A country’s inflation rate can be termed as risen when the prices of different goods and services in the country abruptly experience a hike. Due to this, the value of the currencyfalls in the international market. Thus, with inflation, the purchasing powerof a currency decreases accordingly. However, in general, there has been a significant rise in inflation throughout the world compared to the past. Therefore, most developed countries have tried to maintain the annual inflation rate around 2-3% through different monetary policy toolsadoptedby their Central Banks.
Although there is no universally agreed cause of inflation among world economists, different theories state different causes believed to bring inflation to a country’s economy. For instance, in demand-Pull inflation, inflation results from a steady increase in the demand for goods and services. This significantly affects their prices. Simply,when the supply is low and the demand is higher, inflation is up. For instance, Manchester, amongst other cities in the U.K, is witnessingahouse price growth rate. In reality, according to the Home track research, Manchester tops other cities in the United Kingdom by 8.8% annual growth rate because of the high demand in comparison to the weak supply of housing in the city(“Manchester House Price Growth is the Fastest in the UK”). However, this theory is most applicable in countries with rapid growing economies. Another theory states that the cost-push inflation is caused by companies whose cost of production hikes. Therefore, the companies increase the products’prices to maintain their profits. Lastly, it is believed that the monetary inflation comes about when there is an oversupply of cash to the economy; this is most applicable when there is increased production of fake notes.
Significantly, there are numerous negative impacts of inflation on the economy. A rapid rise in inflation leads to a period of an unsustainable economic cycle. For instance, the United Kingdom experienced a high inflation period in the 1980’s. Since the rise was unsustainable, it ledto the recession in 1990-1992 when the government tried to reduce the inflation. Another effect of inflation on the economy is discouraging investment into the country due to theuncertainty of the value of the currency. On the other hand, inflation discourages saving and people tend to visit the bank more often and end up making unwise investment decisions to save their money (Amadeo).
Moreover, the Keynesian economic theory states that there are two conflicting economic forces that are under the influence of the changes in the interest rates. On one hand is the marginal propensity to consume while on the other hand, the marginal propensity of consumers to save. When the interest rates increase, the consumers tend to increase their savings because they feel that they will get a higher rate in their returns. Nevertheless, an increase in interest rate often results in an increase in the inflation rate. Hence, the consumers might spend more once they feel that the strength of the currency will be decreased by the inflation. It is apparent in this way that the consumers will always react to the health of the economy.
Due to these effects and so many more of inflation on the economy, many governments use their Central Banks to control inflation rates. The Central Banks thus apply various monetary policy tools to accomplish this.One of the common tools of monetary policy used by the Central Banks is the restrictive monetary Policy. Through this monetary policy, the Central bank is able to control the economic growth and inflation (Amadeo). The Central Bank decreases the amount a bank can lend, thus reducing the money supply. In this way, the restrictive monetary policy,also called the contractionary monetary policy,constricts demand and slows inflation in a country. However, moderateinflation is advantageous to the economy, aspeople tend to buy more frequentlydepending on the belief that the prices will increase later (Amadeo). Due to this, the Central Banks increase the prices to control the contemporary demand and thus the economy grows at a healthy pace of around 2-3%.
Governments also utilize the contractionary policy as a fiscal policy by increasingthe taxes or at times reducing the government’s spending(“Monetary Policy”). The government also mayuse this policy reduce governmental financial involvementin the private sector. When this policy cuts the level of crowding in the private market, it literally motivates growing of these non-governmental sections of the economy(“Monetary Policy”).
On the other hand, as a monetary policy tool, the contractionary policy reduces the inflation by controlling the flow of active money in the economy. It also cuts the unsustainable speculation and investments that result from initial expansionary policies. However, the contractionary monetary policy has its side effects on the economy. For instance, it increases unemployment and causes a fall in the gross domestic product (GDP) growth rate.
Nevertheless, apart from the restrictive monetary policy, the Central Banks utilize other alternative monetary policy tools such as the open market operations, the reserve requirements, and the discount rate (Amadeo). The open market operateswhen the Central Bank controls the statebanks’ securities through auctioning. If the Central Bank buys securities, itadds money to the banks’ reserve; thus, providing more money tobanks to lend. whenit sells securities, it adds them to the banks’ balance sheets,thusreducesthe banks’ cash holdings; which meansthe banks’ lending power is weakened.In other words, The Central Bank sells securities when implementing the contractionary monetary policy, while on the other hand, it buys them in the expansionary monetary policy (Amadeo).
Significantly, thereserve requirement is the set standard for each bank’s deposit; every bank has to meet this minimum reserve every dayeither in the bank itself or in the central bank. When a bank has a highreserve, it has thefreedom to lend more from its deposits; this is expansionary to the bank for creating more credit. A lowreserve, on the other hand, means the bank has less money to lend hence it is contractionary. The central bank, however, does not often change the reserve requirements because it is quite cost-ineffective and very disruptive to the banks in amending their set procedures. Instead, if the bank does not fulfill the reserve requirement it borrows from another bank that has more cash (Amadeo).
An official discount rate of a country’s Central bank is the rate at which it lends other commercial banks in the country (Amadeo). The rate ofthe Central Bank is usually quite high and the banks only consider this option when they cannot borrow from other banks. More so, the Central Bank influences the interest rates in a country. Thus, when the rates are high people will bring in more cash to the bank and this in return increases the amount that the banks supply to the market (Amadeo).
Apart from the monetary policy tools used by the Central Banks, the governments also use supply side policies that increase production. In this way, the countryachieves constant growth without inflation rise. Examples of the supply side policies include reduction of the income taxes, increasing education and trainingprograms, and for instance, in the United Kingdom, controlling trade unions’ power(“Monetary Policy”). In fact, many governments believe that by reducing the income taxes they significantly boost the incentives of people to work harder hence achieve more production, although this is not a fact. In addition, when people receive better training and education it directly improves their productivity hence many governments opt to subsidize education and training programs(“Monetary Policy”). Finally,reducing the trade unions power reduces the periods that firms spend in strikes and go-slows hence promoting efficacy. This also makes the labor markets more competitive andcurb unemployment.
In conclusion, the Central Bank is the main influenceon the economy of every country. It is tasked with implementingthe fiscal policies that determine the direction the government is to follow concerning spending, borrowing, and taxations. Again, the Central bank, through the monetary policy committee, sets the monetary policies that are used to supportthe economy in response to the set fiscal policies. The most effective tool used by the central banks to implementtheir monetary policies is the ability to amend and influence the interest rates. By influencing the interest rates, the central banks, in the same way, affects the consumption, saving and investments in the country.
Amadeo, Kimberly. “Monetary Policy Tools: How They Work.” The Balance, 16 Aug. 2016, www.thebalance.com/monetary-policy-tools-how-they-work-3306129.
“Manchester House Price Growth is the Fastest in the UK.” LPC Living, www.lpcliving.co.uk/manchester-house-price-growth/.
“Monetary Policy.” Investopedia, www.investopedia.com/terms/m/monetarypolicy.asp.Web. 07 May 2017.