Inflation is frequently thought of as a monetary phenomenon, which it is, but it is also affected by economic factors. The Fed can increase the money supply by decreasing interest rates to encourage borrowing or buying assets, but it can’t directly inject money into the goods and services markets.
Is inflation caused by monetary policy or fiscal policy?
As the US economy has slowly recovered from the Great Recession in recent years, a mystery has emerged: where has all the inflation gone? Inflation in the United States remains stubbornly below the Federal Reserve’s goal rate of 2%, despite a record low jobless rate and historically low interest rates. A similar conundrum arose during the Great Recession: What happened to the deflation? Inflation fell slightly, but the deflationary spiral that many feared would emerge once interest rates reached zero did not materialize.
According to John H. Cochrane, a senior scholar at the Hoover Institution and distinguished senior fellow at Chicago Booth, there is an explanation for this that defies traditional economics. Standard economic theory has long claimed that inflation is entirely controlled by monetary policy, but that it has little to do with fiscal policy outside of extreme hyperinflations. According to Cochrane and other economists who have worked on the fiscal theory of the price level (FTPL) for the past 30 years, this orthodoxy is incorrect. Fiscal policy, according to this idea, is a significant driver of inflation.
Cochrane investigates what drove US inflation between 1947 and 2018 using statistics on inflation, monetary and fiscal policy, and economic factors. On the basis of the economic principle that the real value of government debt must be equal to the real present value of primary surpluses that the government is projected to run in the future to pay back the debt, his theory relates inflation to the real value of government debt. (Primary surpluses are the difference between tax receipts and government spending, minus interest payments.)
The Federal Reserve’s interest-rate policy, according to conventional wisdom, totally influences price levels and inflation. Even if deflation raises the value of the debt, Congress and the Treasury are expected to raise or cut taxes and expenditure as needed to pay it off. The real worth of government debt, on the other hand, drives prices in the FTPL, much like the present value of future dividends determines a stock price.
Compare the amount of outstanding debt with the present value of future surplusesand with the discount rate, or return that holders of government debt require, according to Cochrane. Unexpected inflation indicates that investors believe the government will not be able to service its debt due to a lack of surpluses, or that they require a greater return to keep debt. They try to sell government bonds in either event, driving up the price of everything else.
The data revealed a long-standing historical correlation that FTPL experts had been perplexed by: a lower rate of inflation during recessions. Deficits in the United States, for example, grew considerably during the Great Recession as a result of lower tax receipts and greater expenditure, particularly on stimulus and bailouts. Expectations for future surpluses have also dropped. Inflation, on the other hand, fell as investors sought out stable assets like government bonds. Why? Because interest rates have fallen. In the name of safety, investors were ready to hold government bonds and even sold less of everything else to buy them, despite the low yields. A low discount rate translates to a higher real value, which necessitates less inflation.
The discount rate is the most important driver of stock prices, according to research, and the discount rate has also had a key influence in US inflation, according to Cochrane. Unexpected inflation has historically been linked to increases in real interest rates, which reduce the value of debt, and vice versarather than changes in expected surpluses.
Is inflation a budgetary issue?
The use of government spending and tax policies to impact economic conditions, particularly macroeconomic variables such as aggregate demand for goods and services, employment, inflation, and economic growth, is referred to as fiscal policy.
What is fiscal policy inflation?
Find out more about our editorial guidelines. When an economy expands as a result of greater spending but not as a result of increased production of goods and services, inflation occurs. Prices rise as a result, and the money within the economy is worth less than it was previously.
What exactly is inflation?
Inflation is defined as the rate at which prices rise over time. Inflation is usually defined as a wide measure of price increases or increases in the cost of living in a country.
What impact does inflation have on monetary policy?
As the rate of inflation rises, the Fed follows this rule and raises the interest rate. The monetary policy rule explains how the Fed responds to changes in inflation rates by adjusting real interest rates. The monetary authority aims for a higher real interest rate as inflation rises.
Is India’s inflation a monetary phenomenon?
Abstract. Some economists and policymakers argue that “inflation is always a monetary phenomenon,” and that the best strategy to stop growing inflation is to reduce the money supply in the economy.
What does hyperinflation look like?
According to the Cato Institute, the most recent example of hyperinflation was Zimbabwe’s currency troubles, which peaked in November 2008, with a monthly inflation rate of almost 79 billion percent. Despite the fact that the Zimbabwean government stopped releasing official inflation numbers during the country’s worst months of hyperinflation, the research employs normal economic theory (purchase power parity comparisons) to calculate Zimbabwe’s worst inflation rates.
With prices nearly tripling every 24 hours, the Reserve Bank issued a $200 million note mere days after issuing a $100 million bill and limited bank withdrawals at $500,000, which was around $0.25 US at the time. Prices surged when the $100 million bill was introduced, with reports claiming that the price of a loaf of bread went from $2 million to $35 million overnight. The government even proclaimed inflation “illegal” at one point, arresting company CEOs for boosting prices on their products.
The situation deteriorated to the point where shops in the country simply refused to accept the money, and the US dollar, as well as the South African rand, became the de facto currency. Inflation was finally brought to a stop by the Reserve Bank of Zimbabwe, which re-priced the currency and pegged it to the US dollar. In addition, the government imposed restrictions that forced the country’s stock exchange to close.
Is inflation beneficial to the economy?
Inflation is and has been a contentious topic in economics. Even the term “inflation” has diverse connotations depending on the situation. Many economists, businesspeople, and politicians believe that mild inflation is necessary to stimulate consumer spending, presuming that higher levels of expenditure are necessary for economic progress.
How Can Inflation Be Good For The Economy?
The Federal Reserve usually sets an annual rate of inflation for the United States, believing that a gradually rising price level makes businesses successful and stops customers from waiting for lower costs before buying. In fact, some people argue that the primary purpose of inflation is to avert deflation.
Others, on the other hand, feel that inflation is little, if not a net negative on the economy. Rising costs make saving more difficult, forcing people to pursue riskier investing techniques in order to grow or keep their wealth. Some argue that inflation enriches some businesses or individuals while hurting the majority.
The Federal Reserve aims for 2% annual inflation, thinking that gradual price rises help businesses stay profitable.
Understanding Inflation
The term “inflation” is frequently used to characterize the economic impact of rising oil or food prices. If the price of oil rises from $75 to $100 per barrel, for example, input prices for firms would rise, as will transportation expenses for everyone. As a result, many other prices may rise as well.
Most economists, however, believe that the actual meaning of inflation is slightly different. Inflation is a result of the supply and demand for money, which means that generating more dollars reduces the value of each dollar, causing the overall price level to rise.
Key Takeaways
- Inflation, according to economists, occurs when the supply of money exceeds the demand for it.
- When inflation helps to raise consumer demand and consumption, which drives economic growth, it is considered as a positive.
- Some people believe inflation is necessary to prevent deflation, while others say it is a drag on the economy.
- Some inflation, according to John Maynard Keynes, helps to avoid the Paradox of Thrift, or postponed consumption.
When Inflation Is Good
When the economy isn’t operating at full capacity, which means there’s unsold labor or resources, inflation can theoretically assist boost output. More money means higher spending, which corresponds to more aggregated demand. As a result of increased demand, more production is required to supply that need.
To avoid the Paradox of Thrift, British economist John Maynard Keynes argued that some inflation was required. According to this theory, if consumer prices are allowed to decline steadily as a result of the country’s increased productivity, consumers learn to postpone purchases in order to get a better deal. This paradox has the net effect of lowering aggregate demand, resulting in lower production, layoffs, and a faltering economy.
Inflation also helps borrowers by allowing them to repay their loans with less valuable money than they borrowed. This fosters borrowing and lending, which boosts expenditure across the board. The fact that the United States is the world’s greatest debtor, and inflation serves to ease the shock of its vast debt, is perhaps most crucial to the Federal Reserve.
Economists used to believe that inflation and unemployment had an inverse connection, and that rising unemployment could be combated by increasing inflation. The renowned Phillips curve defined this relationship. When the United States faced stagflation in the 1970s, the Phillips curve was severely discredited.
What are the differences between fiscal and monetary policies?
Household economic decisions can have a huge impact on the economy. A household’s decision to consume more and save less, for example, can result in an increase in employment, investment, and, eventually, profits. Similarly, business investment decisions can have a significant impact on the actual economy and corporate profitability. Individual firms, on the other hand, rarely have a significant impact on major economies on their own; a single household’s consumption decisions have a small impact on the overall economy.
Government policies, on the other hand, can have a huge impact on even the largest and most sophisticated economies for two reasons. To begin with, most developed economies’ public sectors often employ a considerable portion of the population and are responsible for a significant portion of the economy’s spending. Second, governments are the biggest debtors on the global debt markets.
The borrowing and spending operations of the government eventually convey government policy. We will identify and examine two types of government policy that can have an impact on the macroeconomy and financial markets in this reading: monetary policy and fiscal policy.
Central bank operations aimed at affecting the amount of money and credit in an economy are referred to as monetary policy. Fiscal policy, on the other hand, relates to the government’s decisions on taxation and spending. To control economic activity over time, both monetary and fiscal policies are used. They can be used to boost growth when an economy is slowing down, or to cool down growth and activity when an economy is overheating. Furthermore, fiscal policy can be used to redistribute wealth and income.
The main goal of both monetary and fiscal policy is typically to create an economic climate that is stable and positive, with low inflation. The goal is to direct the underlying economy so that it does not experience economic booms that are followed by extended periods of low or negative growth and high unemployment rates. Households can feel confident in their spending and saving decisions in such a stable economic climate, while companies can focus on their investment decisions, making regular coupon payments to bond holders, and producing profits for their shareholders.
There are numerous obstacles to overcome in order to achieve this broad goal. Not only are economies constantly buffeted by shocks (such as increases in oil prices), but some economists argue that the economy also has natural cycles. Furthermore, there are several historical examples of government policieswhether monetary, fiscal, or bothexacerbating an economic expansion and ultimately causing harm to the actual economy, financial markets, and investors.
The remainder of the reading is organized in the following manner. The second section introduces monetary policy and associated themes. The third section discusses fiscal policy. Section 4 is concerned with the interplay between monetary and fiscal policy. The reading concludes with a summary and practice problems.