Since inflation brings with it a mixed fortune,
we may wonder whether it is economically expedient to control it. For sure, it
is possible to live with inflation, at least in the short run, through
indexation. The tax bracket can be indexed; the government can raise nominal
transfer payments (including pensions) to accommodate inflation. Wages can be
continually adjusted to reflect the cost of living. Banks can charge and pay
high nominal interest rate.
we may wonder whether it is economically expedient to control it. For sure, it
is possible to live with inflation, at least in the short run, through
indexation. The tax bracket can be indexed; the government can raise nominal
transfer payments (including pensions) to accommodate inflation. Wages can be
continually adjusted to reflect the cost of living. Banks can charge and pay
high nominal interest rate.
Firms can adopt inflation accounting3
etc. But all these may prove complicated and costly. In addition, inflation, especially
when it is severe, if left to continue for a long time, will affect the macro
economy negatively. This is why the maintenance of a stable price level (which
is consistent with low and gradual increases in prices) is a macroeconomic goal
of every country. We should point out from the onset that it is easier, cheaper
and better to prevent inflation than to cure it. Once inflation is already
underway, to cure (remove) it will bring harm to some persons or sectors of the
economy. First, you harm farmers and persons whose business normally have long
gestation and who might have taken loans or mortgages at high interest rate
hoping that since the rise in prices will continue, they will be able to sell
off their goods or real assets at high prices in future to repay the loans.
etc. But all these may prove complicated and costly. In addition, inflation, especially
when it is severe, if left to continue for a long time, will affect the macro
economy negatively. This is why the maintenance of a stable price level (which
is consistent with low and gradual increases in prices) is a macroeconomic goal
of every country. We should point out from the onset that it is easier, cheaper
and better to prevent inflation than to cure it. Once inflation is already
underway, to cure (remove) it will bring harm to some persons or sectors of the
economy. First, you harm farmers and persons whose business normally have long
gestation and who might have taken loans or mortgages at high interest rate
hoping that since the rise in prices will continue, they will be able to sell
off their goods or real assets at high prices in future to repay the loans.
To suddenly crash prices will spell doom for
such persons. Again, there are others who might have made rational adjustments
to the inflationary condition, such that a reversal of the situation may be
very costly. And, of course, there is also the unpopularity of contractionary
polices aimed at controlling inflation. Thus, it is more expedient for the
government to adopt measures that ensure that prices do not rise beyond
acceptable levels and keep doing so over long period of time. According to the
monetarist rule, money supply should be increased year in year out at the same
annual rate of growth of potential output. If the real GDP growth for the year
is 2% for example, then money supply should be increased by 2%. If by next
year, the rate of growth of real GDP is 5%, then money supply should be
increased by 5% etc.
such persons. Again, there are others who might have made rational adjustments
to the inflationary condition, such that a reversal of the situation may be
very costly. And, of course, there is also the unpopularity of contractionary
polices aimed at controlling inflation. Thus, it is more expedient for the
government to adopt measures that ensure that prices do not rise beyond
acceptable levels and keep doing so over long period of time. According to the
monetarist rule, money supply should be increased year in year out at the same
annual rate of growth of potential output. If the real GDP growth for the year
is 2% for example, then money supply should be increased by 2%. If by next
year, the rate of growth of real GDP is 5%, then money supply should be
increased by 5% etc.
This will keep prices stable, prevent or limit
cyclical fluctuation in economic activities and eliminate the need for discretionary
monetary policy. Assuming however that inflation is on course, how do we
control it? The instruments that are usually employed to control inflation are
much similar to (or the same as) those employed to control unemployment. We
discuss them as follows;
cyclical fluctuation in economic activities and eliminate the need for discretionary
monetary policy. Assuming however that inflation is on course, how do we
control it? The instruments that are usually employed to control inflation are
much similar to (or the same as) those employed to control unemployment. We
discuss them as follows;
Contractionary
Monetary and Fiscal Policies
Monetary and Fiscal Policies
Contractionary monetary policies will include
increasing the bank rate, legal reserve requirements or liquidity rate of
banks, raising the interest rate etc. The idea is to make less money available
for circulation so that aggregate demand can be reduced. Contractionary fiscal
policy includes increases in taxes, reduction in government spending etc. Contractionary
policies will work well, however, only when inflation is demand-pulled. In addition,
to reduce money supply from an initial position of high inflation will require
an intermediate period of high unemployment (more on this later).
increasing the bank rate, legal reserve requirements or liquidity rate of
banks, raising the interest rate etc. The idea is to make less money available
for circulation so that aggregate demand can be reduced. Contractionary fiscal
policy includes increases in taxes, reduction in government spending etc. Contractionary
policies will work well, however, only when inflation is demand-pulled. In addition,
to reduce money supply from an initial position of high inflation will require
an intermediate period of high unemployment (more on this later).
Income
Policies
Policies
Income policies are policies that attempt to
influence wages and other incomes directly. This can help to reduce or
eliminate cost-push inflation.
influence wages and other incomes directly. This can help to reduce or
eliminate cost-push inflation.
Ban
on Inflationary Imports
on Inflationary Imports
If inflation is fuelled by imports from others
countries, such imports could be banned. But the success of this will depend on
the nature of the products concerned and the effectiveness of the government
control machinery. Where the products are essentials or where there is a high
taste for the products, or where government control systems are porous, ban on
inflationary imports may not produce the desired results.
countries, such imports could be banned. But the success of this will depend on
the nature of the products concerned and the effectiveness of the government
control machinery. Where the products are essentials or where there is a high
taste for the products, or where government control systems are porous, ban on
inflationary imports may not produce the desired results.
Supply-Side Incentive
Ultimately, controlling inflation will have to
include taking measures to increase the level of actual and potential outputs.
Potential output can be increased through factors that enhance labor
productivity (such as advancement in technology and training etc). Labor supply
can also be increased through reductions in taxes. Tax cuts will also encourage
entrepreneurship and stimulate investments, which will transfer into increase
output. The provision of complementary factors (such as infrastructures) and a
favorable climate for investment will also help to boost aggregate supply.
include taking measures to increase the level of actual and potential outputs.
Potential output can be increased through factors that enhance labor
productivity (such as advancement in technology and training etc). Labor supply
can also be increased through reductions in taxes. Tax cuts will also encourage
entrepreneurship and stimulate investments, which will transfer into increase
output. The provision of complementary factors (such as infrastructures) and a
favorable climate for investment will also help to boost aggregate supply.
