Progressive Money

Economics in the Real World · scenario 9 of 10 · about 12 min

“Higher interest rates are the only effective way to control inflation.”

Why people make this argument

Monetary policy is the tool Australians hear about most. When inflation rises, attention turns to the RBA's next decision, and when inflation falls, rate rises usually get the credit.

There are good reasons the claim seems right. The RBA can act at any meeting without passing laws, and it is independent of elections, so it can make unpopular decisions. Rate rises reach the whole economy through mortgages, business loans, asset prices and the exchange rate. The strongest version says other tools are slower, more political or work only on particular prices, so for bringing broad inflation down and keeping expectations anchored, the cash rate is the most reliable lever available.

Ideas you'll need

What isn't in dispute

The RBA's main tool is the cash rate, which it raised thirteen times between May 2022 and November 2023, from 0.10 to 4.35 per cent. It works through saving and investment, cash flow, asset prices and the exchange rate, and some estimates suggest it takes one to two years to have its maximum effect.

Other policies also change measured prices. Energy bill rebates were the main reason electricity prices fell 9.9 per cent in the December quarter 2024. Over 2024 headline CPI inflation was 2.4 per cent, while trimmed mean inflation, a measure of underlying inflation that sets aside the biggest price moves, was 3.2 per cent.

How mainstream economists would analyse it

Most mainstream economists would not say interest rates are the only tool, but many would say they are the best one for keeping inflation near target. Fiscal policy also affects demand: higher taxes or lower spending slow the economy. But budgets are set through Parliament, usually once a year, and serve many goals besides inflation, so most mainstream economists prefer an independent central bank to manage inflation from meeting to meeting.

Rebates lower measured prices but do not remove underlying pressures, and can add to spending elsewhere. Mainstream economists also see roles for supply-side policy, competition and, in Australia's past, agreements on wages: research cited at the RBA's 1990 conference estimated the Prices and Incomes Accord reduced wage inflation by about three percentage points a year.

How MMT economists would analyse it

MMT economists see interest rates as a blunt and uncertain tool. Yeva Nersisyan and Randall Wray argued in 2022 that rate rises work mainly by raising unemployment, do little about supply shocks or pricing power, and can even shrink productive capacity by discouraging investment. MMT economists also note that higher rates raise interest payments to bondholders, adding to some households' incomes while squeezing borrowers.

They favour fiscal tools: taxes to restrain total spending when needed, investment to ease supply bottlenecks, and a Job Guarantee as an automatic stabiliser. Separately, Isabella Weber proposes buffer stocks of essentials, windfall taxes and temporary price limits for shocks in key sectors. On this view the right tool depends on what is causing the inflation.

Your turn

Your turn: Is the claim right? Choose one likely source of Australian inflation and argue which tool, or mix of tools, would best deal with it, noting the trade-offs.

Show a model response and the rubric

The claim is too strong, but it has a point. Interest rates act on demand across the whole economy, can be changed quickly by an independent RBA, and help keep expectations anchored. For inflation driven by spending that outruns capacity, most economists see them as the most reliable tool available.

Take a different case: an oil price spike that lifts fuel and transport costs. Higher rates cannot make oil cheaper; they would cool inflation only by slowing the whole economy, costing jobs in industries that had nothing to do with fuel. A mainstream economist might 'look through' the first-round effect while watching expectations, and raise rates only if price rises spread into wages and other prices. An MMT economist might favour targeted measures, such as fuel reserves and investment that reduces import dependence, with taxes to restrain demand if needed. Rebates would lower measured prices but not the underlying cost.

So the best tool depends on the cause. My conclusion assumes the shock is temporary and expectations stay anchored; evidence of price rises spreading, or rising expectations, would strengthen the case for higher rates.

A strong response

  • Explains how interest rates reduce inflation, through which channels and with what lags
  • Identifies the source of inflation and asks whether rates act on it
  • Considers fiscal, supply-side or targeted tools and their practical limits
  • Distinguishes lowering measured prices, as rebates do, from reducing underlying inflation
  • States the trade-offs and the evidence that would change the choice of tool

There is no single right answer. Reach your own conclusion, and be ready to say what evidence would change it.

Limitations and counterarguments

Fiscal tools for inflation are attractive in theory but hard in practice. Raising taxes or cutting spending fast enough to steer inflation would need Parliament to act quickly and often, against strong political pressure, and no modern economy has relied on fiscal policy as its main inflation tool in the way MMT economists propose. Targeted price limits can create shortages if held too long.

On the other side, rates are blunt. They fall hardest on people with large variable-rate mortgages and on new borrowers, and higher rates can slow housing construction, which worsens a supply shortage. The Accord estimate comes from one era with very different industrial relations. And crediting rates for every fall in inflation ignores supply shocks unwinding on their own.

Revisit Australia's Inflation Target · Isabella Weber: The Economics and Politics of Seller's Inflation · Sellers Inflation [Isabella Weber] · Professor Bill Mitchell - Inflation Targetting

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