In economics, inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy. Furthermore, a high or dynamic inflation rate causes the currency to lose credibility as the value of each unit of that currency decreases as inflation increases. Extreme examples are the case of the currency in Zimbabwe. As such, it is very important for Governments and Central Banks to control this inflation and keep it at manageable levels.
There are several methods a central bank may have to control inflation:
• Fiscal Policy
• Monetary Policy
• Supply Side Economic Policies
This paper will talk about Monetary Policy and whether it is a good way to control inflation. For the most part, I will use examples of the Federal Reserve Bank of America to illustrate examples. Most countries with a mature banking and financial banking system follow similar processes.
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency.
Monetary policy is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in order to avoid the resulting distortions and deterioration of asset values.
The Fed has three main tools of monetary policy:
• Changing the monetary base through open market operations.
• Changing the monetary base through discount lending.
• Changing the money multiplier by changing the required reserve ratio
OPEN MARKET OPERATIONS
The Fed conducts open market operations by buying and selling US government securities–especially US Treasury bills. Since the market for US Treasury bills is so active, the Fed can make large purchases and sales quickly and easily, without disrupting the market.
Open market purchases and sales have permanent effects on the monetary base, but sometimes the Fed will want to change the monetary base only temporarily. At these times,
it engages in two other types of transactions:
• Repurchase Agreement (repo) = The Fed purchases US government securities will an agreement that the seller will buy them back (repurchase them) at a specified price on a specified date, usually within two weeks. A repo is therefore like a temporary open market purchase, temporarily increasing the monetary base.
• Matched Sale-Purchase Transaction (reverse repo) = The Fed sells US government securities with an agreement that the buyer will sell them back at a specified price on a specified date, again usually within two weeks. A reverse repo is therefore like a temporary open market sale, temporarily decreasing the monetary base.
Hence, in conducting monetary policy, open market operations have a number of advantages:
• They are under the direct and complete control of the Fed.
• They can be large or small.
• They can be easily reversed.
• They can be implemented quickly
When a bank receives a discount loan from the Fed, it is said to have received a loan at the “discount window.” The Fed can affect the volume of discount loans by setting the discount rate:
• A higher discount rate makes discount borrowing less attractive to banks and will therefore reduce the volume of discount loans.
• A lower discount rate makes discount borrowing more attractive to banks and will therefore increase the volume of discount loans.
Discount lending is most important during financial panics:
• When depositors lose confidence in the financial system, they will rush to withdraw their money.
• This large deposit outflow puts the banking system in great need of reserves.
• The Fed stands ready to supply these reserves by making discount loans.
In such situations, the Fed acts as a lender of last resort.
Hence, during the stock market collapse (and associated liquidity crunch) of October 1987 and again in September 2001, the Fed made it clear that it would supply additional reserves to the financial system, as necessary, through the discount window.
Advantage of discount loans:
• They allow the Fed to act as a lender of last resort during a financial panic.
Disadvantages of using discount loans as a tool for monetary policy during normal times:
• The volume of discount loans can be influenced by the Fed, but not completely controlled
• The Fed cannot be sure how many banks will request discount loans at any given interest rate.
• Changes in the discount rate must be proposed by the Federal Reserve Banks before being approved by the Board of Governors. Hence, they are neither quickly made nor easily reversed.
CHANGES IN RESERVE REQUIREMENTS
By affecting the money multiplier, changes in the required reserve ratio can lead to changes in the money supply.
Disadvantages to using changes in reserve requirements as a tool for monetary policy:
• Large changes in reserves must be approved by Congress. Hence, large changes cannot be made quickly and easily.
• Also, if a bank holds only a small amount of excess reserves and the required reserve ratio is increased, the bank will have to quickly acquire reserves by borrowing, selling securities, or reducing its loans.
Each of these three options is costly and disruptive. Hence, changes in reserve requirements can cause problems for banks by making liquidity management more difficult.
Fiscal policy is the use of government spending and taxation to influence the economy. When the government decides on the goods and services it purchases, the transfer payments it distributes, or the taxes it collects, it is engaging in fiscal policy. The primary economic impact of any change in the government budget is felt by particular groups—a tax cut for families with children, for example, raises their disposable income. Discussions of fiscal policy, however, generally focus on the effect of changes in the government budget on the overall economy. Although changes in taxes or spending that are “revenue neutral” may be construed as fiscal policy—and may affect the aggregate level of output by changing the incentives that firms or individuals face—the term “fiscal policy” is usually used to describe the effect on the aggregate economy of the overall levels of spending and taxation, and more particularly, the gap between them.
Fiscal policy is said to be tight or contractionary when revenue is higher than spending (i.e., the government budget is in surplus) and loose or expansionary when spending is higher than revenue (i.e., the budget is in deficit). Often, the focus is not on the level of the deficit, but on the change in the deficit. Thus, a reduction of the deficit from $200 billion to $100 billion is said to be contractionary fiscal policy, even though the budget is still in deficit.
Fiscal policy also changes the composition of aggregate demand. When the government runs a deficit, it meets some of its expenses by issuing bonds. In doing so, it competes with private borrowers for money loaned by savers. Holding other things constant, a fiscal expansion will raise interest rates and “crowd out” some private investment, thus reducing the fraction of output composed of private investment.
Governments use fiscal policy to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment, and economic growth. Keynesian economics suggests that increasing government spending and decreasing tax rates are the best ways to stimulate aggregate demand, and decreasing spending & increasing taxes after the economic boom begins. Keynesians argue this method be used in times of recession or low economic activity as an essential tool for building the framework for strong economic growth and working towards full employment. In theory, the resulting deficits would be paid for by an expanded economy during the boom that would follow; this was the reasoning behind the New Deal.
PROBLEMS WITH FISCAL POLICY
But economists still debate the effectiveness of fiscal stimulus. The argument mostly centers on crowding out: whether government borrowing leads to higher interest rates that may offset the stimulative impact of spending. When the government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing, or monetizing the debt. When governments fund a deficit with the issuing of government bonds, interest rates can increase across the market, because government borrowing creates higher demand for credit in the financial markets. This causes a lower aggregate demand for goods and services, contrary to the objective of a fiscal stimulus. Neoclassical economists generally emphasize crowding out while Keynesians argue that fiscal policy can still be effective especially in a liquidity trap where, they argue, crowding out is minimal.
THE TREASURY VIEW
Some classical and neoclassical economists argue that crowding out completely negates any fiscal stimulus; this is known as the Treasury View, which Keynesian economics rejects. The Treasury View refers to the theoretical positions of classical economists in the British Treasury, who opposed Keynes’ call in the 1930s for fiscal stimulus. The same general argument has been repeated by some neoclassical economists up to the present.
Some economists oppose the discretionary use of fiscal stimulus because of the inside lag (the time lag involved in implementing it), which is almost inevitably long because of the substantial legislative effort involved. Further, the outside lag between the time of implementation and the time that most of the effects of the stimulus are felt could mean that the stimulus hits an already-recovering economy and exacerbates the ensuing boom rather than stimulating the economy when it needs it.
CONTRACTIONARY FISCAL POLICY:
1. Controlling aggregate demand is important if inflation is to be controlled. If the government believes that AD is too high, it may choose to ‘tighten fiscal policy’ by reducing its own spending on public and merit goods or welfare payments
2. It can choose to raise direct taxes, leading to a reduction in real disposable income
3. The consequence may be that demand and output are lower which has a negative effect on jobs and real economic growth in the short-term
EXPANSIONARY FISCAL POLICY
A macroeconomic policy that seeks to expand the money supply to encourage economic growth or combat inflation (price increases). One form of expansionary policy is fiscal policy, which comes in the form of tax cuts, rebates and increased government spending. Expansionary policies can also come from central banks, which focus on increasing the money supply in the economy. Expansionary Policy is a useful tool for managing low-growth periods in the business cycle, but it also comes with risks. First and foremost, economists must know when to expand the money supply to avoid causing side effects like high inflation. There is also a time lag between when a policy move is made (whether expansionary or contractionary) and when it works its way through the economy. This makes up-to-the-minute analysis nearly impossible, even for the most seasoned economists. And finally, prudent central bankers and legislators must know when to halt money supply growth or even reverse course and switch to a contractionary policy.
Keynes was a strong advocate of expansionary fiscal policy during a prolonged recession. He argue that in a recession, resources (both capital and labour) are idle, therefore the government should intervene and create additional demand to reduce unemployment.
During times when Inflation increases, the Central Bank may apply a contractionary monetary or fiscal policy to control this inflation. Fiscalists argue that Monetary Policy is not a good way to control inflation, especially for underdeveloped nations. The arguments are explained below.
SLOWING DOWN PRODUCTION
Production is reduced in the economy as a by-product of slowing the economic engine. More expensive investment capital and a reduced demand for products and services are the culprits. Once companies gear down production, it can take years to ramp it up again. If the contractionary monetary policy overshoots the mark and tightens the economy more severely than intended, companies can button down production and shutter planned expansions. This can throw the economy into a recessionary loop.
Increased unemployment results from the slowing production and increasing interest rates. As companies slow their growth rates, they hire fewer employees. Increases in unemployment cost the government in increased unemployment insurance administration costs and social services expenses. Governments must carefully weigh this cost against the economic benefits of reducing inflation. Higher unemployment rates can also shake consumer confidence if the spike happens rapidly. Increases in unemployment reduces the demand for many products and services, making the economic contraction more severe.
Even though monetary policy has quite a few drawbacks, fiscal policy is not the way to go. Increasing Taxes to reduce AD may cause disincentives to work, if this occurs there will be a fall in productivity and AS could fall. However higher taxes do not necessarily reduce incentives to work if the income effect dominates. Fiscal policy will suffer if the government has poor information. E.g. If the government believes there is going to be a recession, they will increase AD, however if this forecast was wrong and the economy grew too fast, the government action would cause inflation. If the government plans to increase spending this can take a long time to filter into the economy and it may be too late. Spending plans are only set once a year. There is also a delay in implementing any changes to spending patterns.
Hence, despite all the drawbacks, monetary policy is what helps control inflation the best. But the usual tools are not going to be enough. A country needs to take into account all the other factors that are influenced by its change in monetary policy as well.