where \$Pt\$ is the price level in the current period and \$P{t-1}\$ is the price level in the previous period.
3. Main Causes of Inflation
Demand‑pull inflation: Aggregate demand (AD) exceeds aggregate supply (AS) at the existing price level.
Cost‑push inflation: Increases in production costs (e.g., wages, raw materials) shift AS leftward.
Built‑in inflation: Expectations of future price rises lead to wage‑price spirals.
4. Government Tools to Achieve Low Inflation
4.1 Monetary Policy (Central Bank)
The central bank influences the money supply and interest rates.
Interest‑rate policy: Raising the policy rate makes borrowing more expensive, reducing consumption and investment.
Open‑market operations: Selling government securities withdraws liquidity from the banking system.
Reserve requirements: Increasing the reserve ratio limits banks’ ability to create loans.
4.2 Fiscal Policy (Government)
Fiscal measures affect aggregate demand directly.
Reducing government spending: Cuts in public expenditure lower AD.
Increasing taxes: Higher income or indirect taxes reduce disposable income and consumption.
4.3 Supply‑side Policies
These aim to increase productive capacity, reducing cost‑push pressures.
Improving labour market flexibility (e.g., training programmes).
Encouraging competition and deregulation.
Investing in infrastructure and technology.
5. Summary Table of Policy Instruments
Policy Area
Instrument
Typical Effect on Inflation
Potential Side‑effects
Monetary
Increase policy interest rate
Reduces AD → lower inflation
Higher unemployment, slower growth
Monetary
Open‑market sale of securities
Reduces money supply → lower inflation
May tighten credit conditions
Fiscal
Increase income tax
Reduces disposable income → lower AD
Reduced consumer spending, possible recession
Fiscal
Cut public spending
Directly lowers AD → lower inflation
Potential cuts to essential services
Supply‑side
Labour market reforms
Increases AS → eases cost‑push pressure
Short‑term disruption to workers
Supply‑side
Investment in technology
Boosts productivity → lower long‑run inflation
Requires time to realise benefits
6. Effectiveness and Limitations
While the above tools can help control inflation, they are not without constraints:
Time lags: Monetary and fiscal actions may take months or years to affect price levels.
Policy conflicts: Measures to curb inflation (e.g., higher rates) can conflict with goals of full employment.
External shocks: Oil price spikes or exchange‑rate movements can cause inflation that domestic policy cannot fully offset.
Political pressure: Governments may be reluctant to raise taxes or cut spending before elections.
7. Suggested Diagram
Suggested diagram: AD–AS model showing a leftward shift of AD (fiscal tightening) and a leftward shift of AS (cost‑push inflation). Label the equilibrium points before and after policy action to illustrate impact on price level and output.
8. Key Take‑aways
Stable prices protect the value of money and support economic confidence.
Inflation is measured primarily by the CPI and expressed as a percentage change.
Governments use monetary, fiscal, and supply‑side policies to keep inflation low.
Each instrument has trade‑offs; effectiveness depends on timing, external conditions, and political will.