How Does the Government Control Inflation?
Created on 16 Apr 2022
Wraps up in 5 Min
Read by 5.5k people
Updated on 11 Sep 2022
A group of robbers entered the minting unit of a country. There were many people inside the unit. The group held all of them hostage. They stayed there for days and started printing money. They printed thousands of currency notes; then millions, then billions. Finally, they stopped at €2.4 billion. And escaped.
Does this sound familiar to you? I’m sure it does.
I just summarized two seasons of the Netflix show, Money Heist in 50 words. While we enjoyed the thrill of the show, have we ever wondered what happened to the country’s economy when a sum, this large, was printed and robbed of the royal mint?
If anything of the sort ever happened in the real world, wouldn’t there be hyperinflation? Wouldn’t it push the economy into a recession epoch? How would the government contain the matter?
Let’s find out today, shall we?
How do Government Decisions impact Inflation?
When we fall short of money, we simply cannot print more to compensate. This will lead to an even higher rate of inflation.
Inflation can be good. Inflation can be bad. There is no established inflation target as such, but experts believe a rate of 2% or below to be acceptable or healthy.
For the past 70 months, the annual inflation rate of India has been above 6%. This seems far away from the ‘established target’ of 2%.
There are many methods used to control inflation. While some of them prove to be beneficial, some may wreak havoc. Like, when the government decides to control inflation through wage and price controls, it could lead to people losing jobs and recession.
Methods to control Inflation
There are three measures through which inflation can be controlled by government policies and decisions. They are:
These measures are aimed at reducing money incomes.
👉The first of many measures that the government takes is to increase the interest rates. When interest rates increase, borrowing money becomes difficult. This in turn, decreases the demand in the economy which leads to decreased economic growth. Hence, rate of inflation decreases.
👉This brings us to our second point that money supply and inflation are directly linked. Inflation can be kept in control if the money supply in the economy is regulated.
👉The central bank can also start issuing government bonds and securities to commercial banks and encourage them to buy those. Once the banks buy the securities, they have lesser amount at their disposal to lend to the general public. This reduces the money supply in the economy and the inflation rate decreases.
This involves measures related to government revenue and expenditure.
👉Government can increase tax rates to generate more revenue and discourage expenditure of the common public.
👉During the demand-pull inflation, the inflation rate can be controlled by regulating public expenditure.
👉But during the cost-push inflation, the government takes decisions that impact the common public directly, like freezing wages of the workers, and putting an upper and lower limit on prices of important utility items such as electricity, coal etc.
The setting of minimum and maximum limits for some specific goods is called price control. It is done to increase the affordability of those goods. They are mostly applied in consumer staples like rent and gasoline. When it is practiced for a long period of time, it leads to other problems such as shortages, deterioration of product quality, rationing problems, and black markets for those goods.
Some other Government policies to control inflation
Apart from these measures, the government intervenes with some policies to stabilize the rising inflation rates. Since inflation is caused when expenditure rises at a rate that is more than expected, the government introduces the following policies to control the growth of money in the economy.
Open Market Operations (OMO)
When the central bank indulges in buying and selling of government securities in the open market with the intention of influencing the money supply in the economy, it is called open market operations. When there is inflation in an economy, the central bank sells more and more securities to reduce the money supply. The payment for these securities is made by the buyers through the money he holds in his account, i.e. the account with commercial banks. This reduces the amount of money commercial banks can lend to people.
The Rediscount Rate
This is essentially the bank rate, also called as the discount rate that the central bank charges for loans of reserve funds to commercial banks and other financial intermediaries. This rate controls the cost that banks pay to add more reserves. When inflation increases, the central bank increase this bank rate. This is passed on the customers of the banks in the form of more expensive loans. Thus, reducing the money supply.
Increase in Taxes
This is probably the easiest to understand and put to practice. Increased taxes mean people will have to spend more to buy the same quantity of goods they could before with lesser amount. This again, reduces the expenditure of common people and controls the money supply.
Increase the Reserve Requirement
The amount of money that the commercial banks are required to keep aside with the central bank is the reserve requirement. By increasing this amount, the central bank's aims to reduce the lending capacity of commercial banks.
Increase in Savings
When the government introduces attractive savings schemes, it encourages people to save more and spend it. This again reduces the money supply.
The Bottom Line
Inflation is inevitable. Without the presence of inflation, it would mean that the economy is not growing, which we do not want, do we?
But we should also be aware of the steps that the government takes which rate are on the rise so that we use our finances to the best of our ability.
Let us know in the comments below if there is anything you would like to know!
Till we meet again.
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