How to fight inflation? | Economipedia

Inflation was already a big economic problem before the outbreak of the war in the Ukraine. The conflict has especially affected European countries, with the increase in prices in Spain being above 10%, which leads us to speak of galloping inflation.

The consequences of galloping inflation are undeniable, which is why they affect all sectors of society. Among the many effects of runaway inflation, the most prominent is the fall in the value of money.

But, how has the world come to such a worrying situation of inflation?

Causes of the problem

As we previously pointed out, inflation was already a headache for governments, economists and international organizations before the war began in Ukraine.

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Until November 2021, the economic predictions looked encouraging. The end of the supply crisis and the economic stimulus packages that had increased aggregate demand and caused prices to rise were expected. Even possible interest rate hikes were being considered while central banks stopped buying bonds.

The indebted States, after having to considerably increase public spending to stimulate aggregate demand, as debtors, benefited from inflation.

There was confidence that the price increase would be transitory, brief, even. Despite rising prices and a loss of purchasing power, employment seemed to be recovering and the economy was on the path of growth.

Furthermore, inflation only became a worrisome problem when employment levels similar to those of pre-pandemic levels were achieved.

But the hopes of a not very lasting inflation vanished in November 2021 and especially with the forecasts of an imminent war in a country like Ukraine. The signs of dangerous inflation were already evident, since, in January 2018, a barrel of Brent went from 90 dollars to 110 dollars.

The cost of energy and the blockade of grain from Ukraine were going to be determining factors in the galloping increase in prices. In fact, measures to alleviate the effects of inflation could lead to economic recession in the countries most affected.

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What are the consequences of runaway inflation?

We are, therefore, facing a problem whose solution is complex for governments and which also requires time. On many occasions, the economic and monetary policies that are applied to combat inflation can end up depressing the economy.

Generally, fighting against the runaway growth of prices entails an increase in interest rates to reduce the money supply of citizens and companies. In other words, the cost of borrowing money will become more expensive, which will cause a sharp decline in consumption and private investment.

If governments and monetary authorities decide not to act on inflation, they risk sending the economy into an inflationary spiral. This implies that prices do not stop growing while the population loses purchasing power until it becomes impoverished.

Another consequence of out-of-control inflation is the loss of public confidence in the economy. Certain products and foods accumulate while there are those who bet on other currencies as a refuge.

Thus, inflation will not only affect everyday consumer products, as the price of real estate will increase disproportionately. Moreover, given a spiral of price growth, there is the possibility that the contracts include clauses that take into account the increase in inflation.

What policies can be applied to combat galloping inflation?

Generally, fighting against the runaway growth of prices entails an increase in interest rates to reduce the money supply of citizens and companies. In other words, the cost of borrowing money will become more expensive, which will cause a sharp decline in consumption and private investment.

Since prices are the result of the convergence between suppliers and demanders, the government has the capacity to act on demand. What does this mean?

The public sector, as a large economic agent, can act on a component of aggregate demand such as public spending. All this means cuts in the public budget.

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Another component of aggregate demand that the public sector can influence is private consumption. To do this, the public sector can deduct income from consumers through tax increases. Although it is an option that is on the table, it is generally very unpopular among society.

However, should all measures against inflation be applied to demand? No, there is also the possibility of acting on the offer.

In this sense, the options would be to promote competition between companies. To do this, it would be necessary to focus on reducing the power of suppliers or companies to influence prices.

Moreover, the authorities in charge of competition-related matters need to be vigilant. This means that they must ensure that competition rules are respected and fight against monopolies or other types of markets where companies have a wide margin to impose prices. And it is that, the power that companies exercise in the formation of prices is something that must be watched especially in contexts of inflation.

Therefore, it is clear that competition between companies gives rise to a greater number of products, which means an increase in the offer and brings with it more affordable prices for consumers.

Another aspect to assess and that has been a problem since the beginning of the COVID-19 pandemic is supply chains. Bottlenecks in factories can cause worrying paralysis in the production and distribution of products.

Beyond the fact that companies need to have agile production and distribution processes, the public sector can provide a good infrastructure network that facilitates communications.

Also in relation to supply chains, bureaucratic procedures and administrative authorizations often slow down economic activity. For this reason, an efficient bureaucracy and a simplification of regulations help streamline economic activity.

Another risky and even dangerous double-edged sword for the economy is price controls. There have been many experiences in which price controls have caused a shortage of certain goods and have led to the appearance of the black market.

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It is precisely in this black market that disproportionate amounts can be paid for goods that are in short supply.

The risks of fighting inflation

The war hostilities in Ukraine are not the first time that the world has faced a context of inflation. So, let’s look back and analyze previous experiences.

Excessive price growth was already a reality after the 1973 Yom Kippur War. What’s more, between 1968 and 1981 prices only increased by less than 4% in two years.

The experience of those years showed that it is very difficult to reduce inflation without damaging the economy. Thus, between 1971 and 1974, President Nixon tried to alleviate inflation by freezing the salaries of the middle and upper classes, while protecting the most disadvantaged workers with increases in the minimum wage.

However, the measure had little effect on prices. His successor, President Ford, also failed to contain price growth by encouraging voluntary savings.

On this occasion, the Federal Reserve acted late, although, on subsequent occasions, it managed to tackle inflation thanks to significant increases in interest rates. To do this, the amount of money in circulation was reduced and interest rates stood at a very high 18% in 1980. In this way, price growth went from 13.3% in 1979 to 3.8% in 1982 .

Although the increase in prices was contained, the collateral damage to the economy was felt during the administration of Jimmy Carter. The cost of borrowing rose disproportionately while unemployment soared, a circumstance that eroded Jimmy Carter and contributed to his electoral defeat.

It is clear that inflation, outside of moderate levels, can mean the prelude to an economic recession.

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