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Effect of economic growth

Although both fiscal and monetary policy can affect inflation, ever since the 1980s, most countries primarily use monetary policy to control inflation. Central banks such as the U.S. Federal Reserve increase the interest rate and slow or stop the growth of the money supply. Some central banks have a symmetrical inflation target while others only control inflation when it rises above a target, whether express or implied.

In the 21st century, most economists favor a low and steady rate of inflation. In most countries, central banks or other monetary authorities are tasked with keeping their interbank lending rates at low stable levels, and the targeted inflation rate is about 2% to 3%. Central bankers target a low inflation rate because they believe that high inflation is economically costly because it would create uncertainty about differences in relative prices and about the inflation rate itself. A low positive inflation rate is targeted rather than a zero or negative one because the latter could cause or worsen recessionsow (as opposed to zero or negative) inflation reduces the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduces the risk that a liquidity trap prevents monetary policy from stabilizing the economy.

Higher interest rates reduce the economy’s money supply because fewer people seek loans. When banks make loans, the loan proceeds are generally deposited in bank accounts that are part of the money supply. Therefore, when a person pays back a loan and no other loans are made to replace it, the amount of bank deposits and hence the money supply decrease. For example, in the early 1980s, when the federal funds rate exceeded 15 percent, the quantity of Federal Reserve dollars fell 8.1 percent, from US$8.6 trillion down to $7.9 trillion.

In the later part of the 20th century, there was a debate between Keynesians and monetarists about the appropriate instrument to use to control inflation. Monetarists emphasized a low and steady growth rate of the money supply. Keynesians emphasize reducing aggregate demand during economic expansions and increasing demand during recessions to keep inflation stable. Control of aggregate demand can be achieved using both monetary policy and fiscal policy (increased taxation or reduced government spending to reduce demand).

A variety of other methods and policies have been proposed and used to control inflation.