Inflation is a persistent increase in the general level of prices of goods and services in an economy over a specific time. It is a significant economic issue that affects the purchasing power of consumers, the profitability of businesses, and the overall financial stability of a country. In this article, we will explore what research says about how to fight inflation.
There are five ways to fight inflation; monetary and /or fiscal policy (policy mix), supply-side policies, wage and price controls, and exchange rate policy.
Monetary Policy
Monetary policy is one of the most common ways to fight inflation. It is the process by which a central bank controls the money supply and interest rates in the economy. The central bank can either increase interest rates or decrease the money supply to reduce inflation. According to research, monetary policy can be an effective tool in fighting inflation. A study by Ball, Cecchetti, and Rich (2018) found that tightening monetary policy can reduce inflation and increase the output of an economy.
Fiscal Policy
Fiscal policy is another way to fight inflation. It involves changes in government spending and taxation to influence the economy. When inflation is high, the government can reduce spending or increase taxes to reduce aggregate demand, leading to lower prices. Research shows that fiscal policy can be effective in reducing inflation. A study by Gertler and Grinols (1982) found that reducing government spending can lead to lower inflation.
Usually, in times of high inflation, fiscal and monetary policy are generally combined in a way called policy mix (Investopedia). So, the central bank may raise interest rates to reduce borrowing and stabilize prices. In this case, the government can also reduce its spending or increase taxes to reduce the amount of money in circulation and cool down the economy.
Supply-Side Policies
Supply-side policies focus on increasing the supply of goods and services in the economy. This can be achieved by reducing regulations, increasing investment, and improving productivity. Research suggests that supply-side policies can be effective in reducing inflation. A study by Kormendi and Meguire (1985) found that policies to increase productivity can lead to lower inflation.
Especially productivity seems to be present in any economic, business, and social challenge. No matter the question or problem, productivity tends to be the answer or solution.
Wage and Price Controls
Wage and price controls limit the level of wages and prices of goods and services. While this policy can be effective in the short term, it can negatively affect the economy in the long term. Research has shown that wage and price controls can lead to shortages, black markets, and reduced economic growth. A study by Nordhaus (1975) found that wage and price controls can lead to lower output and higher unemployment.
Particular concern should be made regarding low wages since they don’t have considerable buying power even for the necessary goods and services.
Exchange Rate Policy
Exchange rate policy involves manipulating the exchange rate of a currency to control inflation. A country can either devalue its currency or increase interest rates to attract foreign investment and reduce inflation. Research suggests that exchange rate policy can be effective in reducing inflation. A study by Amano and van Norden (1995) found that exchange rate policy can significantly impact inflation.
Limitations to the effectiveness of exchange rate policy appear in situations and contexts that share a common currency. Eurozone state members can not ‘play’ with their currencies to relieve inflation or debt.
Conclusion
In conclusion, there are several ways to fight inflation, and each policy has strengths and weaknesses. Research suggests that monetary, fiscal, supply-side, and exchange rate policies can effectively reduce inflation. However, wage and price controls may negatively affect the economy. Policymakers must consider the trade-offs and select the most appropriate policy based on their country’s economic situation.
References
Amano, R., & van Norden, S. (1995). Exchange rates and inflation targeting. Bank of Canada Review, 31–45.
Ball, L., Cecchetti, S. G., & Rich, R. W. (2018). The case for a long-run inflation target of four percent. Journal of Monetary Economics, 98, 70–84.
Gertler, M., & Grinols, E. L. (1982). Fiscal and monetary policy in an optimizing model of Keynesian-type business cycles. Journal of Monetary Economics, 9(2), 254–271.
Investopedia, https://www.investopedia.com/terms/p/policy-mix.asp
Kormendi, R. C., & Meguire, P. G. (1985). Macroeconomic determinants of growth: Cross-country
