The range of policies available to control inflation and their effectiveness

Inflation – Definition and Measurement

Definition (Cambridge IGCSE 0455 4.7.1)

Inflation is a sustained rise in the general price level of goods and services in an economy over a period of time. It is expressed as the percentage change in a price index (usually the Consumer Price Index, CPI). Deflation is not required for the 2027‑29 syllabus.

How Inflation Is Measured (4.7.2)

  • Consumer Price Index (CPI) – the standard measure.

    • A basket of goods and services is selected to reflect the typical consumption pattern of households.

    • Each item is given a weight according to its share of total household expenditure.

    • The price of the basket in the current period is compared with the price in a chosen base year.

  • Formula (percentage change)

    \$\pi = \frac{CPI{t}-CPI{t-1}}{CPI_{t-1}}\times 100\%\$

    where π = inflation rate, t = current period, t‑1 = previous period.

  • Worked example

    If the price of the CPI basket was 120 in month 1 and rises to 126 in month 2, the inflation rate is:

    \$\pi = \frac{126-120}{120}\times100\% = \frac{6}{120}\times100\% = 5\%\$

Why Controlling Inflation Is Important (AO1)

  • Preserves the purchasing power of money.

  • Reduces uncertainty for households and businesses, encouraging investment and saving.

  • Maintains confidence in the national currency and the credibility of economic policy.

  • Prevents the economy from overheating and the risk of a boom‑bust cycle.

Causes of Inflation (4.7.3)

  • Demand‑pull inflation – Aggregate demand (AD) grows faster than aggregate supply (AS).

    Example: A surge in consumer confidence leads to higher spending, shifting AD rightwards.

  • Cost‑push inflation – Rising production costs (wages, raw materials, oil) shift the short‑run AS curve leftwards.

    Example: A rise in global oil prices raises transport costs for most goods.

Additional (extended) causes – useful for evaluation (AO3):

  • Built‑in (wage‑price) inflation.

  • Monetary inflation (excess growth of the money supply).

Consequences of Inflation (4.7.4)

Group AffectedTypical Consequence
SaversReal value of money falls – purchasing power erodes.
BorrowersBenefit if interest rates are fixed – real debt burden falls.
Lenders (banks)Real returns fall unless interest rates rise.
ConsumersHigher living costs; may cut discretionary spending.
WorkersDemand higher wages (built‑in inflation) to keep up with price rises.
Producers/FirmsUncertainty about input costs; may delay investment.
Economy as a wholeIncreased uncertainty, possible overheating, and reduced international competitiveness.

Policy Options to Control Inflation (4.7.5)

1. Monetary Policy (Supply‑side of Money)

Implemented by the central bank; the quickest tool for tackling demand‑pull inflation.

  • Interest‑rate policy – Raising the policy (repo) rate makes borrowing more expensive, reducing consumption and investment.

  • Open market operations (OMO) – Selling government securities withdraws liquidity from the banking system, pushing market rates up.

  • Reserve‑requirement ratio – Increasing the ratio forces banks to hold a larger share of deposits as reserves, limiting loan creation.

2. Fiscal Policy (Government Spending and Taxation)

Directly affects aggregate demand through the government’s budget.

  • Contractionary fiscal policy – Reducing government spending or raising taxes lowers disposable income and AD.

  • Budget surplus – Collecting more revenue than is spent removes excess money from the economy.

3. Supply‑Side (Structural) Policies

Target long‑run determinants of the price level by improving productivity and competition.

  • Increase labour‑market flexibility (e.g., reduce trade‑union power, promote part‑time work).

  • Promote competition through deregulation and anti‑trust legislation.

  • Invest in education, training and technology to raise labour productivity.

  • Remove subsidies that distort relative prices.

4. Exchange‑Rate Policy

Relevant for small open economies. An appreciation of the domestic currency makes imports cheaper, putting downward pressure on import‑priced inflation.

5. Direct Controls (Price and Wage Controls)

Legal limits on the rate at which prices or wages can increase. Usually employed only in extreme situations.

Effectiveness of Each Policy Tool

Policy ToolTypical Time‑lag to ImpactPrimary MechanismShort‑run EffectivenessLong‑run EffectivenessMain Limitation
Interest‑rate increase (Monetary)6–12 monthsHigher cost of borrowing → lower consumption & investmentHigh – quickly cools demand‑pull inflationModerate – may slow growth if kept too highRisk of recession; less effective against cost‑push inflation
Open market sales (OMO) (Monetary)3–6 monthsLiquidity withdrawn from banks → higher market ratesHigh – immediate effect on money supplyModerate – depends on banks’ willingness to lendRequires credible, independent central bank; can affect exchange rates
Higher reserve‑requirement ratio (Monetary)6–12 monthsReduces banks’ capacity to create loansMedium – slower transmission than interest ratesLow – banks can circumvent with other funding sourcesCan constrain credit for productive investment
Contractionary fiscal policy (Fiscal)12–24 monthsLower government spending or higher taxes → reduced disposable incomeMedium – political decision‑making adds delayLow – fiscal stance may be reversed; impact on debtPolitical opposition; crowding‑out of private investment
Supply‑side reforms (Structural)2–5 yearsIncrease productive capacity & competition → lower cost‑push pressuresLow – long implementation lagHigh – sustainable price stability and higher growth potentialRequires structural change; benefits are not immediate
Exchange‑rate appreciation (Exchange‑rate)Immediate to 6 monthsCheaper imports reduce imported inflationMedium – depends on openness of the economyLow – may hurt export competitiveness and current‑account balanceLimited by capital flows; can lead to “Dutch disease”
Price / wage controls (Direct)ImmediateDirectly cap the rate of price or wage increaseHigh – short‑run impact on headline inflationLow – often cause shortages, black markets and loss of credibilityDistorts market signals; hard to enforce over time

Choosing the Appropriate Mix of Policies

  1. Monetary policy is the first line of defence against demand‑pull inflation because it can be adjusted quickly and is under the control of an independent central bank.

  2. Fiscal restraint (lower spending or higher taxes) can reinforce monetary tightening, especially when the government has fiscal space.

  3. Supply‑side reforms should run in parallel to address cost‑push pressures and to prevent a supply‑side “inflationary spiral”.

  4. Avoid over‑reliance on price or wage controls – they give only temporary relief and create market inefficiencies.

  5. Monitor the exchange rate in small open economies; a modest appreciation can help curb imported inflation without severely harming exports.

Potential Trade‑offs

  • Unemployment vs. Inflation (Phillips Curve) – Tightening policies may raise unemployment in the short run.

  • Growth vs. Price Stability – Aggressive anti‑inflation measures can slow economic growth.

  • Public Debt – Contractionary fiscal policy improves the inflation outlook but may increase the debt‑to‑GDP ratio if output falls.

  • Exchange‑rate stability vs. Export competitiveness – An appreciated currency reduces import‑price inflation but can hurt export‑driven growth.

Suggested Diagram for Exams

AD‑AS diagram showing a leftward shift of Aggregate Demand (AD) caused by contractionary monetary or fiscal policy. The economy moves from an inflationary equilibrium (point A) to a lower‑price, lower‑output equilibrium (point B).

Key Take‑aways

  • Monetary policy is the most flexible and quickest tool for tackling demand‑pull inflation.

  • Fiscal policy can support monetary actions but is slower and subject to political constraints.

  • Supply‑side measures are essential for long‑run price stability and for dealing with cost‑push inflation.

  • Direct price or wage controls may give short‑term relief but usually create shortages and distortions.

  • The effectiveness of any policy depends on the type of inflation, the openness of the economy, and the credibility of the institutions that implement it.