The following points highlight the top two cures to control inflation in money market.
Cure # 1. Coping with Demand-Pull Inflation:
If the cause of inflation is an excess of aggregate demand over output, then the remedy would seem to be either increasing output or reducing demand.
It was noted earlier that demand inflation usually occurs when there is full employment, so there is only limited scope for increasing output. There is, therefore, a need to reduce aggregate demand.
One way of reducing aggregate demand is for the government to reduce its own expenditure directly. But, in doing this, some social and political factors are also to be taken into consideration. Should the government, for example, abandon plans to build a new hospital or road simply because this would help reduce inflation?
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By increasing taxation, the government could influence other components of aggregate demand — consumers’ expenditure and investment. Also, monetary measures could be used, e.g., restriction of bank lending and increasing interest rates.
Cure # 2. Coping with Cost-Push Inflation:
Demand-pull inflation is usually associated with full employment, but cost-push inflation may occur during periods of high unemployment. If there is ‘stagflation’, i.e., high unemployment and high inflation, then a reduction in aggregate demand in order to try to reduce inflation may make the problem of unemployment worse.
The remedy for cost-push inflation lies in some form of income policy.
One solution to ending the spiral of rising incomes and prices is to ensure that incomes rise at no higher rate than productivity. This is the aim of an income policy. In carrying out such a policy the government states at the beginning of each year the size of wage increases that can be given without causing an increase in prices — in the light of recent or expected increases in productivity. This figure is used to guide the trade unions and employers in their wage negotiations.
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The aim of a prices policy is to secure price stability. This is very difficult to achieve.
A price and income policy can be voluntary, or statutory, that is, the government enforces compliance on trade unions and employers. However, in a free society — where wages are settled by freely conducted collective bargaining and where trade unions are committed to retaining their freedom to negotiate on behalf of their members — the statutory enforcement of wage levels may not be a practical proposition.
Price control-cum-rationing is imposed in case of essential commodities to suppress the effects of inflation. But rationing and control is not possible in case of all commodities. There are certain disadvantages of this method of allocation.
First, prices in uncontrolled sectors rise disproportionately. Secondly, it prevents people from buying desirable goods and services and thus reduces incentives to work. Thirdly, it distorts consumer preferences and induces people to spend more on uncontrolled goods. Fourthly, black markets come into existence, and working of the free-market mechanism may be hampered. Finally, a considerable amount of manpower is kept blocked in administering the controls.
Indexation:
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If high inflation becomes a permanent feature of an economy, various groups will undertake measures which take this into account. For example, financial institutions will pay higher nominal interest rates in order to maintain the level of real interest rates. Also, the government will raise tax allowances, exemption limits, and transfer payments — such as pensions and unemployment benefit — in line with inflation. The automatic adjustment of payments, contracts, pensions, etc., to take into account inflation is known as ‘indexation’.