Monetary Policy and Inflation

In a purely economic sense, inflation refers to a general increase in price levels due to an increase in the quantity of money; the growth of the money stock increases faster than the level of productivity in the economy. The exact nature of price increases is the subject of much economic debate, but the word inflation narrowly refers to a monetary phenomenon in this context.

Using these specific parameters, the word deflation is used to describe productivity increasing faster than the money stock. This leads to a general decrease in prices and the cost of living, which many economists paradoxically interpret to be harmful. The arguments against deflation trace back to John Maynard Keynes’ paradox of thrift. Due to this belief, most central banks pursue a slightly inflationary monetary policy to safeguard against deflation.

Key Takeaways

• Central banks today primarily use inflation targeting in order to keep economic growth steady and prices stable.
• With a 2%–3% inflation target, when prices in an economy deviate, the central bank can enact monetary policy to try and restore that target.
• If inflation heats up, raising interest rates or restricting the money supply are both contractionary monetary policies designed to lower inflation.

Inflation Targeting

Most modern central banks target the rate of inflation in a country as their primary metric for monetary policy. If prices rise faster than their target, central banks tighten monetary policy by increasing interest rates or other hawkish policies. Higher interest rates make borrowing more expensive, curtailing both consumption and investment, both of which rely heavily on credit.

Likewise, if inflation falls and economic output declines, the central bank will lower interest rates and make borrowing cheaper, along with several other possible expansionary policy tools.

As a strategy, inflation targeting views the primary goal of the central bank as maintaining price stability. All of the tools of monetary policy that a central bank has, including open market operations and discount lending, can be employed in a general strategy of inflation targeting. Inflation targeting can be contrasted with strategies of central banks aimed at other measures of economic performance as their primary goals, such as targeting currency exchange rates, the unemployment rate, or the rate of nominal gross domestic product (GDP) growth.

How Central Banks Influence the Money Supply

Contemporary governments and central banks rarely ever print and distribute physical money to influence the money supply, instead relying on other controls such as interest rates for interbank lending. There are several reasons for this, but the two largest are:

1. New financial instruments, electronic account balances, and other changes in the way individuals hold money make basic monetary controls less predictable.
2. History has produced more than a handful of money-printing disasters that have led to hyperinflation and mass recession.

The U.S. Federal Reserve switched from controlling actual monetary aggregates, or the number of bills in circulation, to implementing changes in key interest rates, which has sometimes been called the “price of money.” Interest rate adjustments impact the levels of borrowing, saving, and spending in an economy.

When interest rates rise, for example, savers can earn more on their demand deposit accounts and are more likely to delay present consumption for future consumption. Conversely, it is more expensive to borrow money, which discourages lending. Since lending in a modern fractional reserve banking system actually creates “new” money, discouraging lending slows the rate of monetary growth and inflation. The opposite is true if interest rates are lowered; saving is less attractive, borrowing is cheaper, and spending is likely to increase, etc.

Increasing and Decreasing Demand

In short, central banks manipulate interest rates to either increase or decrease the present demand for goods and services, the levels of economic productivity, the impact of the banking money multiplier, and inflation. However, many of the impacts of monetary policy are delayed and difficult to evaluate. Additionally, economic participants are becoming increasingly sensitive to monetary policy signals and their expectations about the future.

There are some ways in which the Federal Reserve controls the money stock; it participates in what is called open market operations, by which federal banks purchase and sell government bonds. Buying bonds injects new dollars into the economy, while selling bonds drains dollars out of circulation. So-called quantitative easing (QE) measures are extensions of these operations. Additionally, the Fed can change the reserve requirements at other banks, limiting or expanding the impact of money multipliers.

What Is Monetary Policy?

Monetary policy is a set of actions by a nation’s central bank to control the overall money supply and achieve economic growth. Strategies include revising interest rates and changing bank reserve requirements.

In the United States, the Federal Reserve Bank implements monetary policy through a dual mandate to achieve maximum employment while keeping inflation in check.

What Is Inflation?

Inflation is a gradual loss of purchasing power that is reflected in a broad rise in prices for goods and services over time. The inflation rate is calculated as the average price increase of a basket of selected goods and services over one year.

In the U.S., the Federal Reserve targets an annual average inflation rate of 2% by setting a range of its benchmark federal funds rate, which is the interbank rate on overnight deposits.

What Is a Central Bank?

A central bank is a financial institution responsible for forming monetary policy and regulating member banks. It typically has privileged control over the production and distribution of money and credit for a nation or a group of nations.

The U.S. central bank is the Federal Reserve System. Often called the Fed, it was created in 1913 and is arguably the world’s most influential financial institution.

How Does a Central Bank Affect Monetary Policy and Inflation?

Most nations’ central banks target the inflation rate in their respective countries as their primary metric for monetary policy. A central bank affects monetary policy by adjusting the money supply in the economy. A central bank affects inflation by manipulating interest rates through monetary policy, either raising rates to cool the economy when inflation is high or lowering rates to stimulate economic growth when inflation is low.

The Bottom Line

Arguments for monetary policy are that it controls inflation through a target interest rate; is quick and easy to implement; can be undertaken by independent and politically neutral central banks without fear of political repercussions; and can actually boost exports if the nation’s currency is weaker on world markets.

Arguments against monetary policy are that it takes months or even years to have effects on an economy; can lead to a liquidity trap when interest rates are kept very low for prolonged periods of time; affects an entire economy or country when only some sectors or regions might need the stimulus; and creates a risk of hyperinflation.

Economists continue to debate the usefulness of monetary policy, but it remains the most direct tool of central banks to combat or create inflation.