126.96.36.199 Inflation, Monetarism and the Role of Central Banks
Money facilitates the exchange of goods and services, enabling a transfer of wealth between buyer and seller at an agreed price, but it can also be regarded as a commodity itself. As described earlier, its value is determined by financial markets (3.3.4). It can be bought and sold on foreign exchange markets. Currency traders assess a country’s economic performance to predict whether its currency is likely to increase in value compared to others.
Inflation can be loosely described as an increase in the prices paid by individuals and companies for goods and services, or a fall in the purchasing power of money. Several factors can cause it:
● consumer demand that exceeds an economy’s capacity to grow (referred to as ‘overheating’);
● increases in the prices of imports;
● wage demands which are not accompanied by corresponding increases in productivity;
● an increase in the flow of money in circulation (governments can literally ‘print money’, in the form of coins and bank notes, to fund their spending or pay their debts).
Inflation reduces the real value of people’s incomes and savings. Very high inflation causes hardship: money becomes almost worthless – as described in an Economist article about the hyperinflation in Germany in the 1920s: Loads of money. It is a politically sensitive issue. Harold Wilson felt the need “to reassure viewers that the “pound in the pocket” would be unaffected by the devaluation of sterling”, for example, in a famous speech in 1967. Needless to say, his claim was inaccurate: the pound did not immediately lose 14.3% of its purchasing value in the shops – but eventually prices rose as people had to pay more for imported goods.
Deflation (falling prices), as experienced during the Great Depression in the 1930s and (less sharply) in Japan in the 1990s, is the opposite of inflation. It is associated with a shrinking economy, a recession, that is also a serious problem.
It is therefore important to steer a path between inflation and deflation. Some governments have attempted to apply direct controls to prices and incomes, but this has been unsuccessful (188.8.131.52). There are two viable policy tools: ‘monetarism’ and the fiscal approach (often referred to as Keynesian):
● The fiscal approach restrains inflation by increasing taxes, to reduce demand and slow the rate of economic growth. This in turn reduces wages, as there is less demand for labour, and shoppers become keener on finding lower prices. Keynes advocated this use of fiscal policy to control inflation.
● The monetarist approach, which was advocated by Milton Friedman among others, is to reduce inflation by increasing the price of money. Milton Friedman’s contribution to economic thinking was summarised in a special Economist article, A heavyweight champ, at five foot two, which cited his 1971 book A Monetary History of the United States, 1867-1960. It demonstrated the link between money supply and inflation.
Monetarism became more popular in the 1980s. Samuelson and Nordhaus compare the efficacy of fiscal and monetarist policies in chapter 23 of Economics. Nowadays the central banks manage inflation in most countries, in accordance with targets set by government, as in this Bank of England example:
“To keep inflation low and stable, the Government sets us an inflation target of 2%. This helps everyone plan for the future.
If inflation is too high or it moves around a lot, it’s hard for businesses to set the right prices and for people to plan their spending.
But if inflation is too low, or negative, then some people may put off spending because they expect prices to fall. Although lower prices sounds like a good thing, if everybody reduced their spending then companies could fail and people might lose their jobs.”
Central banks can act in financial markets to control inflation by increasing the cost of borrowing for businesses and consumers. Businesses are then less able to expand their supply of goods and services, and consumers with debts have less free money to purchase them. This cools an overheated economy. Central banks have several ways of doing this:
● They can raise interest rates, which has an immediate effect and is the technique most often used.
● They can reduce the volume of money in circulation, by selling government bonds to remove cash from the rest of the economic system. Lenders then have less money available to lend to consumers, so they charge a higher price for loans.
● They can instruct banks to increase the level of their reserves, which also reduces the amount of money available to lend and increases borrowing costs.
Recently, when inflation has been below its target level, several central banks introduced ‘quantitative easing’: they printed money to buy back government bonds, and thereby increased the liquidity of the bond-holders, as explained in a BBC article: What is quantitative easing? When quantitative easing was used after the 2007-8 recession, it didn’t immediately result in inflation because banks built up their reserves rather than lending it to consumers: reducing the velocity of circulation, as explained in an economicshelp.org article, Velocity of circulation and inflation.
Central bankers need to be expert in managing their communication to the financial markets. By signalling their intentions in advance, and moving slowly, they avoid causing panic. Sometimes this allows them to make less severe changes than would otherwise be necessary.
This page is intended to form part of Edition 4 of the Patterns of Power series of books. An archived copy of it is held at https://www.patternsofpower.org/edition04/3383b.htm