Social Issues / Monetary Policy, Inflation And Growth

Monetary Policy, Inflation And Growth

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Autor:  anton  14 March 2011
Tags:  Monetary,  Policy,  Inflation,  Growth
Words: 2308   |   Pages: 10
Views: 202

Monetary policy is the government or central bank process of managing money supply to achieve specific goals, such as constraining inflation, maintaining an exchange rate, achieving full employment or economic growth. Monetary policy can involve changing certain interest rates, either directly or indirectly through open market operations, setting reserve requirements, or trading in foreign exchange markets. It must be universally agreed that low and stable inflation is a primary and essential goal for monetary policy, in large part because economists believe that it brings stability to financial systems and fosters sustainable economic growth over the longer run.Although, monetary policy is generally referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy has the goal of raising interest rates to combat inflation.(12)- (3)

Inflation is an increase in the money supply or an increase in prices. The two most obvious versions of this, each held by some economists to be "real" inflation, are for prices of goods and services in the currency in question to rise, or for the money supply to increase. Price inflation is closely related to "cost of living" measurement, where a "basket" of goods is used as a standard and the prices of the goods are compared at two intervals and adjusting for changes in the intrinsic basket. But, technically, this is not raw inflation; it is an attempt to determine real-life value of money compared to the members of the society in question, adding other factors like increased expectations. Raw inflation measurement does not adjust for expectations, but directly measures the change in the price of goods. There are different measurements of price inflation, depending on the basket of goods selected. The most common measures are of consumer inflation, producer inflation and GDP deflators, or price indexes. The last measures inflation in the entire economy. General price inflation is a fall in the purchasing power of money within an economy, as compared to currency devaluation which is the fall of the market value of a currency between economies. The extent to which these two phenomena are related is open to economic debate, though the comparison of a currency to foreign currencies is based on investor demand for currencies, and therefore must at least partially be a matter of perception. Both of these are often caused by money being added to an economy, either as printed currency or as virtual money lent to banks or other entities. This is called currency inflation, and can cause price inflation or currency devaluation. But, because the general amount of wealth gradually changes in an economy (as long-lasting things are created, new technologies invented, et cetera), a small amount of currency inflation need not cause price inflation. (6)- (9)

Economic growth is the increase in the value of goods and services produced by an economy. It is generally considered to be an increase in the wealth, or more precisely the income, of a nation or entity. It is conventionally measured as the percent rate of increase in real gross domestic product, or GDP. Growth is usually calculated in real terms, i.e. inflation-adjusted terms, in order to net out the effect of inflation on the price of the goods and services produced. In economics, "economic growth" or "economic growth theory" typically refers to growth of potential output, i.e., production at "full employment," rather than growth of aggregate demand or observed output. The short-run variation of economic growth is termed the business cycle, and almost all economies experience periodic recessions. Explaining and preventing these fluctuations is one of the main focuses of macroeconomics. A statistical relationship called Okun's law relates the growth rate of an economy to the level of unemployment. On a Keynesian view, growth varies because of changes in aggregate demand, causing firms to produce more or less goods and for sale and hence altering the size of the economy. The contrasting real business cycle model suggests that in the short run growth depends on a series of shocks to the productivity of the economy, e.g. an oil price rise making the economy generally less productive and reducing growth. The long-run path of economic growth is one of the central questions of economics; in spite of the problems of measurement, an increase in GDP of a country is generally taken as an increase in the standard of living of its inhabitants. Over long periods of time, even small rates of annual growth can have large effects through compounding. A growth rate of 2.5% per annum will lead to a doubling of GDP within 30 years, whilst a growth rate of 8% per annum (experienced in China) will lead to a doubling of GDP within 10 years.(12)- (4)- (9)

Economic growth is a key part of most governments’ macroeconomic policies, especially monetary policy, due to the benefits of it. The first benefit of economic growth is an increase in the standard of living. The second benefit is it stimulates higher employment. This is because economic growth is represented by an extension in aggregate demand, or a shift to the right of the aggregate demand curve. Either way it means more of an economy's resources, which include labor, are being utilized. Thirdly it means the government has a fiscal dividend. Economic growth boosts tax revenues and provides the government with extra money to finance spending projects. Fourthly it increases the accelerator effect. This means rising demand encourages investment in new capital machinery which helps sustain economic growth by increasing long run aggregate supply. Lastly it boosts business confidence. It normally has a positive effect on firms’ profits, which boosts the stock exchange helps both small and large businesses grow.(12)- (14)

However, there are three major disadvantages to economic growth. The first is the risk from inflation. If an economy grows too rapidly, aggregate demand will race ahead of aggregate supply. Producers may take advantage of this by raising prices for consumers. The second disadvantage of economic growth is its environmental impact. It can produce several negative externalities. For example if the wealth of the population increases, this could result in an increase and over consumption of de-merit goods. This can have a negative effect on people's quality of life and may also affect a country's ability to sustain its rate of growth for example the over-exploitation of fish stocks. The third is that an inequitable distribution of the gains from economic growth can cause civil unrest. (14)- (15) - (17)

In any currency, there is a supply of money, and an interest rate, the price at which money can be borrowed. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation and unemployment. A policy is referred to as contractionary if it reduces the size of the money supply or raises the interest rate. An expansionary policy increases the size of the money supply, or decreases the interest rate. There are several monetary policy tools available to achieve these ends. Increasing interest rates by fiat, reducing the monetary base or increasing reserve requirements all have the effect of contracting the money supply, and, if reversed, expand the money supply. The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various credit instruments, foreign currencies or commodities. All of these purchases or sales result in more or less base currency entering or leaving market circulation.(1)- (8)

Developing countries may have problems operating monetary policy effectively. The primary difficulty is that few developing countries have deep markets in government debt. The matter is further complicated by the difficulties in forecasting money demand and fiscal pressure to levy the inflation tax by expanding the monetary base rapidly.

Constant market transactions by the monetary authority modify the liquidity of currency and this impacts other market variables such as short term interest rates, the exchange rate and the domestic price of spot market commodities such as gold. Open market operations are undertaken with the objective of stabilizing one of these market variables.

Monetary Policy: Target Market Variable: Long Term Objective:

Inflation Targeting Interest rate on overnight debt A given rate of change in the CPI

Price Level Targeting Interest rate on overnight debt A specific CPI number

Monetary Aggregates The growth in money supply A given rate of change in the CPI

Fixed Exchange Rate The spot price of the currency The spot price of the currency

Gold Standard The spot price of gold Low inflation as measured by the gold price

Mixed Policy Usually interest rates Usually unemployment + CPI change

( )

The distinction between the various types of monetary policy lies primarily with the market variable that open market operations are used to target. Targeting is being the process of achieving relative stability in the target variable.

The different types of policy are also called monetary regimes, in parallel to exchange rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking the exact same variables (such as a harmonized consumer price index). (12)

During the last decade, central banks in developing countries have increasingly adopted approaches to monetary policy that focus on lowering the rate of inflation, with little regard to their impact on "real factors" such as poverty, employment, investment or economic growth. Among these approaches, "inflation targeting" is the most prominent. Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index, at a particular level. The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the rate at which banks lend to each other over night for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar. The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee. Changes to the interest rate target are done in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards achieving the defined inflation target. (7)- (9)- (11)- (17)

It is important for policymakers to make credible announcements regarding their monetary policies. If private agents (consumers and firms) believe that policymakers are committed to lowering inflation, they will anticipate future prices to be lower (adaptive expectations). If an employee expects prices to be high in the future, he or she will draw up a wage contract with a high wage to match these prices. Hence, the expectation of lower wages is reflected in wage-setting behavior between employees and employers (lower wages since prices are expected to be lower) and since wages are in fact lower there is not demand pull inflation because employees are receiving a smaller wage and there is not cost push inflation because employers are paying out less in wages.

However, to achieve this low level of inflation, policymakers must have credible announcements, i.e. private agents must believe that these announcements will reflect actual future policy. If an announcement about low-level inflation targets is made but not believed by private agents, wage-setting will anticipate high-level inflation and so wages will be higher and inflation will rise. A high wage will increase a consumer's demand (demand pull inflation) and a firm's costs (cost push inflation), so inflation rises. Hence, if a policymaker's announcements regarding monetary policy are not credible, policy will not have the desired effect. (12)

However, if policymakers believe that private agents anticipate low inflation, they have an incentive to adopt an expansionist monetary policy (where the marginal benefit of increasing economic output outweighs the marginal cost of inflation). However, assuming private agents have rational expectations, they know that policymakers have this incentive. Hence, private agents know that if they anticipate low inflation, an expansionist policy will be adopted that causes a rise in inflation. Therefore, (unless policymakers can make their announcement of low inflation credible), private agents expect high inflation. This anticipation is fulfilled through adaptive expectation (wage-setting behavior) and so there is higher inflation (without the benefit of increased output). Hence, unless credible announcements can be made, expansionary monetary policy will fail. (12)- (10)

Announcements can be made credible in various ways. One is to establish an independent central bank with low inflation targets (but no output targets). Hence, private agents know that inflation will be low because it is set by an independent body. Central banks can be given incentives to meet their targets (e.g. larger budgets, a wage bonus for the head of the bank). A policymaker with a reputation for low inflation policy can make credible announcements because private agents will expect future behavior to reflect the past.



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