Monetary Policy

• Monetary policy is the attempt by government or a central bank to regulate the money supply, the supply of credit, interest rates or other monetary variables to control inflation. Interest rate policy is an important tool to curb inflation, since it can control the growth of aggregate demand and reduce the money supply. Higher interest rates lower the level of aggregate demand in many ways, for instance it lowers the sale of durable goods which leads to lower consumption expenditure. When interest rates are high, households and companies are effectively discouraged from borrowing. A rise in mortgage interest will discourage spending and reduce market demand for houses. Therefore, higher interest rates reduce the price level while a looser monetary policy tends to be inflationary.
  
  

Fiscal Policy

• Fiscal policy is the manipulation of government's spending, taxes and borrowing. Fiscal policy affects inflation through its impact on aggregate demand. High direct taxes and low government spending can reduce the aggregate demand which would lead to a fall in inflation. Tightening fiscal policy can reduce inflation, but at the cost of higher unemployment and lower levels of gross domestic product.
  
  

Supply-Side Policies

• Supply-side policies are the government policies designed to increase the productive potential of the economy and push the long run aggregate supply curve to right. These policies increase the average growth rate of economy and may help to reduce inflation. Effective supply side policies increase the aggregate supply which leads to economic growth and reduces inflationary pressures. The shifting of curve to right controls the unit labor costs and puts less pressure on producers to raise prices, which restricts cost-push inflation. The two types of supply-side policies are market oriented policies and interventionist policies.
  
  

Exchange Rate Policy

• Exchange rate policy is used as a mean to curb inflation. Raising the exchange rate is likely to moderate the inflation. Higher exchange rate will tend to lead to a decrease in import prices, which will lower the domestic prices. An appreciation in exchange rate will lead to a fall in aggregate demand and exports, which will reduce the inflationary pressure. Depreciation in exchange rate will increase the import prices and aggregate demand, leading to higher domestic inflation.