Is it more effective to raise interest rates by the central bank or to cut government spending in order to reduce inflation?
When faced with rising inflation, policymakers can choose between two main strategies: tightening monetary policy (by raising interest rates) or tightening fiscal policy (by reducing public spending). Each of these methods has its advantages and limitations, and their effectiveness depends on macroeconomic conditions.
Both methods have significant macroeconomic consequences. Raising interest rates can limit inflation by reducing demand for credit and curbing consumer spending and investment. However, it can also slow down economic growth, increase the cost of servicing the public debt and lead to recession. In turn, the reduction of public spending may lead to a drop in demand and a decrease in inflationary pressure, but at the same time it threatens to weaken economic growth and worsen the situation on the labour market. The ultimate effectiveness of each method depends on the structure of the economy and factors such as the level of debt, the degree of openness to international trade and the inflation expectations of consumers and businesses.
I have written about the sources of the high inflation that has occurred since 2021 in the wake of the Covid-19 pandemic in the following article based on my research:
THE POST-COVID RISE IN INFLATION: COINCIDENCE OR THE RESULT OF MISGUIDED, EXCESSIVELY INTERVENTIONIST AND MONETARIST ECONOMIC POLICIES
Article THE POSTCOVID RISE IN INFLATION: COINCIDENCE OR THE RESULT O...
I have described the key aspects of the monetary policy pursued by central banks in recent years in the following article:
Comparisons of the monetary policy of the central banks of the Federal Reserve Bank and the European Central Bank and the National Bank of Poland
Chapter Comparisons of the monetary policy of the central banks of t...
And what is your opinion on this topic?
What do you think about it?
Please reply,
I invite everyone to the discussion,
Thank you very much,
Best regards,
I invite you to scientific cooperation,
Dariusz Prokopowicz
Raising interest rates will help to moop up the excess cash in the economy, thus discouraging & reducing unnecessary wasteful spending, which otherwise further fuels the inflationary effect. However the higher borrowing costs for businesses can be mitigated by the government's intervention by reducing the taxable business income and/or reducing the utilities rates such as electricity, gas/fuel etc. For whatever steps to be taken by the government, all concerned must be roped in for discussions as to the best policies & steps to be taken by the government for the sake of the economic sustainability before implementation
Neither of them is very efficient.
Meaningfull budgetary reductions are politically difficult to implement in democracies and cannot be maintained for sufficient time to be effective.
Very high interest rates, as tried during the late 70's , stopped a runaway inflation due to its economic awe effect but it was a crude weapon that could only be held in the short term and addressed the symptoms rather than the cause.
Inflation, as measured by the cpi, is the result of fluctuation in prices of the items of consumptions include in the index. To find a remedy, one should look at what move these prices.
For example (see my paper: "The return of inflation" ) the tamed inflation pre covid period can be traced to the enormous Chinese labor injection in the world economy that effectively reduced the cost of so many consumption items. During that period, USD interest rates fluctuated, US budget deficit blew up all with no effect on very low inflation.
It will be more effective to raise interest rates as it will have a pervasive effect on spending and investment .If the the government budget spending is reduced it affects only one segment of spending though it will have some effects .
Both raising interest rates and reducing budgetary spending can reduce inflation, but their effectiveness depends on the situation:
A combination of both is often most effective, balancing inflation control with minimizing negative economic impacts.
Both raising interest rates and reducing budgetary spending can reduce inflation, but their effectiveness depends on the situation:
A combination of both is often most effective, balancing inflation control with minimizing negative economic impacts.
Both raising interest rates and reducing budgetary spending can help combat inflation, but their effectiveness depends on the specific economic situation. Raising interest rates makes borrowing more expensive, which can discourage consumer and business spending, thereby reducing demand and helping to lower prices. On the other hand, cutting government spending can also decrease overall demand in the economy. If inflation is mainly driven by high demand, increasing interest rates might be the more effective measure. However, if inflation results from supply chain issues or other constraints, reducing spending could have a lesser impact. Ultimately, a combination of both strategies tailored to the current economic conditions may be the most effective approach to reducing inflation.
When the question is put which is better policy under most circumstances the answer that both policies are good , is not normally expected. But here our esteemed members tell that both policies are good !
Dear Thomas Muthucattu Paul ,
Thank you for bringing up an interesting point about expecting a clear answer on which policy is better for controlling inflation. However, it's important to recognize that saying both raising interest rates and cutting budget spending can be effective is actually a reflection of the complexities involved in economic policy.
Each approach can be useful depending on the situation. For instance, if inflation is largely due to high demand, raising interest rates tends to be the better choice because it discourages borrowing and spending, which can help cool things down. But if inflation is more about government overspending, reducing budgetary spending can help rein in demand and stabilize the economy.
By accepting that both policies have their merits, we can move beyond simplistic "either/or" thinking. This suggests that a flexible approach may be more effective, depending on the economic circumstances. Each policy has a role to play, which can lead to a more comprehensive strategy for tackling inflation.
In essence, while it may not be the straightforward answer some expect, emphasizing the effectiveness of both strategies showcases the need for nuance in economic discussions.
Dear Chuck A Arize
I agree with your overview. Both raising interest rates and reducing budgetary spending are contractionary policies that can curb inflation, and their effectiveness does depend on the specific economic situation. To add to that, it's important to consider the type of inflation we're facing. For instance, while both are generally effective against demand-pull inflation, they might be less suitable for cost-push inflation. Additionally, we should delve deeper into the transmission mechanisms of these policies. For example, higher interest rates impact different sectors of the economy in varying degrees, and budgetary spending cuts can have significant multiplier effects. Thinking about the time lags associated with each policy is also crucial. Monetary policy often operates with a longer delay compared to fiscal policy. Ultimately, a carefully calibrated policy mix is often the best approach to balance inflation control with other economic objectives.
Both policies are contractionary . However in an inflationary situation when prices are rising consistently to curb general aggregate demand raising interest rates are superior policy . Having said it I may mention that there is a school of thought called modern monetarism of which some scholars pointed that when interest rates increase some wealth holders who hold bond portfolios may derive more increase income and they may spend more .
Dear Thomas Muthucattu Paul
Although both cutting government spending and raising interest rates shrink the economy, when prices keep going up, increasing interest rates is usually seen as the better move. This is because higher interest rates make borrowing more expensive, which directly reduces how much people and businesses spend. However, it's worth noting that some economists, especially those who follow modern monetarism, argue that higher interest rates can actually lead some people to spend more. This is because those who own bonds earn more interest income when rates rise. This shows how tricky it is to manage the economy with interest rates. While the main goal is to reduce spending, the extra income for bondholders might lessen the effect, or even cancel it out a bit. Therefore, even though raising interest rates is a strong way to fight inflation, those making the decisions need to be aware of these other effects and make sure they adjust things carefully.
Yes both higher interest rates and reduction of government expenditures are contractionary.However if with reduction of government expenditures the taxes of government and the borrowing by the government also come down then the public will increase consumption and the contractionary effect of reducing government expenditures will be neutralized .As faras the increasing interest rates effect is concerned it will have a generally pervasive general contractionary effect.First the increase cost of borrowing will reduce investment.Then the balance sheet of companies will be adversely affected and it will reduce investment.Also increased interest rates will reduce the discounted future cash flows and it will reduce wealth and the consumption of the people will be reduced because of negative effects of wealth effect on future cash flows . However as modern monetarist point out the income from some financial securities will increase and it may encourage to increase consumption.Howrver the general effect of higher interest rates will be contractionary .
There are much more instruments than budgetary spending (which sort of spending?) or interest rates (central bank deposit rate?) to curb inflation. One could e.g. lower taxes on consumption goods (VAT) or intervene in markets to restrict price changes (as. some countries have done e.g. for electricity).
One should also recognize that increased interest rates mean higher cost, which could have an inflationary effect, if and as far added to prices (which itself depends on the economic situation). An important inflation reducing effect could function via the exchange rate. As it is likely to increase, imports will be cheaper in own currency. I do not think, that the positive effect via increased interest income, mentioned by Fatima, is really important. Firstly, an increase of interest rates do e.g. need not influence the interest for my bonds I have bought years ago. Secondly, people with high interest income will likely have a rather low propensity to consume.
Dear Researchers, Scientists, Friends,
The research question regarding the effectiveness of raising interest rates by the central bank versus cutting government spending to reduce inflation is extremely important in the context of combating rising prices. The presented text accurately identifies two main macroeconomic policy strategies and their potential advantages and disadvantages. Raising interest rates can effectively dampen demand and curb inflation, but carries the risk of slowing economic growth and increasing debt service costs. Conversely, cutting government spending, while it can reduce inflationary pressure, threatens to weaken growth and worsen the labor market situation. However, it is worth expanding this discussion to include new research questions, such as the interactions between monetary and fiscal policy in different inflation regimes, the impact of inflation expectations on the effectiveness of individual instruments, the significance of global inflationary factors and their transmission to the domestic economy, as well as the effectiveness of combining both policy strategies under specific macroeconomic conditions. Furthermore, future research could focus on analyzing the long-term effects of each of these policies on the structure of the economy and social inequalities. I sincerely thank all researchers and scientists for their past contributions to the discussion on this important issue. I am open to further scientific cooperation in this area and invite you to continue this crucial discussion.
Best regards,
Dariusz Prokopowicz
Raising interest rates is typically a quicker and more targeted method to reduce inflation by curbing borrowing and spending, while reducing budgetary spending can have a slower but broader impact; the best approach often involves a coordinated mix of both depending on the source of inflation.