A contractionary monetary policy is one common method of managing inflation. A contractionary policy aims to reduce the supply of money within an economy by lowering the prices of bonds and rising interest rates. Thus, consumption falls, prices fall and inflation slows down.
Inflation can be controlled by a contractionary monetary policy is one common method of managing inflation. The aim of a contractionary policy is to reduce the supply of money within an economy by lowering the prices of bonds and rising interest rates. Thus, consumption falls, prices fall and inflation slows down.
The Central Bank and/or the government normally monitor inflation. Monetary policy is the key policy employed (changing interest rates). There are however several instruments to manage inflation in theory, including:
Monetary Policy: Higher interest rates decrease the economy's demand, resulting in lower economic growth and lower inflation.
Money supply management Monetarians claim that there is a near correlation between money supply and inflation, so inflation can be regulated by regulating the money supply.
Supply-side policies are policies designed to boost the economy's productivity and efficiency, placing downward pressure on long-term costs.
Fiscal Policy: A higher rate of income tax could reduce spending, demand, and inflationary pressures through fiscal policy.
Price limits may in principle, help alleviate inflationary pressures by attempting to regulate wages. Nonetheless, apart from the 1970s, it was scarcely used.
Inflation is an economic phenomenon that is used year after year to characterize rising prices for goods and services. This caused the consumer's buying power to decline because the rate of wage and income growth does not keep up with the rate of inflation.
Inflation management is not an easy mission, however. The rise in prices is due to several factors, such as aggregate demand, increased cash supply, etc. We need a lot of steps working in tandem to contain inflation.
Government spending, public borrowing, and taxes comprise the Fiscal Policies to Combat Inflation. The Keynesian economists often referred to as "Fiscal," argue that due to an excess of aggregate demand over aggregate supply, demand-pull inflation is induced. Owing to spending by individuals, companies, and the government, aggregate demand rises (usually excessive spending by the government). This rise in demand due to the government or household spending can be effectively regulated by fiscal policies. Fiscal policy and fiscal initiatives are thus the effective weapons of demand-pull inflation management.
If the key trigger behind demand-pull inflation is government spending, then it can be regulated by reducing public expenditure. The public demand for goods and services declines with a decline in public spending, along with a decrease in private income and consumption expenditure. In cases where demand increases due to an increase in private spending, the most effective way to manage inflation is by taxing profits. The taxation of private income decreases the disposable income in question, and also reduces consumer spending. This has the effect of reducing aggregate demand.
In the event of a very high persistent inflation rate, both such steps may be taken simultaneously by the government to contain inflation. In the case of a decrease in public spending, the rate of taxes on private income is increased to keep demand under control. This form of policy of concurrently using both measures is called the "Surplus Budgeting Policy," which notes that "government should spend less than tax revenue".
Monetary interventions are aimed at reducing revenue from money.
(a) Management of Credit:
Monetary policy is one of the essential monetary interventions. A variety of strategies are employed by the country's central bank to regulate the quantity and quality of credit. To that end, bank rates are raised, securities are sold on the open market, the reserve ratio is raised and a range of selective credit management steps are taken, such as raising margin thresholds and controlling consumer credit. When inflation is due to cost-push variables, monetary policy will not be effective in managing inflation. Due to demand-pull variables, monetary policy can only be effective in managing inflation.
(b) Currency Demonetisation:
One of the monetary steps is to demonetize higher-denomination currencies. Such a step is typically taken when the country has a surplus of black currency.
(c) New Currency Issuance:
The problem of a new currency in place of the old currency is the most drastic monetary measure. Under this process, one new note is exchanged for several old currency notes. Likewise, the value of bank deposits is set accordingly. Such a measure is introduced when the issue of notes is excessive and hyperinflation occurs in the region. It is a measure that is very successful. But it is wrong because it affects the tiny depositors the most.
1. How can Interest Rates Help to Control Inflation?
Ans: Individuals and corporations prefer to demand more loans when interest rates are low. In a fractional reserve banking system, each bank loan increases the money supply. An increasing money supply raises inflation, according to the quantity theory of money. Low-interest rates, therefore, appear to lead to more inflation. The price of holding or lending money is determined by the interest rate. In order to draw depositors, banks pay an interest rate on deposits. Banks also get an interest rate from their deposits for money that is loaned. High-interest rates have the potential to minimize inflation. Although this version of the relationship is very simplistic, it underlines why interest rates and inflation appear to be inversely linked.
2. What are the Effects of Inflation?
Ans: Rising prices, referred to as inflation, have an impact on the cost of living, the cost of doing business, borrowing money, mortgages, yields on corporate and government bonds, and any other part of the economy. Inflation can be both beneficial and in some instances, negative for economic recovery. The negative effects of inflation include an increase in the cost of money keeping opportunities, uncertainty about potential inflation that could deter investment and savings, and if inflation is too rapid, shortages of goods as consumers start hoarding out of fear that future prices will rise. Inflation has positive effects on the economy in the following ways: higher profits as manufacturers are able to sell at higher rates. Better returns on investment provided that investors and entrepreneurs are given incentives to invest in profitable activities output increase.