Policies to correct inflation and deflation

The choice of the most appropriate policy instrument to correct inflation and deflation will be influenced by an assessment of the cause of the inflationary or deflationary episode, and whether the problem is short term and associated with the normal ebb and flow of the business cycle, or whether it is more the result of a structural problem in the economy.

For example, a short-term boost to spending caused by a reduction in income tax is likely to put upward pressure on prices, but this will fade away once the price level has stabilised at a higher rate. In this case, policy makers may not interfere given that the inflationary episode will be short lived.

In contrast, when wages are driven up each year through collective bargaining, or where there is a long-term structural shortage of labour, policy makers are more likely to intervene as the inflationary pressure is embedded.

The options to deal with inflation (and deflation) include monetary, fiscal and supply-side policy.

Monetary policy and inflation

Monetary policy involves managing either the price of money – its interest rate – or the quantity of money, in order to control inflation and stabilise the value of money. Keeping the value of money stable has long been an objective of governments, and later of independent central banks.

Monetary policy is a counter-cyclical policy in that it works to moderate changes in aggregate demand - with policy being loosened (lower interest rate and/or increased money supply) when aggregate demand is growing slowly, or not at all, and tightened (higher interest rate and/or reduced money supply) when aggregate demand is growing too quickly for the current capacity of the economy.

Monetary policy in the short run

The use of monetary policy is regarded as a short-term policy in that it is generally accepted that 'money is neutral' in its long-term impact. It we take a long-range view of an economy through time, the value of money and the quantity of money may change without having an impact on economic growth, or employment levels. Growth and employment levels in the long term are determined more by the availability, quality, and efficiency of factors of production, and factor productivity, than by the price or availability of money.

However, in the short run it is accepted that changes in monetary conditions - interest rates and the quantity of money - can have a direct and significant effect on economic growth, prices and employment. Hence, governments and monetary authorities do not have long range targets for the value of money - only that the supply of money and its growth should be controlled and pegged closely to the economy's ability to grow in the medium term - namely, close to the economy's trend rate of growth.

While most central banks do not have specific long-term targets - other than to achieve monetary stability - they will set short term 'tactical' targets. For example, the Bank of England's daily operations are designed to achieve a specific interest rate or exchange rate¹.

How does monetary policy work?

In 'normal' economic circumstances, monetary authorities use monetary policy to influence the demand for money, which then influences aggregate demand, the real economy, and the rate of inflation.

If a central bank wishes to engineer an increase in rates, it will sell securities to the banking sector, which soaks up money and creates a shortage, driving up the interest rate.

Changes in rates then work their way to other 'market' rates, such as the interbank rate (the rate at which banks lend to each other), and eventually on to rates which affect households and individuals, including mortgage rates, and credit card rates.

The monetary transmission mechanism

The ‘monetary transmission mechanism’ shows how interest rates work their way through the economy, affecting asset prices, confidence, exchange rates, and finally on to the price level. The transmission mechanism highlights the 'interest rate channel' through which monetary policy operates on the rest of the economy.

A monetary contraction will shift aggregate demand (AD) to the left.

Fiscal policy and inflation

Fiscal policy attempts to alter aggregate demand through taxation, government spending, and borrowing.

Fiscal policies target components of aggregate demand (household spending (C), investment spending (I), government spending (G) and 'net exports' - exports, less imports, X - M) in order to achieve specific policy objectives.

In the case of inflation, if excessive household spending is identified at the major cause of inflation, then an increase in income tax would be the chosen instrument.

It should be noted that increasing tax (though unpopular) is easier to accomplish than reducing government spending (which is not a 'quick fix').

Fiscal policy options

While monetary policy is generally preferred to fiscal policy in terms of stabilising prices, changing tax rates or levels, and changing government spending may be used to supplement monetary policy at certain times. The options available are shown below:

Discretionary fiscal policy can be used to supplement automatic stabilisers when the trade (or business) cycle goes through more extreme periods than would normally be expected.

Automatic stabilisers

In contrast to discretionary policy, automatic stabilisers (often just called 'stabilisers') are 'built-in' to the tax-benefits system through the use of 'progressive' taxation and welfare benefits. Stabilisers are like a 'background app' running 'behind' the economy and automatically adjusting aggregate demand without any deliberate decision-making.

Stablisers work in two ways - either through ‘fiscal drag’ which slows down the economy, or through ‘fiscal boost’ which speeds it up - these two processes work to regulate the business cycle to avoid the extremes of activity which can lead to significant economic problems. (Read more on fiscal drag and boost).

In recent years more emphasis has been placed on the use of fiscal policy - mainly because of the weak effect of monetary policy when interest rates are at a virtual zero.

This is especially true in recent months following the Covid-19 pandemic when a fiscal stimulus is more appropriate than a monetary stimulus. In late March 2020, the US Senate approved a stimulus package of around $2 trillion, while in April Japan agreed an $1 trillion stimulus package and India agreed a $260 billion package. In the face of a crisis such as the Covid pandemic, monetary policy may have little effect, and supply-side policy will take too long to have an impact - hence a fiscal stimulus has clear advantages over possible alternatives.

Supply-side policy and inflation

Supply-side policies are designed to improve the performance of an economy through the use of:

1. Incentives to increase productivity, and:
2. Measures to increase competition in markets to improve efficiency.

Features of supply-side policy

Supply-side policies can influence both the microeconomy and the macroeconomy. In terms of macroeconomic performance, supply-side policy became an important policy tool in the early 1980s when economists and policy makers began to question whether fiscal policy alone could achieve key macroeconomic objectives.

Supply-side policies include a range of measures designed to improve productivity and efficiency, including:

The effects of supply-side policy on inflationary pressure

With an effectively working labour market, and increased competition in the economy, factors of production will be used more efficiently. This is likely to reduce upward pressures on prices, as can be shown diagrammatically.

Supply-side policy may increase productivity and reduce short run costs

Criticisms of supply-side policy

Supply-side policies have their critics, especially in terms of their potential effect on equity - for example, measures to control trade union powers and to reduce welfare benefits are likely to impact most on the poorest and widen the gap between 'rich and poor'.  This is often referred to as the efficiency versus equity conflict - policies to improve efficiency may increase inequality and relative poverty. (Read more on the equity-efficiency trade-off).

Supporters of supply-side improvements point to the fact that supply-side policy improves employability and reduces unemployment - a major cause of poverty and inequality.

Also, critics argue that supply-side measures often take a very long time to have an effect, and because of that cannot deal with short term shocks, like the financial crisis and the COVID-19 pandemic. In the case of the pandemic, tax increases in the short run are inevitable to cover the cost of furlough schemes, losses in tax revenue, and increased public spending on healthcare.

However, these policies rely on the government being able to fund them.

Deflation

Deflation is defined as a general fall in the level of average prices. Falling prices are regarded as a significant macroeconomic problem as it is associated with other problems, including unemployment, falling national income, and a decline in living standards.

Deflation can originate from both the demand and supply side.

Benign and malign deflation

Benign deflation

'Benign’ deflation is caused by improvements in production and supply which lower costs and shifts the short run aggregate supply curve to the right. As its name suggests, benign deflation is not particularly problematic as it can provide a stimulus to consumption, and growth, and is associated with increased efficiency. The application of new technology can be a trigger for sustained reductions in average prices.

Given that improvements in technology are gradual, it is unlikely that benign deflation will bring with it the kind of problems associated with malign deflation.

Malign deflation

Deflation can also be ‘malign’ - caused by a reduction in aggregate demand. This is problematic as falling aggregate demand is likely to reduce employment and spending and cause a recession. It will also reduce tax revenues to government, as well as increase government spending on unemployment benefits. This can worsen public sector finances requiring increased borrowing or raising taxes in the future.

In general, an extended period of deflation is problematic as it tends to mean that consumption is deferred as consumers wait for prices to fall further.

Deflationary spiral

The two types can occur together in a deflationary spiral.

Deflation is a relatively rare phenomenon in the modern era, given that central banks target their monetary policy specifically to achieve low levels of inflation (usually around 2%). This means that monetary policy is, by default, mildly inflationary in its effect, and any episode of falling average prices would bring into play a fiscal stimulus to support 'expansionary' monetary policy.

Deflation is closely associated with rising and persistent unemployment, both as a symptom of deflation and as a cause of it. Along with unemployment comes the likelihood of rising poverty and inequality.

Deflation and deferred consumption

A period of deflation is likely to become embedded given that the most significant effect of falling prices is, perhaps, that it encourages consumers to defer their current consumption in the hope that goods will get even cheaper in the longer run.

Deflation can be dealt with by expansionary monetary or fiscal policy.

Monetary policy and deflation

In terms of monetary policy, reducing interest rates is the 'go-to' option chosen by central banks. However, as rates have approached zero, other monetary instruments have been used, including quantitative easing.

Quantitative easing is more formally called asset purchasing, which gives a better clue about how it works. Essentially, central banks purchase financial assets (largely bonds) from the financial or corporate sector and pay for them with highly liquid assets. This, in turn, increases the value of assets and reduces the yield on these assets, which encourages fund holders to invest in other assets, such as shares.

This raises optimism and encourages spending across the economy. The effect is that aggregate demand will increase through a positive wealth effect. The intention is to prevent prices from falling.

Fiscal policy

From a fiscal perspective, expansion of the economy to prevent deflation requires a net injection of aggregate demand through a reduction in withdrawals (such as reduced income tax) or an increase in injections (such as increased government spending).

Assessment of policies

Monetary policy

The major advantages of monetary policy to tackle inflation and deflation:

1. Monetary policy has a 'proven' effect on the price level - interest rates affect many components of AD.
2. Rates can be changed quickly - most central banks have a regular point at which they make decisions - in most cases, at least once a month.
3. Unlike fiscal policy, monetary policy decisions are usually made independently from political interference.

The major disadvantages of monetary policy:

1. One of its key strengths is also a weakness! The fact that change in policy have wide-ranging effects on many components of AD also means that there is a potential for conflict. For example, raising rates to curve inflationary pressure also acts as a deterrent to private sector investment.
2. There is a lower limit to the level that interest rates can drop - a reason why quantitative easing was introduced.
3. Monetary policy cannot easily be targeted - unlike fiscal policy. An increase in interest rates affects all economic agents, and this may reduce equity.
4. The transmission mechanism may be slow to work - perhaps up to 18 months from policy change to effect on the price level.

Fiscal policy

The major advantages of fiscal policy to tackle inflation and deflation:

1. Fiscal policy can operate automatically - through automatic stabilisers.
2. This can be supported with discretionary tax or spending changes (a 'fiscal boost' or 'fiscal break').
3. Money can go directly into the pay-packets of consumers to increase spending power (or can be taken out to reduce spending power).
4. Fiscal policy can be progressive in its impact, improving equity.

The major disadvantages of fiscal policy:

1. Public sector finances are a constraint against a loosening of fiscal policy.
2. Tightening fiscal policy by raising taxes can create a disincentive effect.
3. Increases in public spending take a long time to have an effect.

Supply-side policy

The major advantages of supply-side policy to tackle inflation and deflation:

1. Supply-side policy has far fewer conflicts - generally, all macroeconomic objectives can be achieved.
2. It offers a longer-term solution to the problem of unstable prices.

The major disadvantages of supply-side policy:

1. Supply-side policy takes a long time to have any effect - the long time lag means that it is not always easy to track exactly how the economy benefited.
2. It is also expensive to undertake.
3. Certain supply-side policies affecting the labour market can create uncertainty for workers and increase inequality - at least in the short run.

In conclusion, dealing with inflation and deflation presents policymakers with difficulties. Whichever policy is chosen there is no guarantee that the behaviour of economic agents will adjust. With inflation, tighter fiscal and monetary policy might not work as individuals may compensate by running down their savings. In terms of deflation, consumer pessimism may be difficult to shift.