- 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.
Monetary Policy:
To combat deflation, the central bank can use a cheap money policy to boost commercial bank reserves. They can achieve this by purchasing securities and lowering interest rates. As a result, they will be better able to give loans to borrowers. However, the Great Downturn taught us that in a severe depression, when businessmen are pessimistic, the success of such a policy is essentially zero.
Banks are powerless to bring about a rebirth in such a situation. Due to the near-complete halt in commercial activity, businessmen have little desire to borrow money to build up inventories, even if the interest rate is extremely low. Rather, they seek to minimize their inventories by repaying bank loans they’ve already taken out.
Furthermore, during deflation, when economic activity is already at a low level, the subject of borrowing for long-term capital needs does not arise. The same is true for customers who, because to unemployment and lower incomes, prefer not to take out bank loans to acquire durable items.
How do we keep inflation under control?
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.
- Controlling the money supply Monetarists argue 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.
What is inflation, and how is it managed?
The following are some of the most important inflation-control measures: 1. Monetary Policy 2. Fiscal Policies 3. Additional Measures
Inflation occurs when aggregate supply fails to keep pace with rising aggregate demand. In order to regulate aggregate demand, inflation can be controlled by increasing the supply of goods and services while reducing money incomes.
What can I do to close the output gap?
To close a negative output gap, for example, expansionary fiscal policythat is, policy that increases aggregate demand by boosting government spending or cutting taxescan be implemented.
What can you get during a deflationary period?
Companies that supply products or services that we can’t easily cut out of our lives are considered defensive stocks. Two of the most common examples are consumer products and utilities.
Consider toilet paper, food, and power. People will always require these commodities and services, regardless of economic conditions.
You may invest in ETFs that track the Dow Jones U.S. Consumer Goods Index or the Dow Jones U.S. Utilities Index if you don’t want to invest in specific firms.
iShares US Consumer Goods (IYK) and ProShares Ultra Consumer Goods are two prominent consumer goods ETFs (UGE). iShares US Utilities (IDU) and ProShares Ultra Utilities (PUU) are two ETFs that invest in utilities (UPW).
What does the RBI do to keep inflation under control?
To keep inflation under control, the RBI sells securities in the money market, sucking excess liquidity out of the market. Demand falls when the amount of liquid cash available declines. The open market operation is the name given to this aspect of monetary policy.
What is the formula for GDP?
Gross domestic product (GDP) equals private consumption + gross private investment + government investment + government spending + (exports Minus imports).
GDP is usually computed using international standards by the country’s official statistical agency. GDP is calculated in the United States by the Bureau of Economic Analysis, which is part of the Commerce Department. The System of National Accounts, compiled in 1993 by the International Monetary Fund (IMF), the European Commission, and the Organization for Economic Cooperation and Development (OECD), is the international standard for estimating GDP.
How can you protect yourself from deflation?
- Investors must take efforts to protect their portfolios against inflation or deflation, that is, whether prices for goods and services are growing or declining.
- Growth stocks, gold, and other commodities are all good inflation hedges, as are foreign bonds and Treasury Inflation-Protected Securities for income investors.
- Investment-grade bonds, defensive equities (those of consumer goods companies), dividend-paying stocks, and cash are all strong deflation hedges.
- Regardless of what happens in the economy, a diversified portfolio that contains both types of assets can provide some security.