Contractionary fiscal and monetary policies cut demand-pull inflation; supply-side policies and a stronger currency ease cost-push inflation.
For demand-pull inflation, the government can use contractionary fiscal policy: raise taxes or cut its spending. Total demand falls, easing the pressure on prices.
The central bank can raise interest rates or reduce the money supply. Borrowing becomes dearer and saving more rewarding, so spending falls. A rise in the exchange rate makes imports cheaper, which also lowers prices.
For cost-push inflation, cutting demand works less well and can raise unemployment. Supply-side policies that raise productivity lower costs per unit over time. A stronger currency reduces the cost of imported raw materials.
Each policy has costs. Cutting demand can slow growth and raise unemployment. Supply-side policies are slow. A stronger currency makes exports dearer.
- Demand-pull
- Raise interest rates, raise taxes, cut government spending.
- Cost-push
- Supply-side policy, stronger currency.
- Trade-off
- Cutting demand can raise unemployment and slow growth.
Worked example: Matching the policy to the cause
Compare two inflation problems.
- Country A: a spending boom near full employment is pushing prices up. Raising interest rates or taxes to cool demand fits this demand-pull inflation.
- Country B: imported fuel and food prices are rising sharply. Cutting demand would cost jobs without fixing the cause.
- For country B, a stronger currency to cheapen imports, plus help for firms to raise productivity, fits cost-push inflation better.
Watch out for this
Raising interest rates is always the best way to fight inflation.
It works well against demand-pull inflation. Against cost-push inflation it can push up unemployment without tackling the rise in costs.
Check your understanding
Which policy is most suitable for demand-pull inflation?
- Raising interest rates
- Cutting income tax
- Lowering interest rates