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; the Phillips-curve trade-off (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, revaluing the currency (or letting it appreciate) makes imports cheaper, which directly lowers cost-push inflation. The downside is that exports become more expensive abroad, which can hurt the current account.