Inflation heresy mustn’t always be rejected out of hand

News: Inflation has been on the rise in most part of the world. This has once again started the debate on the best way to restore price stability. 

What are various strategies to deal with Inflation? 

Old/orthodox method-This involves the reduction in spending and raising of interest rates. But this method often has side effects (such as bankruptcies and rising unemployment) and not always produced the desired results quickly enough.  

Lowering the interest rates -This has been followed by Turkey 

The inflation-producing effects of high interest rates is called the ‘Cavallo effect’. This idea suggests that inflation is associated with cost-push factors, such as high interest rates, which boost the cost of working capital and thus make the production cost higher. 

Although this theory has received some empirical support but as seen in Turkey’s case despite lowering interest rates, market rates have continued to rise. It indicates that the inflation in Turkey is the result of more fundamental problems in economy. 

Price controls or by clamping down on large firms with price-setting power-These measures have sometimes worked for example in Israel in 1980s, Latin America. 

Temporary wage-price controls can help coordinate price-setters to move to a low-inflation equilibrium. It is useful when high inflation is driven predominantly by expectations rather than ‘fundamentals’.  

Why single strategy is not perfect? 

Economics is not a science with fixed rules. Different countries face varying conditions which call for different policies.   

Economics works contextually and not universally. 

What is the way forward? 

Currently, Inflationary pressure is the result of transitory set of factors, like the pandemic-related reallocation of spending from services to goods, and supply-chain and other disruptions to production. 

Transitory inflation calls for a restrained response, whether through regulation or the central bank’s exercise of monetary policy. This should not rely heavily on any one method. 

Source- This post is based on the article “Inflation heresy mustn’t always be rejected out of hand” published in Live mint on 14th Jan 2022 

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