The government should try to set an official interest rate offered by banks to check the rate of inflation. Through forming the monetary policy. Monetary policy will reduce inflation through increasing interest rates and making a contraction in the real money supply (Christine and Alok,1995). This policy had worked in the United Kingdom in 1980s when interest rate went high to 15% because of the excessive growth in the economy and contributed to the recession of the early 1990s (William and Alan, 2006). The higher interest rates will bring the following benefits to the government.
First the higher interest rate will reduce aggregate demand by discouraging borrowing by both households and companies. The government should also increase the mortgage interest payment, as this will reduce homeowner’s real effective disposal income and their ability to spend. When the cost of mortgage in increased, there will be reduction in market demand in the housing market. Introducing high interest rates by government banks will lead to a decline in business investment. This is because the cost of borrowing funds will be high therefore few people will be in a position of affording this.
Some planned investment projects for instance will automatically be unprofitable resulting to a decline in aggregate demand. The government should also use the policy of increasing the high interest rates as a mechanism of limiting the monetary inflation. For example when the real interest rates is increased the demand for lending will go down leading to reduction in the growth of broad money. Fiscal policy The government should come up with fiscal policies to reduce demand-pull inflation. The policies include imposing higher direct taxes that will lead to a fall in disposal income.
The increase in taxes paid will regulate the spending of money by different people the country. This will reduce the demand for goods and services, which leads inflation. The government should also ensure that its spending is lowered down or downsized. People will not spend more money or the flow of money outside and within the country will be low. The policy on the reduction in the amount the government sector borrows each year will also reduce the level of aggregate demand for goods and services. All these fiscal policies will lead to an increase in the rate of leakages from the circular flow (Victor, 1997).
At the same time the fiscal policies will reduce injections into the circular flow of income. In the long run demand-pull inflation will be reduced at the cost of slower growth and unemployment. E$? D D1 E$? 1 J E$/? 2 K D A D1 Y1 Y2 Y$ Suppose the economy is originally at a super equilibrium shown as point J in the above diagram, the original GNP is atY1 and the exchange rate is E$? 1. When the government spending is increased, the fiscal policy change causes a shift in the DD curve. The DD curve moves right wards and the new GNP is now at Y2 and exchange rate is E$/? 2.