How Is Monetary Policy Used To Control Inflation?

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 does monetary policy keep inflation under control?

To combat inflation, central banks employ contractionary monetary policy. They limit the amount of money banks may lend, hence reducing the money supply. Banks charge a higher interest rate, increasing the cost of loans. Growth is slowed when fewer businesses and individuals borrow.

Why is monetary policy more effective at keeping inflation under control?

The primary goal of fiscal and monetary policy is to lessen the economic cycle’s cyclical swings. Governments have frequently depended on monetary policy to achieve low inflation in recent years. However, there are compelling arguments for employing fiscal policy to help the economy recover during a recession.

Changes in government expenditure and taxation are part of fiscal policy. It entails a change in the government’s financial condition. e.g. Tax cuts, more government spending, and a larger budget deficit are all examples of expansionary fiscal policy. The amount of money spent by the government is a factor in AD.
The employment of interest rates to influence the demand and supply of money is referred to as monetary policy.
Open market operations and quantitative easing are examples of unconventional monetary policies.

Reducing Inflation

The government or monetary authorities will aim to slow the increase of AD in order to decrease inflationary pressures.

Higher taxes and lesser spending will be the result of fiscal policy. Fiscal policy has the advantage of assisting in the reduction of the budget deficit.

In a country with a big budget deficit, such as the United Kingdom, it may make sense to utilize fiscal policy to lower inflationary pressures since you can cut inflation while also improving the budget deficit.

For political considerations, however, it can be difficult to reduce government spending (or raise taxes). This is why, in most economies, monetary policy has been used to ‘fine-tune’ the economy.

In most cases, raising interest rates is an effective way to reduce inflationary pressures. Higher interest rates raise the cost of borrowing, which slows economic activity.

Raising interest rates, on the other hand, has an impact on the exchange rate. The Pound is expected to climb as a result of hot money flows seeking to profit from higher interest rates. As a result, exporters will be more affected by deflationary monetary policy.
Raising interest rates also has a greater proportional impact on homeowners who have variable mortgage payments. The UK is vulnerable to interest rate changes due to the high amount of mortgage payments.
The housing market and borrowers are disproportionately affected by monetary policy.
Higher interest rates, on the other hand, can benefit savers by increasing their income. Similarly, those who rely on savings have less income during this period of extremely low interest rates.
As a result, monetary policy does not have the same influence across the economy; borrowers and savers are affected differently.

Supply-side effects of fiscal policy

Incentives to labor may be reduced if income tax or company tax rates are raised. Variable tax rates may be unappealing to businesses, resulting in lesser investment. This is why fiscal policy is rarely (if ever) utilized to keep inflation under control.
Cuts to government spending could stifle capital investment, reduce benefits, and exacerbate inequality.

Fiscal vs Monetary policy for dealing with recession

In order to boost consumption and investment during a recession, monetary policy will involve decreasing interest rates. It should also benefit exporters by weakening the exchange rate.

Cuts in interest rates (which allowed for a devaluation of the overvalued Pound) were particularly helpful in spurring economic development in the aftermath of the 1992 UK recession. Because high interest rates were a major cause of the 1992 recession, lowering them eased the burden on homeowners and businesses, allowing the economy to recover.

Interest rates in the United Kingdom were lowered from 5% to 0.5 percent in 2009. (and across the globe). Interest rate decreases, on the other hand, were ineffective in restoring normal growth. There was a liquidity trap during the 2008-09 recession. Interest rate reductions were insufficient to spur expenditure and investment. This was due to the following:

Despite low interest rates, banks were unwilling to lend due to a lack of credit.
Low-interest rates may not be enough to combat deflation, because falling prices might still result in very high real interest rates. As a result, in periods of deflation, zero interest rates may not be sufficient to pull an economy out of a slump.

Unorthodox monetary policy

Quantitative easing is another weapon of monetary policy, in addition to interest rate decreases.

Quantitative easing aims to expand the money supply while lowering bond yields and avoiding deflationary forces.

Despite the increase in the money supply, the persistent credit constraint forced banks to save the newly created money, which had a limited impact on rising growth.

Expansionary fiscal policy

By injecting demand into the economy, expansionary fiscal policy can directly produce jobs and economic activity. In a recession, Keynes contended, expansionary fiscal policy is required due to excess private sector saving caused by the paradox of thrift. Expansionary fiscal policy allows for the use of unused savings and the utilization of idle resources.

Fiscal policy may be more effective than monetary policy in a prolonged recession and liquidity trap because the government can pay for new investment plans directly, creating jobs, rather than depending on monetary policy to indirectly persuade businesses to spend.

Expansionary fiscal policy has the disadvantage of increasing the budget deficit. Some say that this will result in higher interest rates since markets demand higher rates to fund borrowing.

In many cases, however, government borrowing can rise during a recession without raising bond yields. However, it is a delicate balancing act; if borrowing rises too quickly, markets may fear that borrowing would spiral out of control. (See, for example, the European budget crisis.)

Political costs of monetary and fiscal policy

Deflationary policy, in theory, can lower inflation. Inflation would be reduced if income taxes were raised. Changing tax rates and government spending, on the other hand, is a highly political matter. Higher taxes are unlikely to be accepted by politicians or voters on the grounds that they are required to reduce inflation.

Interest rates established by an impartial central bank enhance demand management by removing political calculations. In theory, a central bank would disregard political factors in order to achieve its goal of low inflation. Just before an election, a government can be tempted to support an economic boom.

Which is best monetary or fiscal policy?

The most common application of monetary policy is to ‘fine-tune’ the economy. The simplest approach to influence the economic cycle is to make tiny changes to interest rates. Politically, deflationary fiscal policy is extremely unpopular. However, monetary policy has its limitations in specific situations. A mixture of two approaches may be required in severe recessions.

However, monetary policy has its limitations in specific situations. A combination of the two measures may be required in severe recessions.

What is the purpose of monetary policy?

The control of the amount of money accessible in an economy, as well as the routes through which new money is delivered, is referred to as monetary policy. A central bank’s goal in controlling the money supply is to impact macroeconomic parameters like inflation, consumption, economic growth, and general liquidity.

Which policy is utilised to keep inflation under control?

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 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 effect does monetary policy have on the rate of inflation and economic growth?

By affecting the cost and availability of credit, inflation management, and the balance of payment, monetary policy has a substantial impact on the economic growth of a developing country like Bangladesh. The contribution of different components of monetary policy to Bangladesh’s current increasing GDP growth is the contribution of different components of monetary policy to Bangladesh’s present improving GDP growth. The purpose of this article is to determine the impact of monetary policy on Bangladesh’s overall economic development. The study’s goal is to establish a cause-and-effect relationship between monetary policy and several economic elements that contribute to Bangladesh’s economic growth. The data for this study was gathered during the last 20 years, from 1997 to 2017. To conduct this study, primary data from 57 respondents from various commercial banks was obtained. This study used many economic indicators that affect a country’s GDP, such as inflation, employment, lending, borrowing, export-import growth rate, broad money growth rate, and FDI rate in percent of GDP. The data was analyzed using both descriptive and inferential statistics. To determine the factors that influence Bangladesh’s overall economic performance, a multivariate analysis technique called exploratory factor analysis was used with SPSS version 20.0. The relationship between monetary policy and Bangladesh’s economic progress was studied using multiple regressions. The findings reveal that consumption, investment, government net expenditure, and net export all have a substantial impact on Bangladesh’s GDP growth. The study also finds that Bangladesh’s monetary policy has a big impact on these mediating elements. By guaranteeing effective monetary policy implementation, the research provides valuable insight into Bangladesh’s socioeconomic progress. Bangladesh will witness more robust economic growth in the near future if the central bank and policymakers focus on the following major issues.

What benefit does monetary policy provide?

Adjustments to interest rates and the money supply, known as monetary policy, can help to combat economic slowdowns. Such adjustments can be made swiftly, and monetary authorities commit significant resources to economic surveillance and analysis. Lower interest rates cut the cost of financing for big-ticket items like cars and houses, which can help to counteract a slump. Monetary policy can also lower the cost of investment for businesses. As a result, lower interest rates can benefit the economy by increasing expenditure by both people and businesses.

The Federal Reserve can make monetary policy changes faster than the president and Congress can make fiscal policy changes. Because most economic contractions endure only a few quarters, timely policy responses are critical. In fact, however, fiscal policy responds slowly to changes in economic conditions: it takes time to enact and then implement a stimulus measure, as well as time for spending increases or tax reductions to reach consumers’ pockets. As a result, the fiscal stimulus’ impact on consumer and business expenditure may be delayed.

The extent to which and how much stimulus is required is determined by current economic conditions, future projections, and potential dangers to both economic growth and inflation. Given the constraints in the data available and economists’ understanding of the world, forecasting economic conditionsor even determining the current status of the economyis intrinsically challenging. However, the Federal Reserve’s vast and professional team of experts is better positioned than any other federal agency to complete this duty. Furthermore, the Federal Reserve personnel works without regard for political factors.

However, monetary policy’s ability to resist catastrophic events is limited because its main tool is the short-run interest rate, which cannot fall below zero. That means that in a particularly severe downturn, such as the previous Great Recession, the Federal Reserve will cut the short-term interest rate to zero, limiting the Fed’s options to less effective and well-understood strategies like asset purchases. In similar circumstances, fiscal policy may be able to assist monetary policy in stimulating the economy.

What are the benefits of utilising monetary policy rather than fiscal policy?

Expansionary monetary policy can boost GDP by boosting asset prices and cutting borrowing costs, making businesses more profitable. Monetary policy aims to boost economic activity, whereas fiscal policy focuses on total spending, total spending composition, or both.

What is the primary goal of monetary policy in a country?

The goal of monetary policy is to keep the economy’s price level stable. The term “price stability” refers to the preservation of low and stable inflation.

What role does monetary policy play in promoting economic growth?

Furthermore, as per capita income rises and the population grows, so does the demand for money to conduct day-to-day transactions. Because of the expanding demand for money, the monetary authority must increase the money supply at a pace that is nearly equivalent to the rate of increase in real income, so that prices do not fall as a result of increased national output.

Initiating a vicious downward spiral of prices and output, a declining price level has a negative impact on the rate of economic growth. Similarly, if the amount of money available exceeds the needs of commerce and industry, it may be used for speculative reasons, stifling growth and producing inflation.

The main point is that tighter control over money supply will eliminate economic swings and prepare the way for rapid development. As a result, monetary policy may play an important role in the economic development of developing countries by limiting price fluctuations and overall economic activity by striking an acceptable balance between the demand for money and the economy’s productive capability.