Are higher interest rates the only tool for managing inflation? 

Many countries around the world are currently experiencing above normal rates of inflation. The general response to this situation has been to raise interest rates. However, a good case can be made that other policy responses should also be considered.

What is inflation and why is it a problem? 

Inflation is a general rise in prices. This necessarily decreases the purchasing power of money. This is understood to be a problem because it generates winners and losers, creates uncertainty, and has various adjustment costs. 

Inflation is usually measured via changes in a consumer price index (CPI) which tracks the cost of a basket of goods and services that is understood to represent the purchases of an average household. That said, there are other types of inflation such as asset price inflation, which central banks – rightly or wrongly – are usually far less concerned about. 

What is the traditional explanation of inflation? 

To this day, many textbooks persist in saying that ‘inflation is the result of the government printing too much money.’ At the bottom of such explanations are two ideas. The first is that inflation starts with an increase in money which then causes an increase in prices. The second idea is that the government – via its central bank – can control the amount of money in the economy. 

What is wrong with the traditional explanation? 

One of the key problems with the traditional explanation of inflation is that central banks have great trouble even measuring the amount of money in the economy, let alone controlling it. Indeed, most central banks gave up trying to target the amount of money in the economy decades ago. Instead, they target the price of money. In other words, they target a particular interest rate. So, central banks set the price of money in an economy, rather than set the amount of money in an economy. 

Of course, the price of money that the central bank sets will influence the amount of money created. However, other factors also have an influence, perhaps far greater than that of the rate of interest. So, interest rates might have to be raised quite high to have their intended effect. This raises the risk that high rates of interest will choke off investment and/or consumption, triggering an economic downturn. High interest rates are also likely to cause hardship for some groups and leave others relatively untouched. 

Another issue with the traditional explanation of inflation is that there is much to indicate the inflation can often start with a rise in prices which then induces an increase in the amount of money in the economy. So, causation can run from prices to money rather than from money to prices à la the traditional explanation of inflation. 

Is this alternative account of the relationship between inflation and money plausible? Well, we have already examined how difficult it is to control the amount of money in the economy. Indeed, money is constantly being created and destroyed across the economy. Most of this money is not in the form of cash but is instead credit money that exists as a matching set of debits and credits held between different actors. However, this credit money is very real. For example, any solvent bank will be able to pay out any credit money liabilities it has towards you in real cash upon request.  

It may help at this point to put yourself inside a story. Imagine, prices at the supermarket have gone up and to buy the food you are accustomed to, you resort to going into debt on your credit card. By doing so you have created money. At some unknown point in the future – perhaps in many months’ time – you will pay off your credit card debt and that money will be destroyed. However, in the meantime, you have increased the stock of money in the economy. This is but one example of how actors across the economy can increase the money supply as they respond to higher prices. 

Okay, but what causes prices to rise? There are several potential causes. You have to carefully evaluate each inflationary situation to try and determine which cause (or causes) are at work. 

The most general explanation of inflation presents it as a conflict between different groups in society about the proper distribution of income. In other words, one group in society feels that they can (or they must) increase their prices and in response other groups in society retaliate by raising their own prices. For example, workers might ask for higher wages in response to firms increasing their prices. This gives rise to a type of arms race or inflationary spiral. It is important to note that these types of conflict can break out and persist even in the absence of excess aggregate demand or negative shocks to aggregate supply. Notice how in this explanation of inflation it is understood as a political and conflictual process rather than being a strictly technical, or even economic, matter. 

Let’s now get a little more specific about different types of inflation:  

• Cost-push inflation occurs due to some problem on the supply side of the economy. For example, bad weather causes a fall in agricultural yields raising the price of most foods, or a war disrupts the supply of oil and gas causing energy prices to skyrocket. The increase in these prices can cause other prices in the economy to rise. 
• Demand-pull inflation is due to demand across the economy outstripping the economy’s current capacity to meet this demand. 

What can be done? 

There are a range of options to respond to inflation. It is important to understand that the responses must be tailored to whatever factor (or factors) are causing the particular episode of inflation. There is no one size fits all response. 

• The traditional medicine of raising interest rates to manage inflation can be warranted in certain circumstances. Often the real issue is not whether this type of contractionary monetary policy should be used or not, but instead on how heavily it should be used. 
• If it is decided that the inflation is genuinely of a demand-pull nature, then there may be a case for raising taxes (i.e., using contractionary fiscal policy). This has a number of advantages over resorting to contractionary monetary policy. For example, the extra taxes could be returned to citizens (perhaps with interest) when the inflationary episode is over. 
• One might also use price controls, which could be combined with rationing as required to avoid shortages. This has often been done during wartime.
• Cost-push inflation can be managed via the establishment of buffer stocks. In the case of case of oil and gas, accelerating the transition to renewables might also be an option. 
• An incomes policy could be established where a government brokers an agreement between different groups in society to end or moderate an inflationary arms race. 

This short article is an all to brief examination of inflation. Much more needs to be said to do the topic justice. However, we have at least examined why the conventional textbook coverage of inflation is problematic and also flagged some alternatives to simply raising the rate of interest.