Monetary policy can be used to reduce demand-pull inflation.



Monetary policy involves altering the supply of money in the economy or manipulating the rate of interest.

Target inflation rate

Central banks have a target rate for inflation and are instructed to use interest rate changes to achieve it. If the inflation rate is rising outside its target range, a central bank is likely to raise the rate of interest.

Raising interest rates to tackle demand-pull inflation

If inflation is forecast to be excessive, increasing interest rates should increase saving, reduce borrowing and reduce investment, thus reducing aggregate demand in the economy. With lower aggregate demand, there is less pressure for suppliers to increase prices as they struggle to hit sales targets, so inflationary pressure is reduced.

Effectiveness of monetary policy to tackle inflation.

A rise in the rate of interest may not always discourage consumer expenditure.

Commercial banks usually do keep their interest rates in line with the central bank’s as it is the rate they will have to pay if they need to borrow from the central bank. There is, however, no guarantee that they will always raise their interest rates when the central bank increases its rate. Furthermore, even if consumers are faced with higher interest rates, they may not reduce their spending if they are optimistic about the future.

There may be time lags.

It can take up to 18 months for interest rate increases to reduce spending.