Causes of inflation are many and varied. Monetarists and classicists blame on an increase in money supply that results in an increase in aggregate demand.
Keynesians, on the other hand, do not attach any importance to the monetary factors. To them, inflation is caused, of course, by an increase in aggregate demand (C + I + G + X – M).
Basically, these two arguments for inflation lead to demand management policies. Demand management policies may be broadly grouped into (i) monetary policy, and (ii) fiscal policy. However, inflation is also caused by cost-push factors. Often prices and incomes policy are suggested to control this type of inflation.
In fact, inflation in an economy is a mixture of demand-pull and cost-push factors. Thus, for controlling inflation, policymakers employ three methods: (i) monetary measures; (ii) fiscal measures; and (iii) non-monetary measures. In advanced countries, indexation method is sometimes employed as an anti-inflationary devise.
(i) Monetary Measures:
Monetary policy is the policy employed by the central bank to alter the cost of credit, demand for credit and the availability of credit. It is also known as the credit control policy.
A central bank has the following instruments of credit control at its disposal to influence the demand, cost and availability of credit or the country’s money supply:
(a) Bank rate,
(b) Open market operations,
(c) Variable cash reserve ratio, and
(d) Selective methods of credit control.
The stabilisation policy of the central bank requires a ‘dear money policy’ with the intention of reducing aggregate demand. In order to fight inflation, the central bank increases bank rate, conducts open market sale of bonds and securities, increases the minimum cash reserve ratio.
All these measures make bank credit more costly. Higher cost of credit makes less availability of credit and, hence, less money supply. These have the potentiality of contracting aggregate demand. Since all these measures reduce the credit-creating potentiality of commercial banks, aggregate private spending gets reduced and inflation is thereby controlled.
Finally, central bank employs selective credit control when any particular sector(s) rather than the entire economy experience inflationary price rise. However, this instrument is effective mainly in controlling consumption spending.
However, there are some limitations of the monetary policy that restrict its effectiveness. First, monetary policy affects aggregate demand only indirectly, i.e., by raising interest rate and reducing money supply. Thus, its efficacy can only be felt after a time lag. Secondly, not all types of aggregate spending are influenced by monetary control weapons.
If public spending rather than private spending constitutes the bulk of aggregate demand, monetary policy measures will be of little use. Public spending is not easily amenable to control by central banking policies. Thirdly, monetary policy can combat demand-pull inflation rather successfully, but cost-push inflation is not subject to central banking control. High wages or hike in prices of raw material, etc., generate cost-push inflationary tendencies. Bank rate, open market operations and other instruments of credit control have no answer to cost-push inflation. In view of these limitations, other policy measures are used. The most important of these is fiscal policy measures.
(ii) Fiscal Measures:
Fiscal policy measures comprise the policy of the government relating to taxation, expenditure and borrowing. These three elements of fiscal policy influence aggregate spending. Contractionary fiscal policy is recommended during inflation. We know that the bulk of aggregate spending is derived from government spending. During inflation, government spending may be reduced.
However, due to some political reasons or economic compulsion, cut in public spending may be difficult. However, unproductive public expenditure must be controlled. Often, modern governments have the tendency to spend more to please the voters without bothering about the impact of inflation that may fall upon the society badly. In fact, control of expenditure is one of the important solutions to inflation.
When a country is exposed to inflation, the government may raise both direct and indirect taxes to wipe out excess aggregate spending. Once a tax on income and/or wealth is imposed, disposable income gets reduced. This will greatly reduce private aggregate spending. However, in reality, a government may be reluctant in raising the rates of taxes since taxpayers may vote out a government from power.
In order to mop up excess purchasing power at the time of inflation, the government may resort to borrowing from the public by selling government bonds.
Fiscal policy, like monetary policy, is not faultless. It is exposed to certain limitations. First, the fiscal policy and politics go hand in hand in the sense that fiscal policy is never taken in a political vacuum. Political compulsions greatly reduce its effectiveness. Secondly, injudicious use of tax-expenditure programme may not yield desired results.
An increase in income tax reduces disposable income and, hence, consumption spending. But increase in tax rates causes rates of saving and capital formation to decline. Further, a cut in transfer payments like food subsidy programme to poorer persons or unemployment allowance, etc., may seem to be unwise during inflation though such expenditures are required to be curbed.
Before we conclude the effectiveness of monetary policy and fiscal policy measures, we must say that even the best combination of these two policy measures may not yield desired results. What is required for the effectiveness of these policy measures is ‘good timing’. In addition, it is well-nigh impossible to achieve a right blending of monetary and fiscal policy measures to influence aggregate spending because of many reasons.
First, we cannot say definitely whether aggregate demand is really rising or falling. No economy does own a ‘speedometer’ that can tell how fast the aggregate demand is growing—’We find out what GDP is doing during the current quarter only at the end of the quarter’. Even then such figures are tentative and subject to revisions. Above all, stabilisation policy is necessarily based on forecasting and short term economic forecasting may be an art, but not an exact science.
(iii) Non-Monetary Measures:
The permanent solution towards inflation should be an increase in output since inflation is caused by the excess aggregate demand over available output. By shifting resources of the country from the unproductive to the productive sectors, output can be increased. Technological improvement may also lead to higher output. Secondly, by controlling wages and other allowances, inflation of cost-push variety can be checked. Thirdly, price control cum rationing of essential commodities may also be recommended as short run measures.
In addition, corrupt and inefficient administration often blunts the efficacy of various anti- inflationary measures. The activities of black marketers, speculators, hoarders, etc., are to be dealt with severely since their activities basically provoke inflation.
An indexation—sometimes called index- linking—method is recommended to combat inflation, rather reducing it. This policy works by linking money payments (such as wages and salaries) to an index of price inflation so as to maintain purchasing power at the same level. This means that if the price index rises by 7 p.c., money wages would also increase automatically by the same percentage. Wage- earners, under the circumstance, will not experience any reduction in their purchasing power. However, with indexation, not only wage earners but also creditors are protected.
Indexation method is considered to be a less popular method as it is itself inflationary in character. Indexation may be desirable only when high inflation rates prevail.
In conclusion, we must say that the control of inflation remains a multi-pronged attack. A particular policy cannot yield the best results. In other words, to control inflation the argument that only monetary policy or only fiscal policy matters is utterly wrong. These anti-inflationary measures must be used simultaneously so as to obtain the best result.
These policy measures should not be viewed as competitive; rather, they are complementary to each other. All of them should be used together. Such an approach is known as ‘package deal approach’.