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Inflation And Monetary Policy Economics Essay

Money might not buy happiness but it is a major factor of economic well-being. As a matter of fact, for over centuries, the fluctuations of money supply have highly impacted the economy, both in a good and the bad way. A long time ago, gold was used as a base to keep money supply from skyrocketing but nowadays things have long changed. That report aims at showing and analyzing all the possibilities that are possible to increase or decrease the amount of money flowing in the economy.

Monetary policies

Definition

A monetary policy is a policy that aims to control aggregate demand in the economy. It involves altering the money supply in the economy or altering the cost of money that are the interest rates.

Generally, central banks such as the Federal Reserves in the United States, or the European Central Bank in the Euro system do monetary policies.

We can distinguish two kinds of monetary policies:

Expansionary policy aims to increase money supply by printing more money, or by lowering interest rates in order to make borrowing easier.

Thus, aggregate demand increases because firms, people and actors of the economy will borrow and spend more money.

The counterpart of an expansionary policy is that it can lead to inflation.

Contractionary policy aims to reduce money supply by stopping printing money or raising interest rates, leading to a decrease of money lending.

Banks, firms and people thus will be dissuaded of borrowing money, and aggregate demand will decrease.

One of the drawbacks of this kind of policy is that it may lead to unemployment.

Brief history

We started to talk about monetary policy in the 7th century in China. Indeed, the Chinese government created a paper money around the year 600.

At a moment, they were in lack of paper money to finance a war. So they started to print a lot of money. What they didn’t think about is that few months later, they were facing a hyperflation. Then, they learnt from this experience that money supply had to be controlled, and they started to think about monetary policies.

The first central bank was created in the UK in 1694. Its goal was to maintain the nation money at the gold standard. Thus, they started to adjust interest rates. From this point, government understood that interest rates had an important impact on the economy. During the industrialization in the end of the 19th century, many central banks were created, as the Federal Reserves in 1913.

Monetary policies have taken more and more importance for managing the economy and control aggregate demand. The history of such policies shows that money supply was firstly important to control, and then it was also necessary to control interest rates.

Operations of monetary policies.

The main objective of a monetary policy is to control aggregate demand and stabilize the economy, ensuring high employment, price stability and economic growth.

So to keep the equilibrium in the economy, monetary authorities have to control monetary policies.

Long-run monetary policies

To control the money supply over the long-run, central banks and monetary authorities can control two sources of monetary growth, which are the bank’s liquidity ratio and public sector deficit.

Thus, central banks may impose to banks a statutory minimum reserve ratio higher than the ratio chosen by banks.

Imposing such policies allows having too much printed money in the economy (too much credit from banks). Indeed, too much money can create hyperinflation, so money supply has to be controlled in the long-run.

Minimum reserves ratio is a mean of controlling long-term money supply.

To avoid surplus of money when governments borrow money from banks, central banks can impose government to finance the Public-Sector Net Cash Requirement (PSNCR) by selling bonds. However, if governments wish to sell extra-bonds, it will offer higher interest rates, and it will have a negative effect on private-sector rates of interest.

For monetarists, the most efficient thing to operate is to reduce the PSNCR by cutting government expenditures which will thus lead to a private sector growth, which is the best source of employment in the long-run.

Short-run monetary policies

To achieve a controlled monetary growth in the long run, it is very important to control the situation in the short-run.

In the short run, the central bank may want to increase or reduce aggregate demand.

Thus, it will have to adjust rate of interest of control monetary supply in function of the policy they want.

For example:

Central bank wants to reduce aggregate demand.

They reduce the money supply that will lead to a higher interest rates. Thus, less money will be spent in the economy, and aggregate demand will decrease.

Central bank wants to stimulate aggregate demand.

They increase the printing of money, thus interest rates will go down, and firms, people will borrow more in order to spend more. Aggregate demand will increase.

Tools to conduct a monetary policy

To conduct monetary policies, central banks have at their disposal several tools.

They can either use open market operations, minimum reserves, standing facilities.

These different tools will be used by the central banks depending on what type of strategy they want to implement (liquidity absorbing/liquidity providing)

Open market operations

Open-market operations are the most used tools by central banks to operate monetary policies. Their objective is to alter the monetary base, which means all the cash flows outside central banks. Actually, central banks want to affect the credit creation of banks and hence control the money supply in the economy.

Open market operation consists in buying or selling assets in the open market.

Concretely, if a central bank wants to increase the monetary base, it buys securities in exchange of liquidity. Thus, sellers will have more liquidity and there will be a higher monetary base.

On the contrary, if a central bank wants to reduce the money supply, it will sell securities.

We distinguish 4 types of open-market operations:

Main refinancing operations

They are short-term operations that have a maturity of one week.

Issued weekly, they are made according to standard tenders that credit institutions can buy. They maintain the equilibrium between liquidity and rate of interest chosen by the central bank.

Long-term refinancing operations

They are similar to main financing operations but are conducted monthly and attain their maturity after three months. They maintain long-term liquidity for banks.

Fine-tuning operations

They are short-run liquidity absorbing or liquidity providing among the economy, meaning selling or purchasing short-term assets. They respond to any changes in liquidity and thus keep stable the interest rates.

Structural operations

They are quite similar to fine-tuning operation, excepted that they are used regularly to adjust the liquidity, money supply and the interest rates in the economy.

Minimum reserves

Minimum reserves are amounts of money that financial institutions are required to hold on deposits account. The reserve base in relation to its balance sheet determines these amounts. The reserves requirements are computed by multiplying the reserve base by the reserve ratio. Most of the time, the reserve ratio is positive for assets included in reserves base.

Requiring a minimum reserve to banks is a mean of control the money supply in the economy for central banks. They regulate money supply by affecting the size of the bank multiplier. Also, with a minimum reserve ratio, banks will stabilize interest rates.

Thus, if central banks want to reduce the money supply, they will reduce the bank multiplier by increasing the minimum reserves ratio.

To resume, the purposes of implementing minimum reserves are to stabilize the rates of interest and to enlarge the liquidity shortage of the banking system.

New 20% reserves ratio

Reserves assets

10bn

Advances

40bn

10% reserves ratio

(total of 100bn€)

Reserves assets

10bn

Advances

90bn

We can see above that if we change the minimum reserve ratio, banks will reduce their advances, and the money supply in the market will be reduced (from 90bn to 40bn)

Standing facilities

Standing facilities are held by central banks and freely available for banks and other institutions dealing with central banks.

Generally, banks often use standing facilities because they can benefit from the higher rates of interest of the market compared to those that they need to apply.

They can be liquidity providing or liquidity absorbing. We can distinguish two standing facilities:

· Marginal lending facilities

Marginal lending facilities allow liquidity providing from central bank to counterparties, on their own initiative, against sufficient assets.

It allows counterparties to obtain liquidity in the short-run

· Deposit facilities

Deposit facilities consist on the opposite of marginal lending facilities. Actually, it allows counterparties to make deposit with central banks in just one night.

Inflation:

Economically speaking, inflation represents a persistent general increase in price throughout the economy over a certain period of time. This phenomenon must not be confused with a punctual rise of price for one specific good or service as inflation is global phenomenon. Consequently, the inflation rate, which measures the annual variation of the consumer price index (CPI), reflects the erosion in the purchasing power of money. As this report treats the subject of monetary policy, it is important to see the link between the quantity of money and the inflation and to analyze the impact of the first on the second.

Milton Friedman, who is undoubtedly one of the most influential economists of the XXth century, explained that “inflation is always and everywhere a monetary phenomenon; it is always and everywhere the result of too much money; of a more rapid increase of the quantity of money than of output”. Historically speaking, there has never been an inflation that was not accompanied by an extremely rapid increase in the quantity of money.

What kind of inflation?

There are three main ways to obtain inflation; these inflations are demand-pull inflation, cost-push inflation and inflation through monetarist model. The following chapter aims to define clearly these situations thanks to the AD/AS model:

Monetarist model

Monetarist model. Let’s start with a very simple remark: The more money there is in the economy, the money there is to be spent, and therefore aggregate demand goes up. This is what explains the monetarists in their model mostly represented by Friedman’s theories. In that scenario, because the economy has reached full employment level of output in long-term, the right shift of aggregate demand will be solely inflationary.

Demand-pull inflation is linked with a constant rise in aggregate demand. The scenario is likely to happen during a full employment period. In this case, the right shifting of the aggregate demand curve leads to higher prices and increased output. However, as the period is of full employment it is impossible to expand anymore. Thus, although the AD curve’s shift might benefit to the economy in the short-run, the long-run result is different. As a matter of fact, the last increment will fall into a liquidity trap and its result will be uniquely inflationary. A perfect historical example of demand-pull inflation occurred in the United-States after John Fitzgerald Kennedy’s death and Lyndon Baines Johnson’s election in 1963

Demand-pull inflation

Cost-Push inflation

Cost-push inflation is associated with changes in the cost of production. If costs go up, companies are likely to compensate by increasing prices and slowing down the production. Graphically, this implies a left shift of aggregate supply and thus a movement along the AD curve from right to left. In that scenario, the effects are completely opposite to what happens in a demand-pull situation as prices go up but the GDP decreases at the same time.

Costs of inflation:

Redistribution

Inflation is a source of inequality. It takes money from people with fixed income that are paid interest rates on their savings that are lower than the actual rate of inflation which leads to an erosion of their purchasing power. On the other hand, inflation has some benefits for people with assets that rise in value at an outstanding pace during inflation periods. Also, according to Milton Friedman’s analysis; inflation is a form of taxation. It is inevitable result of government spending exceeding government income. “The real tax, he says, is what government spends. If government spends 450 billion dollars and only raises 400 billion dollars in taxes, who pays that other 50 billion dollars? … One of the ways we pay it is by the tax which we call inflation”.

Loss of purchasing power

When inflation rises, this means that the general price of goods and services increases. Therefore, with the same income, one would no longer be able to buy as much as he or she would have before the inflation occurred. That is a loss of purchasing power. Inflation increases the cost of holding money as the value of this money tends to go down. As a consequence, the leather shoe cost refers to the opportunity cost that people face while attempting to offset the effect of inflation by holding less money.

Negative impact on saving

If the inflation rate is higher than the interest one gets from his or her savings, the real interest rate (adjusted according to inflation) will turn out to be negative. In this case, the amount of money that was initially deposited is now worth less that it was before yielding interests. Thus, the consumer would have been better off spending that money instead of saving it as his/her purchasing power was diminished through the process.

Rise in interest rates

Commercial banks are negatively impacted by inflation as they charge interests to people borrowing from them. Therefore, banks will tend to increase their nominal interest as to keep up with their current revenue.

Negative effect on exports

The competitiveness of a country is likely to suffer from inflation if its rate of inflation is higher that its trading partners’. Imported goods will become cheaper than home-produced ones and the balance of trade will be negatively impacted.

Lack of visibility in the future

Inflation might cause problems in terms of predictability of future economic situation, especially if inflation is highly fluctuating. This is the reason for all the inflation targeting policies implemented all across the world by some central banks. As a matter of fact, the uncertainty created by this fluctuating inflation leads to reluctance from companies to invest as they are not able to predict their future costs and revenues.

Labor conflicts

If inflation is too high, employees’ purchasing power goes down dramatically and the only solution for them is to ask for higher salary which will lead to conflicts between labor unions and management.

The way to fight against inflation is dependent on what kind of inflation is being experienced. For instance, a demand-pull inflation would force government to reduce aggregate demand.

Jonathan Schleffler, research associate at Harvard Business School and author of “The assumptions economists make”, sees euro as an “anti-inflationary gamble” arguing that the Eurozone tried to implement the same anti-inflationary strategy that dramatically failed in South-America during the 1990’s. For him, “neither theory nor evidence suggests that a vibrant economy requires very low inflation”.

To conclude on the topic of inflation, it is possible to see that different opinions are confronting when discussing whether or not inflation hurt the economy. Indeed, although monetarists see inflation as a “disease” it is undeniable that modern example such as China, Chile or even Mexico have proven that a moderate inflation near 20% didn’t impair their economy. However, for all the reasons mentioned above, it seems clear that a high level of inflation is recommended and historical facts, such as the situation after the oil crises of 1973 and 1979, proved the dramatic impacts of inflation. That is why central banks have been trying to conquer inflation for a small time now. As matter of fact, monetary policy is now considered as the most effective way to influence aggregate demand which implicitly means that central banks’ decisions are by far more important than governments’ action on the economical level.

The role of Central banks in monetary policy.

Presentation of Central banks

Now let’s focus on the role of the central banks in general in order to understand the link between the central banks and the monetary policy. Then there will be a short presentation about two specific central banks (ECB and the Fed). Lastly there will be a timeline which focus on the main events and actions implemented by the ECB and the Fed.

Why do the central banks exist? A Central Bank or the Fed (Federal Reserve System in United States) is still referred to the government’s bank because it buys and sells of government bonds. The central banks are also different tasks to do. The central banks have to operate under rules to prevent political interference. The central banks do not belong to a government but the most developed nations have an independent central bank. The main role of the central bank is to provide the economy when commercial banks have no enough funds to cover a supply shortage. The central bank has to act as the regulatory authority of a country’s monetary policy.

The central banks have different tasks to execute. They have to:

Implement a monetary policy to regulate the inflation and to control price stability

Determine the interest rates they are ready to lend to the other banks.

Supervise the banking industry.

Keep an eye on the foreign reserves and gold reserves all over the world.

They are also named as “the lender of last resort”.

The central bank has the power to change and regulate the inflation and the money supply.

When the central bank sells or buys bonds for other governments it will happened on the “open market operations”. The main operations are:

Lend money in exchange of collateral securities. It is based on regular basis with fixed maturity loans.

Buys and sells securities of the other governments

Are all central banks independent?

What’s about the independence of the Central Banks? The independence start in the 1980’s because before the governments used Central banks to achieve their own short term goals. There was a very high level of inflation because the Central banks printed all the money the governments wanted.

The Central banks have also the targeting inflation which is benefit because it reduces the inflation and there no expectation of a high rate of inflation. It lead to a cost-push inflationary pressure. The Central banks must be free to use monetary policy instruments in order to achieve inflation goals. In some countries (like Sweden) the target is announced by the Central bank and endorsed by the government, and in some other countries (like Australia) it’s jointly announced.

What is the ECB?

The ECB is the Central Bank of the 17 EU member states which composed the Eurozone. The Eurozone is one of the largest currency area in the world and the ECB is one of the most important central bank. It was created by the treaty of Amsterdam in 1998 and the headquarter is in Frankfurt. The actual president who controlled the ECB is Mario Draghi.

The first main objective for the ECB is to maintain price stability in the Eurozone inferior to 2%. The second one is to keep inflation low and also prevent deflation.

How can they success their objectives? The ECB choose to:

implement a monetary policy

Maintain the Euro Purchasing Power and the price stability.

Lend money to the other banks

The activities of the ECB can be divided into two groups: The first one is the economic analysis. 

This concerns the evaluation of the current financial and economic development and the possible short to medium-term risks to price stability. Moreover they keep an eye on the dynamics of real activity and the development of prices with regard to supply and demand for goods and services and factors markets at shorter horizons. The second one is the monetary analysis. They implement the monetary policies in the short-run monetary policy on the basis of the short term from the analysis of economic and financial conditions and on the analysis of money and liquidity considerations, the ECB announced a reference value for the monetary aggregate M3.

First of all this chart presents the evolution of the interest rates given by the ECB since July 2008. We can admit that the interest rates falls during these four years and nowadays the interest rates is very low (inferior to 1,00%). Why did they do that? First the ECB want to give the economy back. When the interest rates fall, people stop saving their money in the banks and they will consume more than if the interest rates would be higher.

What is the Fed?

The Federal Reserve was created by the US Congress in 1913. Before there was not

for studying and implementing monetary policy, the market was unstable and people did not trust the banking system. The Fed and its 12 regional Federal Reserve banks are directed by the Board of Governors of the Federal Reserve based in Washington DC. All the policies from the Federal Reserve come from the Federal Open Market Committee. That committee is charged with overseeing USA’s open market operation, meaning deciding for the buying and selling of Treasury bonds, and is responsible for all the important decisions on interest rates and all other kind of monetary policies.

What did the two organizations since 2006? What were there actions related to the crisis and the Greek problem?

Actions since 2006 of the Fed and the ECB:

Timeline: 163 words

Conclusion:

One can argue that European countries are in that situation because they didn’t have the power of controlling the money supply and it wouldn’t be completely wrong. Indeed, how come Spain borrows money at an incredible rate when USA benefit from the lowest rates they ever had? The answer is simple, the USA have their own money and the Fed would print a unlimited amount of money to rescue them from a sovereign default or to back up banks, Spain doesn’t have to power to do it and the question of whether or not each country should be able to print its own money is still a real debate. Moreover, it is undeniable that the current economic situation is dramatically complex and the ECB for instance is facing a really urgent problem with the Greek crisis, and although it is impossible for Central Banks to go bankrupt, a too important action from ECB would create some real problems such as inflation. In our global economy, monetary policies are clearly much more efficient then fiscal ones and since the entire monetary system controlled by Central Banks, it therefore is irrefutable that the revival of our western economy is hanging by a thread… held by Central Banks.

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