Inflation: Causes & Effects

The three families of macroeconomic policy each play a role.

Monetary policy: interest rates

The central bank (e.g. the Bank of England, the European Central Bank) raises interest rates to fight inflation.

Mechanism: higher interest rates discourage borrowing (mortgages, business loans, credit cards become more expensive) and encourage saving. Households spend less; firms invest less. Aggregate demand falls, which slows demand-pull inflation.

Monetary policy is the first-line tool against demand-pull inflation in most countries. It can be adjusted quickly (the central bank can vote to change rates every few weeks) and is reversed easily when inflation eases.

Limits:

• Interest-rate rises take months to a year to fully work through the economy.
• Higher rates also slow growth and raise unemployment in the short run, which is the conflict between low inflation and full employment covered in topic 12.
• Monetary policy cannot directly attack cost-push inflation, only demand-pull.

Fiscal policy: taxes and government spending

The government uses contractionary fiscal policy to fight inflation: raise taxes or cut public spending, reducing aggregate demand.

Two arms:

• Higher taxes (income tax, VAT) leave households with less to spend.
• Cuts in government spending reduce demand directly.

Both shift AD to the left, slowing demand-pull inflation.

Limits:

• Fiscal policy is slow to change. Tax laws take months to legislate; spending plans are usually set for years.
• Cuts can be politically painful: voters dislike higher taxes and reduced public services.
• Like monetary policy, fiscal contraction risks slowing growth and raising unemployment.

Supply-side policy: raising productive capacity

Supply-side policies lift the economy's productive capacity so that aggregate supply can keep pace with aggregate demand. They are the main response to cost-push inflation.

Examples:

• Education and training: better-skilled workers produce more output per hour at lower unit cost.
• Investment in infrastructure: better roads, ports, broadband cut firms' costs.
• R&D incentives: new technology raises productivity.
• Deregulation: easing rules that restrict competition or trade.
• Privatisation: sometimes argued to raise efficiency.

Supply-side policy is the long-run solution: it takes years to bear fruit, but lifts the economy's capacity permanently and eases the inflation-growth trade-off.

Exchange-rate policy (special case)

If imported inflation is the problem, strengthening the currency (an appreciation of the exchange rate, e.g. via higher interest rates or government intervention in the foreign exchange market) makes imports cheaper, which directly lowers cost-push inflation. The downside is that exports become more expensive abroad, which can hurt the current account.