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 monetary policy based on inflation?
- Monetary policy is used by the Federal Reserve to control economic growth, unemployment, and inflation.
- Economic growth is boosted by expansionary monetary policy, whereas contractionary policy slows it down.
- Controlling inflation, moderating employment levels, and preserving long-term interest rates are the three goals of monetary policy.
- Open market operations, reserve requirements, discount rates, the federal funds rate, and inflation targeting are all ways the Fed executes monetary policy.
Is inflation affected by fiscal or monetary policy?
Changes in government expenditure and taxation have an impact on aggregate demand. These variables have an impact on employment and household income, which in turn has an impact on consumer spending and investment. Monetary policy affects an economy’s money supply, which determines interest rates and inflation.
Is fiscal policy to blame for inflation?
- The US government produced and spent trillions of dollars to stimulate the economy, resulting in unprecedented inflation.
- Too many dollars are chasing a static supply of products, and the economy is collapsing.
Inflation is a difficult concept to grasp. On a personal level, it causes harm to consumers through no fault of their own. It gives customers poor options, such as spending more money for the same things, changing your consumption basket, or foregoing a purchase. It depletes workers’ salaries and valuable savings. In politics, inflation has damaged candidates, demonstrating that voters are concerned about it. By a 77 to 20 majority, voters in North Carolina rated inflation as a more serious issue than unemployment.
So, what is inflation, exactly? Simply explained, inflation is defined as a general increase in prices and a decrease in the value of money. “Inflation is always and everywhere a monetary phenomenon,” said economist Milton Friedman. It is not a budgetary phenomenon, as it has nothing to do with taxes or government budgets. Inflation, Friedman concluded, “can only be caused by a faster growth in the supply of money than in productivity.”
The current bout of inflation is the result of huge spending: the government spent the equivalent of 27 percent of GDP on “Covid relief” and “stimulus” in 2020 and 2021, the second-largest fiscal reaction as a percentage of GDP of any industrialized country. And the Federal Reserve’s newly produced money was mostly used to fund this spending.
The money supply graph below depicts the tremendous infusion of cash since the outbreak of the pandemic:
The money supply expanded by the same amount in just 21 months, from February 2020 to November 2021, as it did in the roughly 10-year period before it, from July 2011 to February 2020.
Due to the uncertainties surrounding the outbreak of the pandemic, consumers spent less money. Personal consumption, on the other hand, had surpassed pre-pandemic levels by March 2021, continuing long-term trends.
High, simulated demand is being supported by trillions of newly produced currency. Supply is unable to keep up with demand.
The government-mandated corporate shutdown is exacerbating the supply problem. Shutdowns have wreaked havoc on entire industries and caused a drop in the labor force participation rate. The government also raised benefits to those unemployed people who refused to work, prompting some wages to rise even more as businesses competed for workers with a government check in particular industries. Wage gains, on the whole, haven’t kept up with inflation.
While government programs helped some people in need (for example, businesses with Paycheck Protection Program loans), much of the “relief” money was wasted. According to The Heritage Foundation, public health was addressed in less than 10% of the $1.9 trillion “American Rescue Plan” Act for Covid relief.
Consumer and producer prices are now at all-time highs. Wholesale costs have grown 9.7% since last year, according to the most recent data. Consumer prices have increased by 7% in the last year, reaching a 39-year high. CPI hikes of at least 0.5 percent have occurred in six of the last nine months. A growing cost of living is eating away at the value of your dollars.
Government spending in the trillions has resulted in an economy bloated with cheap money. Solutions to inflation are neither quick nor simple due to the significant spending and myriad downstream repercussions of the pandemic’s reactions. The Federal Reserve indicated recently that it expects to raise interest rates three times in 2022 to keep inflation under control. However, with an economy buoyed up and hooked to cheap money, doing so could have a significant negative impact on the economy as a whole. Furthermore, with increased interest rates, servicing the large national debt would become much more expensive.
Unfortunately, White House leaders have provided dubious answers, frequently blaming an undeserving third party. The Biden Administration maintained throughout the end of last year that the “Build Back Better” Act would assist to reduce inflation by making living less expensive for working people at no cost. It was unclear how spending trillions more in freshly minted currency would truly combat inflation.
Another ridiculous approach proposed by the White House is to use antitrust to disarm the large corporations (who were large long before current inflation) that are allegedly responsible for price increases. The Biden administration even blames inflation on port delays and the supply chain crisis. While these supply chain concerns exacerbate an already strained supply, they are not the cause of inflation, which is defined as a general increase in prices rather than a rise in prices in specific industries. These measures are more about furthering Biden’s goal than they are about lowering inflation.
While politicians debate remedies, inflation continues to wreak havoc on American families. Low-wage workers, pensioners, and people on fixed incomes are the ones that suffer the most because they are unable to keep up with inflationary pressures. Inflation has the impact of a hidden tax on them, which they bear the brunt of. Because the majority of their income is already spent on needs, they have limited room to adjust their consumption habits.
America requires leaders who see the true dangers of inflation. Inflation is a small annoyance for the wealthy, but it poses a severe threat to the budgets of the working class and low-income people. Creating inflation indiscriminately to get pet projects through Congress snubs those who are most in need.
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 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.
Which fiscal policy leads to higher inflation?
However, if used during a solid economic expansion, expansionary fiscal policy can lead to higher interest rates, larger trade deficits, and faster inflation.
What distinguishes monetary policy from fiscal policy?
- Monetary and fiscal policy are both macroeconomic tools for managing or stimulating the economy.
- Interest rates and the supply of money in circulation are dealt with by monetary policy, which is usually administered by a central bank.
- Taxation and government spending are addressed by fiscal policy, which is mostly controlled by government legislation.
- Together, monetary and fiscal policy have a significant impact on a country’s economy, businesses, and consumers.
What causes inflation, exactly?
- Inflation is the rate at which the price of goods and services in a given economy rises.
- Inflation occurs when prices rise as manufacturing expenses, such as raw materials and wages, rise.
- Inflation can result from an increase in demand for products and services, as people are ready to pay more for them.
- Some businesses benefit from inflation if they are able to charge higher prices for their products as a result of increased demand.
What are the reasons for India’s inflation?
When the government cannot earn enough revenue to cover its expenses, it must rely on deficit financing. Massive amounts of deficit finance were used during the sixth and seventh plans. In the sixth Plan, it was Rs. 15,684 crores, while in the seventh Plan, it was Rs. 36,000 crores.
Increase in government expenditure:
India’s government spending has been rapidly increasing in recent years. What’s more alarming is that the proportion of non-development spending has risen fast, now accounting for nearly 40% of overall government spending. Non-development spending does not produce tangible commodities; instead, it increases purchasing power, resulting in inflation.
Not only do the elements described above on the Demand side produce inflation, but they also add gasoline to the fire of inflation on the Supply side.
Inadequate agricultural and industrial growth:
Our country’s agricultural and industrial expansion has fallen well short of our expectations. Food grain output has increased at a rate of 3.2 percent per year during the last four decades.
Droughts, on the other hand, have caused crop failure in some years. During years of food grain scarcity, not only did the prices of food articles rise, but so did the overall price level.