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CPI and GDP deflator are the commonly used price indices in measuring inflation. The rise in CPI and GDP deflator by 3% in the past six months is an indication of an increase in the general price level of goods and services in the economy. If this increase becomes consistent, it translates to about 6% per year, and this approaches mild inflation. As a result, a tight monetary policy should be used to constrict aggregate demand, contain the overheating economy, and curb inflation.
The tight monetary policy is achieved in two ways: reducing money supply and increasing interest rates. Money supply can be reduced through open market operations where the central bank issues treasury bills on the open market, increasing the reserve requirement ratio, or through moral suasion. Interest rates are usually increased through an increase in bank rediscount rate by the central bank. An increase in interest rate increases the cost of borrowing hence reducing borrowing and aggregate demand. Thus, tight monetary policy reduces excess liquidity in the economy thereby reducing excess demand, and curb inflationary pressure.