiatives may improve the economy’s competitiveness while also reducing inflationary pressures. More flexible labor markets, for example, may aid in the reduction of inflationary pressures.
Supply-side reforms, on the other hand, can take a long time to implement and cannot address inflation induced by increased demand.
Ways to Reduce Hyperinflation change currency
Conventional policies may be ineffective during a situation of hyperinflation. Future inflation expectations may be difficult to adjust. When people lose faith in a currency, it may be essential to adopt a new one or utilize a different one, such as the dollar (e.g. Zimbabwe hyperinflation).
Ways to reduce Cost-Push Inflation
Inflationary cost-push inflation (for example, rising oil costs) can cause inflation and slow GDP. This is the worst of both worlds, and it’s more difficult to manage without stunting growth.
How can cost pull inflation be managed?
- Commodity prices are rising. A spike in oil prices would result in higher gasoline prices and transportation costs. Costs would rise for all businesses. Higher oil prices, being the most essential commodity, frequently lead to cost-push inflation (e.g. 1970s, 2008, 2010-11)
- Inflation caused by imported goods. Import prices will rise as a result of the depreciation. As a result of the growing cost of imports, we frequently see an increase in inflation following a devaluation.
- Wages that are higher. Wages are one of the most significant expenses for businesses. As businesses incur increased costs as a result of growing wages, prices will rise (higher wages may also cause rising demand)
- Taxes will be raised. The cost of goods will rise as VAT and excise charges rise. This price rise will only be temporary.
- Inflationary profit-push. If businesses develop more monopoly power, they will be able to raise prices in order to boost profits.
- Food costs are rising. Food accounts for a lesser percentage of overall spending in western economies, but it plays a larger importance in developing countries. (inflationary food)
A rise in the price of oil or other raw commodities could trigger cost-push inflation. Imported inflation can occur when the currency rate depreciates, raising the price of imported items.
Cost-Push Inflation Temporary or Permanent?
This graph depicts cost-push inflation in the United Kingdom between 2008 and 2011. Because the economy was in recession, these times of cost-push inflation were only brief.
Many cost-push causes, such as increased energy prices, greater taxes, and the impact of currency depreciation, may only be temporary. As a result, if greater inflation is caused by cost-push causes, central banks may be willing to tolerate it. In 2011, for example, CPI inflation hit 5%, yet the Bank of England kept interest rates at 0.5 percent. This indicated that the Bank of England believed there was little underlying inflationary pressure.
In 2011, CPI inflation reached 5%, however inflation was just 3% if we subtract the effect of taxes (CPI-CT). Inflation would have been much lower if we took out the effect of increasing import prices (due to depreciation).
Others may be concerned that transient cost-push factors would affect inflation expectations. People may bargain for greater salaries if they see higher inflation, and the temporary cost-push inflation becomes permanent.
There is evidence that transient cost-push inflation in the 1970s resulted in persistently greater inflation. Part of the reason for this is that workers requested higher salaries in reaction to rising prices.
Inflation was induced in the 1970s by a significant rise in oil costs, as well as growing nominal wages. Workers were able to demand higher wages because they had more negotiating power.
Measures of Inflation
Some inflation strategies aim to avoid ‘temporary cost-push forces.’ CPI-Y, for example, ignores the impact of taxes. The term “core inflation” refers to a method of measuring inflation that excludes volatile elements such as commodities and energy.
Policies to Reduce Cost-Push Inflation
Cost-push inflation policies are similar to demand-pull inflation strategies in that they both aim to reduce inflation.
The government might follow a deflationary fiscal strategy (more taxes and reduced spending), or the central bank could raise interest rates. This would raise borrowing costs while reducing consumer spending and investment.
The difficulty with employing higher interest rates is that, while they will cut inflation, they will also cause a significant drop in GDP.
For example, due to rising oil and food costs, we saw a significant period of inflation (5%) in early 2008. Central banks kept interest rates high, but the economy fell into recession as a result. Interest rates should have been lower, and less emphasis should have been placed on minimizing cost-push inflation, according to others.
We may witness a period of cost-push inflation in 2010, but the Central Bank may need to be more flexible in its inflation targets in 2010. If inflation is caused by transient circumstances, rigidly adhering to an inflation target is pointless.
Better supply-side measures that help to enhance productivity and shift the AS curve to the right could be the long-term solution to cost-push inflation. These policies, however, would take a long time to take effect.
How can demand-pull inflation be reduced?
The term “inflation” refers to a time of rising prices. Monetary policy is the most important tool for lowering inflation; rising interest rates, in particular, reduces demand and helps to keep inflation under control. Tight fiscal policy (increased taxes), supply-side policies, wage control, exchange rate appreciation, and money supply control are some of the other strategies that can be used to minimize inflation (a form of monetary policy).
Summary of policies to reduce inflation
- Higher interest rates are part of monetary policy. This raises borrowing costs and discourages consumption. As a result, economic growth and inflation are reduced.
- Tight fiscal policy A higher income tax rate and/or less government spending will reduce aggregate demand, resulting in slower growth and lower demand-pull inflation.
- Supply-side policies try to improve long-term competitiveness; for example, privatization and deregulation may assist lower corporate costs, resulting in lower inflation.
Policies to reduce inflation in more details
1. Macroeconomic Policy
Monetary policy is the most essential weapon for keeping inflation low in the United Kingdom and the United States.
The Bank of England’s Monetary Policy Committee (MPC) is in charge of monetary policy in the United Kingdom. The government assigns them an inflation objective. The MPC’s inflation target is 2 percent +/-1, and it uses interest rates to try to meet it.
The MPC’s first task is to try to forecast future inflation. They use a variety of economic indicators to determine whether the economy is overheating. The MPC is likely to raise interest rates if inflation is expected to rise over the target.
Increased interest rates will aid in reducing the economy’s aggregate demand growth. As a result of the slower growth, inflation will be lower. Consumer expenditure is reduced by higher interest rates because:
- Borrowing costs rise when interest rates rise, discouraging consumers from borrowing and spending.
- Mortgage holders’ discretionary income is reduced as interest rates rise.
- Higher interest rates lowered the currency rate’s value, resulting in fewer exports and more imports.
Diagram showing fall in AD to reduce inflation
In the late 1980s and early 1990s, base interest rates were raised in an attempt to keep inflation under control.
- Cost-push inflation is tough to cope with (inflation and low growth at the same time)
- There are pauses in time. Higher interest rates can take up to 18 months to have an effect on demand reduction. (For example, persons who have a fixed-rate mortgage)
- It all boils down to self-assurance. Businesses and consumers may continue to spend despite higher interest rates if confidence is high.
What factors are responsible for demand-pull inflation?
Demand-Pull Inflation Has Six Causes
- Inflationary Expectations Ben Bernanke, the former Chairman of the Federal Reserve, put it this way:
What can be done to keep inflation under control?
- Governments can fight inflation by imposing wage and price limits, but this can lead to a recession and job losses.
- Governments can also use a contractionary monetary policy to combat inflation by limiting the money supply in an economy by raising interest rates and lowering bond prices.
- Another measure used by governments to limit inflation is reserve requirements, which are the amounts of money banks are legally required to have on hand to cover withdrawals.
How may cost-push inflation result from demand-pull inflation?
Pulling on the demand Inflation occurs when an economy’s aggregate demand grows faster than its aggregate supply. Simply put, it is a type of inflation in which aggregate demand for goods and services exceeds aggregate supply due to monetary and/or real variables.
- Inflation caused by monetary factors: One of the key causes of inflation is an increase in the money supply that is greater than the growth in the level of output. Inflation produced by monetary expansion in Germany in 1922-23 is an example of Demand-Pull Inflation.
- Demand-Pull Inflation as a result of real-world factors: Inflation is considered to be induced by real factors when it is caused by one or more of the following elements:
The first four of these six elements will result in an increase in discretionary income. As aggregate income rises, so does aggregate demand for goods and services, resulting in demand-pull inflation.
Definition of Cost-Push Inflation
Cost-push inflation is defined as an increase in the general price level induced by an increase in the costs of the factors of production due to a scarcity of inputs such as labor, raw materials, capital, and so on. As a result, the supply of outputs that primarily employ these inputs decreases. As a result, the rise in goods prices stems from the supply side.
Furthermore, natural resource depletion, monopoly, and other factors can all contribute to cost-push inflation. Cost-push inflation can be classified into three types:
- Wage-push inflation occurs when monopolistic social groups, such as labor unions, utilize their monopoly power to raise their money wages above the level of competition, resulting in an increase in the cost of production.
- Profit-push inflation occurs when corporations operating in monopolistic and oligopolistic markets use their monopoly strength to boost their profit margin, resulting in an increase in the price of products and services.
- Supply shock inflation is a type of inflation that occurs when the supply of essential consumer items or important industrial inputs falls unexpectedly.
Which of the following scenarios represents demand-pull inflation?
Consumers have more money to buy televisions, thus the prices of televisions and their parts are rising as a result of demand-pull inflation.
What is the difference between demand-pull and cost-push inflation?
What is the difference between demand-pull and cost-push inflation? Consumers cause demand-pull inflation, while producers drive cost-push inflation.