If the raise of price levels is not efficiently and objectively controlled, as well as the amount of money in the economy and the interest charged on loans, inflation, the sustained increase in the average price level, will most certainly become a threat to the Nation’s economy itself. On the other hand, a careful control leaded by an objective and alienorganism can prevent: the loss of purchasing power, the decrease in the availability of savings, uncertainty and labor unrest. Cases seen in Yugoslavia, Argentina an even Colombia leads us to affirm the vital importance of central banks to be separated from governments.
There are three main causes for inflation to take place in an economy which are: Demand-pull inflation, which occurs mainly whenaggregate demand increases until a point where the economy can’t expand its output further and so prices significantly increase; cost-push inflation, which involves the supply side of the economy -if there is an increase in the price of the factors of production there is a decrease in aggregate supply and thus, there is an increase in prices- and lastly; an excess monetary supply within the economy,which leads to an increase of aggregate demand that is likely to further increase prices.
Taking into account what was said before, it is reasonably to declare that a well-organized system of both, monetary and fiscal policies will help to reduce inflation. It is important to keep clear that, fiscal policies, which involve taxes and government spending, should be exclusively managed by thegovernment for them to be useful in reducing demand-pull inflation, while monetary policies, those concerning the supply of money in the economy and the level of interest rates, should be strictly control by an organism outside the government.
Increasing direct taxes, which are set up on income, will reduce the amount of money disposable for people to buy goods and services. As a consequence, adecrease of aggregate demand (AG) is likely to happen, which would then lead to a fall in prices and thus inflation. Likewise, monetary policies could be helpful in reducing inflation. This is, if interest rates are raised, people are less prone to borrow money from banks and instead, are expected to keep their savings in the entity. This is the result of the money they will receive in return of thehigh interest rates. All in all, the adjustment of interest rates is an effectively used mechanism to promote a decrease or increase in AG. Reason why, it must be held by an organism alien to the government, so there would be no interference from what would be a normal economic cycle but can still be supported by the government polices on taxes and expenditure. Now, it is important to emphasizethat the correct use of these policies is vital in their aim to reduce inflation, otherwise, not only they wouldn’t be able to cope with the rise in prices, but could prompt a hyperinflation to take place.
The theory seems to work tremendously well and in fact it does work in economies where minimum flaws are found. However, in the practice, theory is not so concordant with reality and thetruth is very different. Increasing direct taxes and reducing government spending in order to reduce inflation would certainly result in unpopular feelings from the people towards the government, especially in developing economies where people depend hugely upon the government help and social differences are very high. For these reasons, many times such policies are not wisely applied and can befound to be absolutely biased. For instance, if a government is facing low rates of popularity and decides to increase the level of taxes upon income, this will certainly result in an even worse popularity rate. These types of circumstances occur daily in governments that are easily corrupted. Subsequently, if we added the control of interest rates to them, then the economy will be simply chaotic....