Inflation is a sustained rise in the price level over a period of time. One of the main macroeconomic objectives of the government is having a low level of inflation. To achieve it government can use different policies. One of them is monetary that is decisions on the rate of interest, money supply and exchange rate. The main instrument of monetary policy is rate of interest. By changing interest rates, government can influence producers and consumers. But whether to use different policies, it is important to know which inflation is it and how high it is. If inflation is demand pull, that is caused by increase in AD, high interest rates may influence people’s consumption and reduce it while savings will increase and so this might reduce inflationary pressure. However it is difficult to consider how high interest rates should be in order not to have surplus in the market.
If inflation is cost push, government can reduce costs by appreciating exchange rate and make imports cheaper and maybe reduce some costs of firms. High exchange rates however can cause current account deficit and make the country less competitive. Also in order to deal with inflation, government can increase supply of money and make it easier for banks to lend more and people spend more, however increase in the money supply lowers interest rates as banks will have a bigger amount that they can lend. And so this again affects AD. Also it is difficult to consider how much government has to increase it’s supply. So all instruments of monetary policy are connected and affect each other. When government is seeking to reduce inflation in the long run, government will use supply side as by increasing productive capacity, quantity and quality of labor productivity can increase and costs will reduce. AD will be increasing with parallel increase in AS.
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