As we know Inflation is caused by increase in the number of currency without increasing the amount of stuff. In simple terms, Inflation is MORE money chasing the SAME amount of stuff.
So how do we control inflation? Stop creating money? Reduce the government spending? Stop new money from entering the system? Sell bonds in the market to remove all extra money? Raise Interest Rates?
Let us try and understand this.
The different methods used to control inflation are known as anti-inflationary measures. These measures attempt mainly at reducing aggregate demand for goods and services on the basic assumption that inflationary rise in prices is due to an excess of demand over a given supply of goods and services.
We know that inflation is caused by the failure of aggregate supply to equal the increase in aggregate demand. Inflation can, therefore, be controlled by increasing the supplies and reducing money incomes in order to control aggregate demand.
The various methods to control inflation are given below however the most common ones are Monetary and Fiscal Policies:
1. Monetary Policy
With growth of 3.8%, demand in the economy could be growing faster than capacity can grow to meet it. This leads to inflationary pressures. We can term this demand pull inflation. Therefore, reducing the growth of Aggregate demand, should reduce inflationary pressures.
Monetary policy is the policy of the central bank of the country, which is the supreme monetary and banking authority in a country. The central bank may use such methods as the bank rate, open market operations, the reserve ratio and selective controls in order to control the credit creation operation of commercial banks and thus restrict the amounts of bank deposits in the country. This is known as tight money policy. Monetary policy to control inflation is based on the assumption that a rise in prices is due to a larger demand for goods and services, which is the direct result of expansion of bank credit. To the extent this is true, the central bank’s policy will be successful.
Monetary policy may not be effective in controlling inflation, if inflation is due to cost-push factors. Monetary policy can only be helpful in controlling inflation due to demand-pull factors.
The most extreme monetary measure is the issue of new currency in place of the old currency. Under this system, one new note is exchanged for a number of notes of the old currency. The value of bank deposits is also fixed accordingly. Such a measure is adopted when there is an excessive issue of notes and there is hyperinflation in the country. It is very effective measure. But is in-equitable for its hurts the small depositors the most.
Let us see how increasing the rate can help control inflation
A higher interest rate should also lead to higher exchange rate, which helps to reduce inflationary pressure by
- Making imports cheaper.
- Reducing demand for exports and
- Increasing incentive for exporters to cut costs.
2. Fiscal Policy
It is the policy of a government with regard to taxation, expenditure and public borrowing. It has a very important influence on business and economic activity. Taxes determine the size or the volume of disposable income in the hands of the public. The proper tax policy to control inflation will avoid tax cuts, introduce new taxes and raise the rates of existing taxes. The purpose being to reduce the volume of purchasing power in the hands of the public and thus reduces their demand. A precisely similar effect will be achieved if voluntary or compulsory savings are increased. Savings will reduce current demand for goods and thus reduce the inflationary rise in prices.
As an anti-inflationary measure, government expenditure should be reduced. This indicates that demand for goods and services will be further reduced. This policy of increasing public revenue through taxation and decreasing public expenditure is known as surplus budgeting. However, there is one important difficulty is this policy. It may be easy to increase revenue in times of inflation when people have more money income, but difficult to reduce public expenditure.
During war times as well as during a period of development, it is absolutely impossible to reduce the planned expenditure. If the government has already taken up a scheme or a group of schemes, it is ruinous to give them up in the middle. Therefore, public expenditure cannot be used as an anti-inflationary measure. Lastly, public debt, i.e., the debt of the government may be managed in such a way that the supply of money in the country may be controlled.
The government should avoid paying back any of its previous loans during inflation so as to prevent an increase in the circulation of money. Moreover, if the government manages to get a surplus budget, it should be used to cancel public debt held by the central bank. The result will be anti-inflationary since money taken from the public and commercial banks is being cancelled out and is removed from circulation. But the problem is how to get a budget surplus, which is extremely difficult.
3. Price Control and Rationing
This is the most important and effective method available during war and other critical times particularly because both monetary and fiscal policies are more or less useless during this period. Price control implies the establishment to legal upper limits beyond which prices of particular goods should not rise. The purpose of rationing, on the other hand, is to distribute the goods in short supply in an equitable manner among all people, irrespective of their wealth and social status. Price control and rationing generally go together. The chief objection behind use of this method to fight inflation is that they restrict the freedom of the consumers and thus limit their welfare. Besides, its success depends on administrative efficiency, which in many underdeveloped countries is very low.
4. Other Methods
Another important anti-inflationary device is to increase the supply of goods through either increased production or imports. Production may be increased by shifting factors of production from the production of less inflation sensitive goods, which are in comparative abundance to the production of those goods which are in short supply and which are inflation-sensitive. Moreover, shortage of goods internally may be relieved through imports of inflation sensitive goods, either on credit or in exchange for export of luxury goods and other non-essentials.
A word may be added about the measures to control cost-push inflation. It is suggested that wages, salaries and profit margins should be controlled and fixed through a system of income freeze. Business units may particularly welcome wage freeze. However, wage freeze is not so easy or just, unless trade unions agree to the proposal and there is also freezing of prices. At the same time, the Government should not raise the rates of commodity taxes. Thus, it is difficult to control cost push inflation through controlling wages and other incomes. The best method is to bring a rapid increase in production, which will automatically check prices and wages also.