Monetary Policy - Inflation - Cures

Theory 3 - Demand-side policies - how can we be less demanding?

It is universally acknowledged that if the level of demand in the economy grows too fast, then this may cause inflation. This is shown in the diagram below. As aggregate demand shifts to the right, the price level increases - inflation.

So if we want to control demand-pull inflation, we have to control the level of demand. If demand is growing too fast this means putting in place deflationary policies. Think of the economy as a balloon. If there is too much air in the balloon, it will be at risk of bursting, so you need to deflate it a little. The same is true of the economy. Deflationary policies reduce the level of demand in the economy, and so avoid the dangers of the economy bursting (with the inflation and balance of payments problems that go along with that).

So what demand-side policies are available? It is possible to use both fiscal and monetary policy to influence demand. Fiscal policy changes are in the hands of the government and Chancellor, whereas since 1997, monetary policy is now in the hands of the Bank of England.

Fiscal policy

Fiscal policy is the use of government expenditure and taxation to influence the economy. It can be used as both a demand-side and supply-side weapon, but here we are focusing on its use to reduce demand. To reduce aggregate demand, the government somehow has to spend less itself or use its tax-setting powers to persuade other people to spend less. That way consumption (a key component of aggregate demand) is reduced. So, deflationary fiscal policies might include:

• Cutting government expenditure (e.g. on defence, education, health, social welfare payments and so on)
• Increasing the level of income tax (to reduce people's disposable income, and therefore their purchasing power)
• Increasing indirect taxes (VAT, petrol, cigarettes and so on)

Monetary policy

Interest rates are the main weapon of monetary policy. Increasing interest rates will have a variety of effects on aggregate demand. Remember that aggregate demand includes all spending in the economy, and so is made up of:

Aggregate Demand = C + I + G + (X-M)
(where C is consumption, I is investment, G is government expenditure, X is exports and M is imports)

Let's look at the effects of interest rates on each component. People who have borrowed money (including those with mortgages on their houses) will find that their loan payments have increased. This leaves them less money to spend on other things, and so reduces the level of consumption.

Firms will be affected as well. To fund their investment plans, and often their everyday spending, they borrow money. They too will face higher repayments and so may find many investment projects less profitable. This will reduce investment.

Even governments don't get away with the effects. Governments are also borrowers. They have to pay interest on the National Debt, and so an increase in interest rates will raise the cost to them of servicing that debt. This may mean a trade-off with other spending - they may have to cut spending on some other public service.

Higher interest rates may attract more overseas investment into the UK. This will lead to an increased demand for sterling and may lead to an appreciation in the exchange rate. This could adversely affect exports and lead to a further fall in aggregate demand.