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(b) In response to the crisis, UK's central bank is considering whether to increase interest rates. Discuss whether the UK should prioritise reducing inflation over promoting economic growth and whether increasing interest rates is an appropriate policy to deal with stagflation in the UK. 

[15]

RI 2024

Introduction
Stagflation refers to a situation where an economy experiences both high inflation and stagnant economic growth, often accompanied by high unemployment. It is particularly challenging for policymakers because traditional tools to tackle inflation, such as increasing interest rates, may exacerbate economic stagnation, while tools to boost growth may further fuel inflation.

Should the UK prioritise reducing inflation over promoting economic growth?

The negative implications of both inflation and recession must be considered before deciding on which objective to prioritise. High inflation erodes purchasing power, reducing the real value of incomes, savings, and wealth, particularly affecting low-income households. It also creates uncertainty for businesses and investors, deterring long-term investments and harming economic stability. On the other hand, a recession leads to rising unemployment, reduced incomes, and lower standards of living, which can have long-term social and economic consequences.

Given that the UK has already entered a recession, there is a strong argument that promoting economic growth should take precedence. Recessions tend to have more immediate and severe impacts on employment and household welfare. Moreover, if the recession deepens, there will be further declines in consumption and investment, which could prolong the downturn and lead to more structural damage to the economy. As a result, prioritising economic growth through policies that support demand and employment may help to prevent a prolonged period of economic stagnation.

Is increasing interest rates an appropriate policy to deal with stagflation?

Increasing interest rates is a form of contractionary monetary policy, which works by reducing the money supply in the economy. The central bank typically achieves this by selling government bonds, which decreases the supply of loanable funds and raises interest rates. As interest rates increase, the cost of borrowing for consumers and businesses rises, making loans and credit more expensive. This leads to reduced Consumption (C) as households face higher mortgage rates and other loan repayments, and reduced Investment (I) as businesses find fewer projects profitable at higher borrowing costs.

The fall in consumption and investment would cause a leftward shift in Aggregate Demand (AD), from AD₀ to AD₁, leading to a reduction in the general price level from P₀ to P₁. This reduction in AD helps to address demand-pull inflation by curbing excess demand in the economy.

However, this approach may not be appropriate in the current context of stagflation in the UK. First, the recession indicates that demand in the economy is already weak (having already previously fall from YF to Y1, and reducing AD further from AD1 to AD2 would worsen the recession, as real national income would fall from Y1 to Y2, leading to increased unemployment and further declines in growth. Second, the inflation in the UK is primarily cost-push inflation, driven by rising energy prices due to external factors such as the natural gas supply shock from Russia. Increasing interest rates may have limited impact on addressing cost-push inflation, as this type of inflation originates from the supply side rather than excess demand.

Evaluation and Conclusion

In evaluating whether the UK should prioritise reducing inflation or promoting economic growth, it becomes clear that there is no need to exclusively focus on one objective at the expense of the other. The UK faces two distinct problems: demand-driven recession and supply-side inflation. Therefore, addressing both simultaneously is possible without facing a trade-off between inflation control and economic growth.

The government and central bank could implement supply-side policies aimed at reducing the cost of production for firms, such as investing in alternative energy sources to reduce dependence on natural gas or providing subsidies to firms facing higher energy costs. This would alleviate some of the inflationary pressures without stifling growth.

At the same time, the UK could use expansionary demand management policies to stimulate economic growth. For example, fiscal policies such as increased government spending on infrastructure or tax cuts could boost Aggregate Demand without exacerbating inflation, given that the inflation is primarily cost-driven. These policies would help to restore consumer and business confidence, promote investment, and create jobs, thus mitigating the effects of the recession.

In conclusion, while increasing interest rates may reduce inflationary pressures in normal circumstances, it is likely to be ineffective in addressing the UK’s current cost-push inflation and would exacerbate the recession. Instead, a combination of supply-side and demand-side policies is needed to tackle the unique challenges posed by stagflation, allowing the UK to reduce inflationary pressures while promoting economic growth.