In a purely economic sense, inflation refers to a general increase in price levels due to an increase in the quantity of money; the growth of the money stock increases faster than the level of productivity in the economy. The exact nature of price increases is the subject of much economic debate, but the word inflationnarrowly refers to a monetary phenomenon in this context.
Using these specific parameters, the term deflation is used to describe productivity increasing faster than the money stock. This leads to a general decrease in prices and the cost of living, which many economists paradoxically interpret to be harmful. The arguments against deflation trace back to John Maynard Keynes' paradox of thrift. Due to this belief, most central banks pursue a slightly inflationary monetary policy to safeguard against deflation.
Key Takeaways
- Central banks today primarily use inflation targeting in order to keep economic growth steady and prices stable.
- With a 2-3% inflation target, when prices in an economy deviate the central bank can enact monetary policy to try and restore that target.
- If inflation heats up, raising interest rates or restricting the money supply are both contractionary monetary policies designed to lower inflation.
Inflation Targeting
Most modern central banks target the rate of inflation in a country as their primary metric for monetary policy. If prices rise faster than their target, central banks tighten monetary policy by increasing interest rates or other hawkish policies. Higher interest rates make borrowing more expensive, curtailing both consumption and investment, both of which rely heavily on credit. Likewise, if inflation falls and economic output declines, the central bank will lower interest rates and make borrowing cheaper, along with several other possible expansionary policy tools.
As a strategy, inflation targeting views the primary goal of the central bank as maintaining price stability. All of the tools of monetary policy that a central bank has, including open market operations and discount lending, can be employed in a general strategy of inflation targeting. Inflation targeting can be contrasted to strategies of central banks aimed at other measures of economic performance as their primary goals, such as targetingcurrency exchange rates, theunemploymentrate, or the rate ofnominal Gross Domestic Product (GDP)growth.
How Central Banks Influence the Money Supply
Contemporary governments and central banks rarely ever print and distribute physical money to influence the money supply, instead relying on other controls such as interest rates for interbank lending. There are several reasons for this, but the two largest are: 1) new financial instruments, electronic account balances and other changes in the way individuals hold money make basic monetary controls less predictable; and 2) history has produced more than a handful of money-printing disasters that have led to hyperinflation and mass recession.
The U.S. Federal Reserve switched from controlling actual monetary aggregates, or number of bills in circulation, to implementing changes in key interest rates, which has sometimes been called the "price of money." Interest rate adjustments impact the levels of borrowing, saving, and spending in an economy.
When interest rates rise, for example, savers can earn more on their demand deposit accounts and are more likely to delay present consumption for future consumption. Conversely, it is more expensive to borrow money, which discourages lending. Since lending in a modern fractional reserve banking system actually creates "new" money, discouraging lending slows the rate of monetary growth and inflation. The opposite is true if interest rates are lowered; saving is less attractive, borrowing is cheaper, and spending is likely to increase, etc.
Increasingand Decreasing Demand
In short, central banks manipulate interest rates to either increase or decrease the present demand for goods and services, the levels of economic productivity,the impact of the banking money multiplierand inflation. However, many of the impacts of monetary policy are delayed and difficult to evaluate. Additionally, economic participants are becoming increasingly sensitive to monetary policy signals and their expectations about the future.
There are some ways in which the Federal Reserve controls the money stock; it participates in what is called "open market operations," by which federal banks purchase and sell government bonds. Buying bonds injects new dollars into the economy, while selling bonds drains dollars out of circulation. So-called quantitative easing(QE)measures are extensions of these operations. Additionally, the Federal Reserve can change the reserve requirements at other banks, limiting or expanding the impact of money multipliers. Economists continue to debate the usefulness of monetary policy, but it remains the most direct tool of central banks to combat or create inflation.
FAQs
Inflation. Contractionary monetary policy is used to temper inflation and reduce the level of money circulating in the economy. Expansionary monetary policy fosters inflationary pressure and increases the amount of money in circulation.
What is the transmission of monetary policy to inflation? ›
The transmission of monetary policy describes how changes made by the Reserve Bank to its monetary policy settings flow through to economic activity and inflation. This process is complex and there is a large degree of uncertainty about the timing and size of the impact on the economy.
What are the instruments of monetary policy to control inflation? ›
Ans. The various different tools and instruments of monetary policy are as follows: cash reserve ratio, statutory liquidity ratio, bank rate, repo rate, reserve repo rate and open market operations.
What is the relationship between inflation and interest rates in monetary policy? ›
The conventional view among economists is that higher interest rates lead to lower inflation. The rationale behind this view is that higher interest rates increase the cost of borrowing and dampen demand across the economy, resulting in excess supply and lower inflation.
How does the Fed use monetary policy to manipulate the economy? ›
The Fed primarily conducts monetary policy through changes in the target for the federal funds rate. To encourage short-term interest rates to move close to the target range, the Fed uses various policy tools including: interest on reserve balances, and. the overnight reverse repurchase facility rate.
Can monetary policy affect inflation? ›
Monetary policy has an important additional effect on inflation through expectations—the self-fulfilling component of inflation.
What is the monetary policy theory of inflation? ›
The monetary theory of inflation asserts that money supply growth is the cause of inflation. Faster money supply growth causes faster inflation. In particular, 1% faster money supply growth causes 1% more inflation. With other things constant, the price level is proportional to the money supply.
Which monetary policy tool most often used to impact inflation? ›
Manipulating Interest Rates
The first tool used by the Fed, as well as by central banks around the world, is the manipulation of short-term interest rates. This practice involves raising and lowering interest rates to slow or spur economic activity and control inflation.
What are the three main tools of monetary policy? ›
The Federal Reserve controls the three tools of monetary policy--open market operations, the discount rate, and reserve requirements.
How does monetary policy work? ›
Central banks conduct monetary policy by adjusting the supply of money, usually through buying or selling securities in the open market. Open market operations affect short-term interest rates, which in turn influence longer-term rates and economic activity.
More jobs and higher wages increase household incomes and lead to a rise in consumer spending, further increasing aggregate demand and the scope for firms to increase the prices of their goods and services. When this happens across a large number of businesses and sectors, this leads to an increase in inflation.
What happens if inflation is zero? ›
No increase inflation (or zero inflation) economy might slipping into deflation. Decrease in pricing means less production & wages will fall, which in turn causes prices to fall further causing further decreases in wages, and so on.
What are the goals of monetary policy? ›
The Federal Reserve sets U.S. monetary policy and the New York Fed plays a central role in implementing it. The Fed's economic goals prescribed by Congress are to promote maximum employment, stable prices, and moderate long-term interest rates.
What are monetary measures to control inflation? ›
One of the commonly used measures to control inflation is controlling the money supply in the economy. If the Government decreases the supply of money, then the demand will fall, leading to a fall in prices. Therefore, the Government may decide to withdraw certain paper notes and/or coins from circulation.
How can the government reduce inflation? ›
Monetary policy primarily involves changing interest rates to control inflation. Fiscal policy enacted through legislative action also helps. Governments may reduce spending and increase taxes as a way to help reduce inflation.
What is the Fed's most important monetary policy tool? ›
Because the interest on reserve balances rate is an administered rate, the Fed can steer the federal funds rate by adjusting the interest on reserve balances rate. In fact, interest on reserve balances is the primary tool the Fed uses to adjust the federal funds rate.
What is the monetary transmission theory? ›
Monetary transmission mechanism can be described as the effect of a change on nominal money stock or nominal short- term interest rates on real variables such as aggregate output and employment (Ireland, 2005).
What causes inflation fiscal or monetary policy? ›
Inflation may occur due to increases in production costs associated with raw materials or labor. Higher demand can also lead to inflation. Certain fiscal and monetary policies such as tax cuts or lower interest rates are also potential drivers.
Is inflation target monetary policy? ›
Inflation targeting is a goals-based approach to monetary policy whereby a central bank seeks a specific annual rate of inflation for a country's economy (normally around 2% or 3% per year).
What are the three main transmission mechanisms? ›
Expert-Verified Answer
The three main transmission mechanisms by which the yield curve affects the economy are Corporate impact, global impact and consumer impact.
