The Methods Open To a Government to Control the Rate of Inflation within an Economy - Essay Example

Introduction Inflation is defined as the reduction in the purchasing power of the consumers over the period of time. It is the measure of how the prices change/increase over the period of time. Inflation is a general rise in prices across the economy. This is distinct from a rise in the price of a particular good or service. Individual prices rise and fall all the time in a market economy, reflecting consumer choices and preferences, and changing costs. Inflation is considered as one of the vital economic variables because of its impacts on the economy as a whole. From impacting the savings to investment, there are lots of uses of inflation which are more negative in their impact on the economy of any country rather than having positive impacts on the economy. UK economy, in recent years have consistently shown an increasing trends as the inflation has remained as high as 4.8% in March 2007. (Moneyextra, 2008). This general increase in the price levels within the economy has resulted in the widespread economic measures both by the Bank of England an the UK government including the raising of the interest rates by Bank of England and other measures to curb the inflation in the economy. This essay will look into some of the measures which UK government can take to contain the inflationary pressures on its economy. Firstly, we will be exploring the historical trends in the inflation within the UK and then based on the findings, means and ways will be suggested to control the inflation in the economy. Inflation: Inflation is an economic concept which generally means a sustained increase in the general price levels of all goods and services. In layman language we can easily summarize inflation as the phenomenon which makes your money value less with each passing day as it erodes its purchasing power. Generally, inflation is measured through a consumer price index which usually measures the price changes in some predefined commodities of greater use by the consumers. These can include essential commodities like wheat, sugar, gasoline etc which are basically considered as very critical and are used by many. Based on the basket of these goods or even services, changes in price levels of this basket of goods and services are measured over the period of time usually taking or setting one particular year as a base year and all subsequent calculations are then based on this base year. There various types or rather variations of inflation. Deflation is that variation of inflation in which prices decrease rather than increasing thus works other way round. Deflation was a phenomenon mostly observed in era when gold based standards were prevalent in the world. Hyperinflation is extraordinarily high inflation. When a nation is experiencing hyperinflation, it means prices are increasing more than their historical normal rates and an abnormal behavior is rather witnessed in hyperinflation. Under very extreme cases, hyperinflation can result into the break up of the nation’s whole monetary system also. The last commonly known variation of inflation is called stagflation which is usually considered as a combination of high unemployment and stagnant economic growth. Stagflation was usually witnessed during 1970s era when OPEC oil embargo hit the western nations. Though the variations can be much but the reasons behind the inflation are very solid. One cause of inflation is demand pull. This theory is simply put in this way that there is very limited supply against ever growing demand. When demand increases and on the same hand supply do not than there is a very strong tendency that the price levels will increase because too many buyers will be chasing too few goods. The second cause of inflation is cost push inflation. When the costs of the inputs increase, the suppliers are usually forced to increase the price in order to keep their profit margins intact. This resulting increases in the inputs therefore makes goods more expensive to their producers hence that burden is finally transferred to the end user. UK Inflation – a historical perspective Historically, UK inflation till 2003 in recent past has remained low as compared to the other neighboring countries. This inflation was mainly contained due to positive economic growth in the recent past of the United Kingdom. However, until recently, there are growing trends in the inflation appearing within the UK economy eroding its purchasing power and impacting its real economic growth. During the year 2007, Inflation rates within the UK remained over 3.8% and were recorded as high as 4.8% in March 2007. This trend seems to be carrying into the New Year also as annual inflation in the month of January 2008 was recorded at 4.1%. The economic period preceding the new century i.e. 1990s also witnessed somewhat stable patterns in the inflationary figures over the decade. During early 1990’s, inflation remained low however it started to pick up during 1994 when it finally broke 2.5% mark for the inflation rate. (Moneyextra, 2008). Traditionally, Inflation has been measured through so called Harmonized Index of Consumer Prices which is now being changed to the Consumer Price Index by the National Statistics department. However whatever the measures of inflation be, there is a very growing evidence which clearly suggest that the inflation in the UK economy is clearly on the rise and if the pace of economic growth does not match with that of inflation there are strong chances that the UK economy may result into recession. How to contain inflation There are various ways through which the England government can contain or rather control the inflation within the economy. However these tools are used at different levels with their different impacts however the aim of all these tools is same i.e. to contain the inflation. The first line of defense available to the UK government is to correct its monetary policy. Since Bank of England is the sole authority in England to regulate the monetary policy it is therefore imperative that the first line of action be drawn from there. It has long being established that the central banks are one of the key players behind the control of inflation and also for the behavior of the inflation. (Hetzel, 2004). Therefore central bank being responsible for the regulation of monetary policy in the economy achieves its targets of controlling the inflation by raising the interest rates. The discount rates at which the Bank of England lend to various banks is considered as one of the explosive tool to regulate the inflation in the economy. First, central banks try to do that by raising the interest rates on short term securities like Gilts. By raising the interest rates, central bank actually wants to achieve the target that people start to perceive that getting the easy money in the form of bank retail credits will not be as simple and cheap as it used to be. By raising interest rates on these securities therefore make money more costly to acquire and borrow. And since when money will not easily be available to consumers, he will start to live under his norms and expectations. Second and more lethal tool available to the Bank of England is to do the Open market operations. Through open market operations central of England will mop up the extra liquidity inavailbe in the market hence purchasing the extra money from the banks, central bank basically try to bring down the money supply within reasonable level so that it can help contain inflation. Lastly through increasing discount rates, Bank of England can also contain the inflation within in the economy. An other way of doing to reduce cost push inflation specially is by direct intervention or Prices and Income Policy. This is when the government moves itself to control the wage rates in the economy and thus effectively the price levels. Through offering subsidies, Government of UK can restrict the free movement of prices according to the market forces. This so called direct intervention therefore is largely viewed with great suspicion by those who champion no role of government in the affairs of the economy. Direct intervention policies in the UK have not been used lately. Anyway, in the past they were quite usual. It was first used in 1945 and it was successful till 1950, but collapsed in inflation. Labour and Conservative governments promised not to use it before the election, but then were faced with rising inflation and finally had to. This playing continued for quite a while until in 1980-ies it was agreed that a long-term strategy should be worked out worked out. Direct intervention policy is more effective in short-term, but it stores up trouble for the future, because prices tend to rise rapidly as soon as the policy is abandoned. Conclusion Inflation is quite complex economic phenomenon as it requires a very cool head from the policy makers to contain and counter it successfully. Largely a result of economic growth, inflation can be controlled either by government itself through fiscal intervention or through monetary intervention through central bank. References: 1) Hetzel, Robert L, 2004,’how do central banks control inflation? Retrieved March 6, 2008 from http://www.richmondfed.org/publications/economic_research/economic_quarterly/pdfs/summer2004/hetzel.pdf 2) moneyextra,2008,’UK Inflation History’ retrieved March 5, 2008 from.http://www.moneyextra.com/dictionary/UK-Inflation-History-003663.html Read More