Whenever a problem effects society, it’s a common refrain to ask government to try and fix it. Today, I want to talk about what the government can do to reduce inflation.
A blunt instrument
The causes of inflation are complicated and murky, so when it comes to solutions there’s really no targeted solution. Instead, governments and central bankers look to fairly blunt instruments: interest rates and taxes. If the core definition of inflation is that prices are going up and people are willing to pay them, both interest rates and taxes offer ways to make it harder for people to pay higher prices.
Interest Rates
People and businesses finance a great deal of their spending with borrowed money. Just think about the prevalence of car loans and mortgages to see borrowed money at work. When interest rates rise, borrowing money gets more expensive. That means the same monthly payment gets you a smaller overall loan. The idea is that if a person or business can only afford so much in payments this reduces overall spending due to smaller loans. Less money being spent reduces overall demand in the economy and puts downward pressure on prices. At the same time, higher interest rates generally mean better returns for savers at banks and other savings institutions. Because money saved is money not being spent, this also keeps money from moving around the economy.
Taxes
Taxes are an even blunter instrument than interest rates in the fight against inflation. This is because taxes are mandatory where loans and saving are optional. By raising taxes while also either reducing or freezing spending the government removes money from the economy. The idea here is that if everyone has less money to spend people and businesses alike will tighten their belts and cut spending, reducing overall demand. This is effective by impacting all parts of society, but is the definition of killing a fly with a sledge hammer as it negatively impacts spenders and savers alike.
Does Any of This Work?
The biggest problem with both of these solutions to inflation is that evidence for them working is somewhat sketchy. This is because reality is far more complicated than theory. If food and fuel prices are driving inflation, neither of those are discretionary. People must eat, stay warm, and move around. As a result, if those prices go up people will do whatever they need to in order to pay them. Also, if the job market is very strong wages can keep rising in the face of both measures as employers keep trying to attract and retain workers. So, while both interest rates and taxes can reduce overall demand in the economy, there is no guarantee that they will, or even if they do, to how quickly they will work.
Hanging Tight
All of that is to say, that while tools to fight inflation exist how well they will work and how quickly they will work are both open questions. Any tool to fight inflation is ultimately trying to change people’s behavior in some way, and people are not always receptive to having their behavior changed. The net result is that average folks like you and me have to sit tight, hold on, and try our best to skip out on buying that thing whose price makes us cringe.