STOPPING INFLATION

The key instrument through which governments and central banks seek to control inflation is through the setting of interest rates, which determine the growth of the overall supply of money. A secondary effect of interest rate changes is their impact on employment and production levels, which have an inverse relationship with prices. However, different central banks often have differing policies when it comes to how they seek to control inflation. For example, the European Central Bank controls inflation only when it gets too high, while others follow what is known as a symmetrical inflation target.

Not surprisingly, economists also differ as to their recommendations regarding the best ways to control inflation. While monetarists advocate the use of monetary policy to influence the supply of money, Keynesians advocate the use of fiscal policy to reduce the demand for money instead. Also, supply-side economists recommend fixing the exchange rate to a relatively fixed form of value such as gold, or by lowering tax rates within economies with floating currencies to encourage saving and investment. These policies are known as Open Market Operations, since they require the central bank to directly intervene in the global financial markets.

While these methods can be seen as fairly sophisticated, a simpler way of combating inflation is by fixing wage and price levels – a policy implemented in the US in the 1970’s. However, these policies were undermined quickly by the fact that at the time, economic stimulus measures were being applied under the Nixon Administration, bringing attempts to limit the supply-side of the economy in conflict with attempts to boost the demand-side. In general, therefore, most economists agree that government intervention in the setting of prices lead to distortions within the economy – although these costs may be a price worth paying if they succeed in avoiding a serious recession for example.