There are two ways of controlling inflation in an economy:
- Monetary measures
- Fiscal measures
- Monetary Measures
- Bank rate policy
- Cash reserve ratio
- Open market operations
- Fiscal Measures
- Price Control
The government of a country takes various measures and formulates policies to control economic activities. Monetary policy is one of the most commonly used measures taken by the government to control inflation. Here, the central bank increases the interest rate on borrowings for commercial banks. As a result, they increase their rate of interests on credit for the public. Hence, individuals prefer to save money instead of investing it. This reduces money supply in the market, which, in turn, controls inflation. Also, the central bank reduces the credit creation capacity of commercial banks to control inflation.
Monetary measures used to control inflation include:
Bank Rate Policy: This policy is used as the main instrument of monetary control during inflation. When the central bank raises the bank rate, it leads to increase in the cost of borrowing which in turn reduces commercial banks borrowing from the central bank. Consequently, the flow of money from the commercial banks to the public gets reduced. Thus, inflation is controlled to the extent it is caused by the bank credit.
Cash Reserve Ratio (CRR): To control inflation, the central bank increases the Cash Reserve Ratio, which reduces the lending capacity of the commercial banks. Hence, flow of money from commercial banks to public reduces. In the process, it stops the rise in prices to the extent it is caused by banks credits to the public.
Open Market Operations: these refer to purchase and sale of government securities and bonds by the central bank. To control inflation, central bank sells the government securities to the public through the banks.
Besides the monetary policy, the government also uses fiscal measures to control inflation. The two main components of fiscal measures are government revenue and government expenditure. In fiscal policy, the government controls inflation by either reducing private spending, or by reducing government expenditure, or both.
It reduces private spending by increasing taxes on private businesses. When private spending is more, the government reduces its expenditure to control inflation. However, in the present scenario, reducing government expenditure is not possible because there could be certain on-going projects for social welfare that cannot be cancelled or postponed.
Apart from this, the government expenditures are essential for other areas, such as defence, education, health and law and order. In such a case, reducing private spending is more preferable rather than reducing government expenditure. When the government reduces private spending by increasing taxes, individuals decrease their total expenditure.
For example, if direct taxes on profits increase, the net disposable income would decrease. As a result, the total spending of individuals reduces, which, in turn, decreases money supply in the market. Therefore, during inflation, the government reduces its expenditure and increases taxes for dropping private spending.
Another method for ceasing inflation is preventing any further rise in the prices of goods and services. Here, inflation is suppressed by price control, but cannot be controlled in the long run. In such a case, the inflationary pressure in the economy is not exhibited in the form of increase in prices for a short time. Such inflation is called suppressed inflation. Historical evidences have shown that price control alone cannot control inflation, but only reduces the extent of inflation.