How to reduce inflation

Question

I have my economics finals next week and could use some revision. How to reduce inflation? I’m still not very familiar with the idea of inflation and how occurs in the economy. The theory of it seems confusing. What are the methods that are used to reduce inflation? Some kind of policies? Is it possible for the economy to deflate naturally?

Answer 1

One of the most common and important tools to maintain the low inflation is the monetary policy. The UK, for example, the Bank of England sets their contractionary monetary policy by the aptly named Monetary Policy Committee (MPC). Then the government gives them an inflation target. Thus, the MPC will use the interest rates in order to try and bring the inflation to the target.

With an increase in interest rates, growth of the aggregate demand (AD) will slow down in the economy, slower growth leading to lower inflation as a whole since the higher interest rates reduce the overall spending of consumer. Why? Higher interest rates raise the cost of borrowing, so consumers are discouraged from spending and borrowing. Then saving money is now much more attractive. With the increased interest rates, people with mortgages or similar loans would have effectively lowered disposable income and consume less. The raised interest rates mean higher exchange rate value, meaning more cheaper foreign currency for the locals and a domestic currency becomes more expensive for the foreigner. This results in more imports to lower exports. As such, the slowing down of the economy by higher interest rates leads to lower inflation for all.

Comments

a nice point on how to reduce inflation!

Answer 2

Supply-side policies can be used to lower inflation, although it takes forever to kick in. The whole aim of the supply sides policies it to raise the long-term productivity and competitiveness of the economy, such as training and education. In the long run, the policy can help to alleviate these inflationary pressures, although again, it takes forever to work, so this policy isn’t that effective if you want to reduce inflation quickly.

Answer 3

Contractionary fiscal policy could be the answer to how to reduce inflation. Similar to the monetary policy, the policy targets the aggregate demand and hasit fall to reduce the inflation. The policy involves the use of increased tax and reduces government spending to shift the aggregate demand down. The tax increases make it less profitable for the company to produce more, leading to people getting sacked from work or gets lower pay. Now these people don't spend as much anymore. With the increased tax further reducing their disposable income, they are less likely to spend more too. The economy slows down and the inflation will fall.