Introduction
Inflation, often misunderstood, is a crucial aspect of economic theory and practice. It describes the rate at which the general level of prices for goods and services rises and, subsequently, how purchasing power is falling. It results from too much money chasing too few goods: Amount of money > Economy. The fundamental equation that governs this phenomenon can be expressed as follows:
Amount of Money × Velocity of Money Flow (Circulation) = Market Value of Goods and Services (Economics);
Quantity Theory of Money: MV=PQ, where
- M represents the total amount of money in circulation in an economy. M1 or M2 are the standard measurement
- V represents the velocity of money, which measures the rate at which money is exchanged from one transaction to another.
- P refers to the general price level. CPI is the most common measurement.
- Q denotes the quantity of goods and services produced, typically represented by real GDP.
While understanding inflation in isolation is important, it’s even more critical to consider how it fits into the broader economic landscape. Central banks, the institutions that manage a country’s money supply, are pivotal in monitoring and influencing inflation rates to ensure economic stability and growth. This leads us to the crucial role of central banks in managing inflation.
The Role of Central Banks and the Concept of Inflation
A central bank’s primary goals include maintaining an optimal unemployment rate and a stable inflation rate, often portrayed in economics as the Phillips curve. The bank uses money as a medium to achieve these targets. An increase in the money supply can stimulate economic activity, leading to job creation and wealth redistribution.
Inflation plays a significant role in this process. Moderate inflation, typically around 2%, is healthy for an economy. It encourages individuals to invest and spend (because the value of money is decreasing), thus promoting economic growth and a higher GDP. Conversely, deflation, where the value of money increases, leading to decreased spending, can be detrimental to an economy. GDP will decrease if everyone stops spending money, refraining from unnecessary expenditures, and no one wants to work. Japanese is a good example: the lost decade.
(The Misery Index, a sum of the inflation and unemployment rates, is often used as a measure of economic wellbeing. A high Misery Index indicates an unhealthy economy, while a low index signifies economic stability and growth.)
The Dangers of Deflation and Hyperinflation
While moderate inflation can be beneficial, both deflation and hyperinflation can have detrimental effects on an economy.
Deflation, a decrease in the general price level of goods and services, increases the value of money. While this might initially seem optimistic, it can lead to reduced spending as people hold onto their money in anticipation of further price drops. This can cause a decrease in GDP, as seen in Japan’s period of deflation.
Hyperinflation, on the other hand, is a rapid and often uncontrollable increase in inflation. It can quickly erode the value of money, destabilize economies, and lead to social unrest. For example:
- Lost Purchasing Power: As currency quickly loses value, people’s ability to buy goods and services significantly diminishes.
- Vanishing Savings: Hyperinflation rapidly devalues savings, wiping out people’s stored wealth.
- Business Paralysis: The unpredictability of costs and profits amid hyperinflation stunts business planning and investment, stifling economic growth.
- Sociopolitical Instability: As economic hardship escalates, social and political unrest can follow, leading to societal breakdown.
Thus, controlling inflation is crucial for policymakers to maintain economic stability. As a result, staying in the spectrum of slight inflation, 2% - 3%, is the most acceptable by the governments.
Understanding the Causes of Inflation
Inflation can be attributed to three primary factors: demand-pull, cost-push, and money supply.
Demand-Pull Inflation
Demand-pull inflation occurs when demand for goods and services exceeds their supply. In essence, this situation pulls money into sectors of the economy that are at full capacity, leading to an increase in prices. On the other hand, if money is pulled into sectors that are not at full capacity, it can lead to economic growth with minimal price increases, the ideal scenario for the government and central bank. The employment rate can gauge the level of capacity.
However, if the unemployment rate is already low, a further increase in demand may only increase prices, thus accelerating inflation.
One of the most common ways to measure capacity is the combination of Unemployment Rate + Job Vacancies + Companies Profit Margins. For example, if the Unemployment Rate is decreasing, Job Vacancies are increasing, and Companies Profit Margins are increasing, demonstrating the economy is at full capacity, which will lead to price increases.
Cost-Push Inflation
Cost-push inflation happens when the costs of production increase, causing producers to raise prices to maintain their profit margins. Rising prices of raw materials or changes in global conditions can cause this type of inflation. For example, a decrease in the exchange rate of the Russian Ruble against the US Dollar coupled with Western sanctions led to increased costs (because Ruble exchange rate to the USD plunged 30%, meaning a 30% price increase for the USD-denominated commodities) and decreased supply, resulting in inflation. The price increase will lead to a decrease in total demand, resulting in lower production.
Money Supply
An increase in the money supply without a corresponding increase in goods and services can also lead to inflation. Furthermore, expected price increases can also lead to an increase in the velocity of money circulation, even if the total amount of money in the system is fixed. This anticipation of inflation can, in turn, cause actual inflation, a phenomenon known as the Expectation Theory (Self-fulfilling Prophecy). But why does the Central bank print too much money, leading to oversupply?
The Interplay of Central Bank Tools, Commercial Banks, and Fiscal Policy in Economic Management
Central banks primarily rely on two tools to manage the economy: 1. Interest rate control and 2. Purchasing financial assets on the open market. However, the effectiveness of these tools hinges significantly on the responses of commercial banks and financial institutions.
For instance, a central bank may purchase financial assets from commercial banks, infusing them with cash. But if these banks choose to refrain from lending this money to the real economy, the intended stimulus falls short. The situation can worsen if banks redirect this cash into the financial economy, potentially inflating asset bubbles without relieving a struggling real economy.
In such scenarios, government intervention through fiscal policy becomes essential. Implementing fiscal stimulus packages, which may involve distributing money directly to households, can effectively bypass the banking system to stimulate economic activity. Monetary Policy vs Fiscal Policy
Both monetary and fiscal policies are crucial tools for managing an economy. However, they are administered by different entities and have unique features and limitations.
The Central Bank, which is typically independent of the government, implements monetary policy. It uses tools like interest rate manipulation and buying/selling government bonds to control the money supply and influence the economy. On the other hand, fiscal policy is administered by the government and involves changing the level of government spending and taxation to affect aggregate demand directly.
Monetary and fiscal policies often need to be coordinated for maximum effectiveness. For example, during a recession, a combination of expansionary fiscal policy (increased government spending or tax cuts) and monetary policy (lowering interest rates) can help stimulate the economy.
However, conflicts can arise due to the fiscal and monetary authorities' differing goals and time horizons. For example, the government might be interested in a short-term economic boost to win an upcoming election and run a large budget deficit. The Central Bank may be more concerned about long-term price stability and could counteract this by tightening monetary policy. Therefore, the two entities need to communicate effectively and work towards the economy's overall health.
Yield Curves and their Economic Implications (extension)
Central banks can influence the yield curve through their monetary policy actions. The yield curve is a graph that depicts yields on similar quality securities across various maturities, from short-term to long-term.
- Short-term yields: These are most directly affected by central bank policy rates. For example, short-term yields also drop when a central bank lowers its policy rate.
- Expectations of future inflation and economic activity influence mid-term and long-term yields. However, a central bank can also influence mid to long-term yields through Quantitative Easing, aiming to manage economic cycles and prevent extreme economic fluctuations. By buying long-term securities, a central bank increases demand for these securities. This increased demand leads to a price increase for the securities, which leads to a drop in their yield (as price and yield are inversely related).
The impact of central bank actions on the yield curve can have broad implications for the economy. A steep yield curve (where long-term yields are significantly higher than short-term yields) is often seen as a sign of a healthy, growing economy. A flat or inverted yield curve (where short-term yields are higher than long-term yields), on the other hand, can be a sign of economic slowdown or impending recession.
The Complex Interactions Between Inflation, Interest Rates, and Asset Prices
Numerous factors can influence inflation and asset prices, creating a complex interplay that shapes market dynamics. Generally, inflation can prompt individuals to invest in assets like stocks as a means to protect their wealth from eroding purchasing power. However, the picture isn’t so straightforward.
Inflation often coexists with higher interest rates, a monetary policy tool central banks use to control rising prices. These higher interest rates can increase the cost of borrowing, dampening business expansion and potentially leading to lower corporate profits. Consequently, the valuation of stocks decreases, and their prices fall.
Moreover, higher interest rates can make fixed-income investments more attractive relative to stocks, leading investors to rebalance their portfolios away from the equity market.
It’s important to note that expectations can also influence market reactions to inflation. If inflation is anticipated and considered within a healthy range, the market might react differently than when inflation is unexpected or excessively high.
Therefore, understanding inflation’s impact on asset prices requires a multifaceted perspective that considers current economic conditions, expectations, interest rates, and the broader financial environment. The relationship between inflation and asset prices underscores economic systems' intricate, interconnected nature.
Reference
The changing Phillips Curve in the UK economy
