Introduction
An increase in prices, or inflation, means people have less money to spend. Over time, the average price hike of a group of products and services can be used to estimate the rate at which buying power is eroding. A unit of money is worth less now than in the past due to the price increase, commonly stated as a percentage. Deflation, in which prices fall and people’s buying power rises, is the opposite of inflation. This analysis provides evidence that an economic system is an approach to achieving a thriving economy for society and measures to reduce inflation.
Economic Analysis
Although changes in the money supply can impact prices, some economists argue that real GDP, the standard measure of economic production, is stable throughout time. Since there is often a lag between when prices and wages are adjusted, changes in the money supply may not have a lasting influence on production, but they could have an instant impact (Ayub et al., 2022). The monetary policy, often administered by central banks like the Federal Reserve (Fed) or the European Central Bank (ECB), is valuable for reaching inflation and growth targets.
When the economy is in a recession, consumers cut back on their spending, businesses lay off workers and halt investments in new infrastructure, and overseas buyers become less interested in purchasing American goods. In short, the government can respond to a drop in aggregate demand by adopting a stance that goes counter to the trend of the economy (Ayub et al., 2022).
As part of a countercyclical policy, increasing the money supply would contribute to the desired output expansion (and employment) and increase prices (Smith, 2019). When an economy nears maximum capacity, rising demand puts upward pressure on input costs, particularly wages (Ayub et al., 2022). As a result of spending their newfound wealth, workers drive up prices and pay levels, creating a vicious cycle that policymakers try to forestall at all costs.
Twin Objectives
The monetary policymaker must strike a balance between price and output targets. Furthermore, even inflation-focused central banks like the ECB would generally concede that they also pay attention to output stabilization and maintaining economic growth close to full employment (Kashyap et al., 2023). Aggregate demand for goods and services can be influenced by means other than monetary policy.
Governments have also heavily utilized fiscal policy, which includes taxing and spending, in response to the recent global crisis. However, changing tax and spending laws is a lengthy process that can be politically contentious once passed (Trading Economics, 2022). Consumers could not react as expected to a fiscal stimulus; it is easy to see why monetary policy is often seen as the first defense in stabilizing the economy during a crisis.
Independent Policy
Most economists agree that monetary policy, one of the government’s most potent economic instruments, is best handled by an entity apart from the democratically elected government, such as a central bank. This view originates from scholarly investigations conducted nearly three decades ago, highlighting the issue of time inconsistency (Kashyap et al., 2023). If central bankers had less autonomy, they could feel pressured to guarantee low inflation to maintain stable inflation expectations among consumers and companies.
However, as events unfold, they may be unable to resist the temptation to increase the money supply, leading to an “inflation surprise.” In the short run, the unexpected increase in the price of labor would enhance output (wages tend to move slowly) while decreasing the actual worth of government debt (Trading Economics, 2022). Nevertheless, once the public became aware of this “inflation bias,” they would raise their expectations for future price increases, making it even more challenging for policymakers to maintain low inflation.
Some economists have proposed that policymakers commit to a rule that eliminates choice in changing monetary policy to address the issue of time inconsistency. Nonetheless, it was challenging to make a credible commitment to a (perhaps complex) rule in actual practice (Williams, 2022). Another alternative was to delegate monetary policy to an independent central bank, which would shield the process from politics and boost public trust in the authority’s commitment to low inflation (Williams, 2022). Inflation tends to be lower and steadier when central banks are allowed more autonomy.
Conducting Monetary Policy
The central bank decides to alter monetary policy to reduce or increase the money supply to achieve the desired effect. Typically, this is accomplished through open-market operations, in which government debt with shorter maturities is traded with the private sector (Williams, 2022). When the Federal Reserve buys or borrows Treasury bills from commercial banks, it deposits that money into the reserve accounts that those institutions must maintain with the Fed. This increases the total amount of currency in circulation (The Guardian, 2022). However, the Fed can reduce the money supply by receiving payments for selling or lending treasury securities to banks.
In public statements about monetary policy, central banks typically refer to the target range for interest rates rather than a specific dollar amount. The interest rate that commercial banks charge one another for short-term loans, typically overnight, is the “policy rate” that central banks pay the most attention to (Williams, 2022). Rates go down when the central bank “loosens policy” by injecting more cash into the economy by purchasing or borrowing securities. It tends to go up when the central bank tightens monetary policy by reducing the number of reserves it can spend (Detmers et al., 2022). When the policy rate is adjusted, the central bank anticipates a ripple effect throughout all other interest rates that matter to the economy.
Transmission Mechanisms
Changing monetary policy significantly impacts aggregate demand, output, and prices. Several channels allow for the dissemination of policy acts into the underlying economy. The interest rate channel has traditionally received a lot of focus and attention (Tejvan Pettinger, 2022). If the Fed raises interest rates, individuals and businesses will be less likely to finance significant purchases like automobiles or homes and invest in capital expenditures like new machinery or office space (Goodman et al., 2022). Reduced economic activity is consistent with lower inflation, as lower demand typically results in lower prices.
An increase in interest rates has the additional effect of lowering firms’ and consumers’ net worth through the “balance sheet channel,” making it more difficult for them to get loans at any interest rate. By reducing their profits, banks are less likely to use their lending channel after a rate increase (Detmers et al., 2022). Due to increased demand from outside buyers, a currency tends to rise in value when interest rates rise (Goodman et al., 2022). When exports grow more expensive, and imports get more affordable, these effects are transmitted through the exchange rate channel, reducing the GDP.
Inflation has a self-fulfilling component that can be significantly influenced by monetary policy through expectations. Inflation forecasts are used in many salary and price contracts that are signed in advance (Tutor2u, 2021). The public may believe authorities are serious about keeping inflation under control if interest rates are raised and it is communicated that additional hikes are likely. As a result, inflation will be kept to a minimum since long-term contracts account for gradually increasing wages and prices.
One strategy has involved purchasing many financial instruments on the market (Goodman et al., 2022). The so-called “quantitative easing” expands the central bank’s balance sheet and adds fresh funds to the economy (Tutor2u, 2021). The money supply expands as banks receive more reserves (deposits they keep at the central bank).
Similarly, credit easing may lead to a larger central bank balance sheet, but the focus here would be on the quality of the assets acquired. The interest rate channel failed during the recent crisis because many specialized loan markets shut down (Tutor2u, 2021). As a result, central banks went after the problematic markets specifically (Trading Economics, 2022). Specifically, the Fed established a facility to buy commercial paper (extremely short-term corporate debt) to guarantee that companies would always have access to working capital (Detmers et al., 2022). Moreover, it purchased mortgage-backed securities to prop up the housing finance sector.
Conclusion
Increases in prices, or inflation, erode people’s purchasing power over time. While the U.S. government aims for an inflation rate of 2% per year, rapid and excessive inflation is a concern regardless. Price increases due to inflation are magnified if wage growth falls short of the inflation rate. Inflation also decreases the value of various assets, particularly cash. Governments and central banks use monetary policy to try to rein in inflation.
References
Ayub, T., & Pusparini, M. D. (2022). Inflation in the United Kingdom in times of war and pandemic (a solution from the Islamic economics). Tasharruf: Journal Economics and Business of Islam, 7(1), 1-16. Web.
Detmers, G. A., Ho, S. J., & Karagedikli, Ö. (2022). Understanding consumer inflation expectations during the COVID‐19 pandemic. Australian Economic Review, 55(1), 141-154. Web.
Goodman, D. and Aldrick P. (2022). BOE’s Chief Economist Says U.K. fiscal news needs significant policy response. Web.
Kashyap, A. K., & Stein, J. C. (2023). Monetary policy when the central bank shapes financial-market sentiment. Journal of Economic Perspectives, 37(1), 53–75. Web.
Smith, P. (2019). OCR a level economics, 4th Ed. Hodder education, London. Chapter 25 & Chapter 31 are most relevant but also Chapter 30 & 32 gives you some ideas of government intervention in general and problems of government intervention. Web.
Tejvan Pettinger (2022). Policies to reduce inflation. Web.
The Guardian (2022). Austerity could be more difficult this time round, says Lord King. Web.
Trading Economics (2022). United Kingdom Inflation Rate. Web.
Tutor2u (2021). Inflation – Policies to control inflation. Web.
Williams, N. (2022). One small step for U.K. monetary policy, one giant leap for the MPC. Web.