Higher interest rates will also cause a rise in mortgage interest payments for people on variable-rate mortgages (the same is true for those on fixed-rate mortgages, although there will be a time lag before their rates change). Homeowners will therefore have a reduced real effective disposable income, thus reducing consumption. Increased mortgage costs will also reduce market demand in the housing market. For example, the series of increases in interest rates from 5% in June 1999 to 6% by February 2000 helped to take some of the excess demand for housing out of the market and contributed to the slowdown in the rate of house price inflation during the summer of 2000. This is therefore another way in which higher interest rates reduce aggregate demand.
Lower interest rates, on the other hand, stimulate demand in the housing market, causing an upward pressure on house prices. This has the effect of increasing the wealth of homeowners, making consumers feel more confident about their personal finances. Homeowners, for example, may take out housing equity loans (added to their existing mortgage) to finance big ticket spending. Such behaviour will lead to an increase in consumer spending and therefore aggregate demand, possibly leading to demand-pull inflation. This is therefore another way in which interest rates influence inflation.
Lower interest rates might cause a depreciation of the exchange rate (due to speculative outflows of 'hot money' due to the relative increase in attractiveness of assets denominated in currencies other than sterling), thus raising the demand for exports. This will cause an increase in aggregate demand. In order to reduce inflation, interest rates can be risen which will cause an appreciation of the exchange rate, leading to a fall in the demand for exports and thus reducing aggregate demand. This is therefore another way in way in which demand-pull inflation in particular can be controlled by raising the interest rates.
A rise in interest rates will also cause the cost of borrowing funds for investment to increase, so some planned investment projects will become unprofitable. Since investment is a component of aggregate demand, aggregate demand will again fall due to a rise in interest rates.
The second type of inflation is cost-push inflation, which occurs when firms increase prices to maintain or protect profit margins after experiencing a rise in their costs of production. This type of inflation is not usually controlled by interest rates, but other policies such as incomes policies (which set limits on the rate of growth of wages) and supply side reforms can be used in conjunction with interest rate changes in order to control cost-push inflation.
Interest rates therefore have a big impact on the rate of inflation. An increase in interest rates results in a decrease in aggregate demand (although by how much partly depends upon the interest elasticity of demand for bank loans). Since excessive growth in aggregate demand is one of the main causes of inflation, interest rates and inflation are related. The interest rate is therefore a useful way of controlling inflation.
Discuss the role of monetary policy in controlling inflation.
Monetary policy plays an important role in controlling inflation. The main tool of monetary policy, short-term interest rates, is manipulated with the specific aim of achieving an inflation target (of 2.5%). As shown in the chart below, interest rates are under constant review in order to try and keep inflation under control. For example, in the late 80s, interest rates went up to 15% because of excessive growth in the economy. The interest rate is therefore an important way in which monetary policy is used to control inflation.
A contraction in the real money supply is another way in which monetary policy can be used to control inflation. A contraction of the money supply has the effect of shifting the aggregate demand curve to the left, since there is less money available for consumers to spend. This is therefore a way of reducing demand-pull inflation. The opposite of this occurred in the late 1980s during the 'Lawson Boom'. There was a sharp rise in the demand for credit and an explosion in house prices. The amount of money in circulation grew at alarming rates and caused excess demand in the economy. As a result, by the autumn of 1999, retail price inflation had climbed to 19.9%.
Monetary policy therefore has an important role to play in the control of inflation. There are, nevertheless, other methods of control which are used. Fiscal policy, for example, can be used. During periods when the economy is experiencing demand-pull inflation, the government can increase direct taxes, resulting in a fall in households' disposable income. This will reduce consumer spending, which will cause a fall in aggregate demand. The government can also cut its own spending, which will cause a fall in aggregate demand of which government expenditure is a component. Since excessive growth of aggregate demand is the cause of demand-pull inflation, fiscal policy can be used to curb inflation.
There are, however, problems associated with such demand management policies. The first is that they are largely impractical since there is a time lag involved before a tax comes into effect. It is therefore very difficult for the government to be able to quickly implement a tax, for example, to reduce inflation. In addition, such budget manipulation would mean that health care and other public goods would suffer a budget cut whenever the government wished to curb inflationary pressures.
Fiscal policy is nevertheless often used in conjunction with monetary policy. For example, during periods of inflationary pressure, interest rates may be increased and increases in government spending may be frozen. Such policies then complement one another and drastic fiscal measures are not needed. In addition, during periods of economic growth and inflationary pressures, tax revenues automatically increase (through increases in employment) and government spending is reduced (due to fewer transfer payments). Fiscal policy, therefore, automatically helps to reduce inflation. despite this, however, the automatic stabiliser on its own is not enough to keep inflation at bay and monetary policy remains central to the control of inflation.
Supply side reforms are long term policies partly aimed at controlling inflation. If a greater output can be produced at a lower cost per unit (i.e. if productivity is increased), then the economy can achieve sustained economic growth without inflation. Hence, an increase in aggregate supply is often the key long term objective of government economic policy. The benefits of an outward shift in the short-run aggregate supply curve are both an increase in real national income and a fall in the average price level:
productivity gains help to control unit labour costs, which are an important cause of cost-push inflation, and so put less pressure on producers to raise their prices. Supply side policies designed to improve productivity may include education and training schemes.
Supply side policies are therefore an important way of controlling inflation, but they are, like fiscal policy, used in conjunction with monetary policy. Supply-side policies on their own are unlikely to keep inflation at bay. However, they have resulted in a 'new ' where economic growth and low inflation seem to be able to co-exist in the economy.
Monetary policy is therefore an important tool in controlling inflation. Other policies are also used, however, such as fiscal policy and supply side policies, but these on their own are usually problematic, often giving rise to policy conflicts. Supply side policies are important ongoing measures which help to reduce the price level, particularly through controlling cost-push inflation. Monetary policy, however, is currently the main method of controlling demand-pull inflation.
