Inflation is the rate at which the prices of both goods and services keep rising, consequently reducing the purchasing power of the currency. Central banks attempt to reduce inflation rates and avoid deflation for the economy to run smoothly. It leads to the reduction of the purchasing power of a particular currency. For example, if a packet of gum costs $1, it will cost $1.02 next year. Since goods and services require money, the implicit value of that money falls (Ball, 2014). Governments use core inflation data that excludes food and energy prices. External factors can influence the price of such types of goods, but it does not reflect the overall rate of inflation. Excluding these industries from the inflation data shows a clear picture of the state of inflation. Some methods used to control inflation in many countries include moderate long-term interest rates, maximum employment, and price stability.
When prices are stable, businesses can plan for the future, since they know what to expect. It also enables the government to promote maximum employment, which is determined by nonmonetary factors that change over time. Monetarism theorizes that inflation is directly associated with the money supply in the economy. For example, during the Spanish conquest of the Aztec empire, massive amounts of gold and silver flowed into Spain and other countries in Europe (Davine, 2015a). However, prices spiked and the value of money fell since money supply had increased rapidly, leading to the collapse of the Spanish economy.
The most famous example of inflation is the hyperinflation that struck the Weimar Republic in Germany in 1925. Countries that won World War 1 demanded reparations from Germany, and since the country could not pay the debt in German paper currency, they started printing paper notes and used the printed money to buy foreign currency (Gali, 2015). However, the plan led to rapid devaluation known as the German mark, followed by hyperinflation. German consumers thought by spending more and more money, they would balance the situation, but this was not the case. More money swamped the economy, and its value culminated to a point where people would stick money on their walls. Similar situations occurred in countries like Zimbabwe and Peru in 2008 and 1990 respectively.
Inflation is measured by the consumer price index, which usually tracks the prices of core goods and services over time. In other words, the tool measures the real-time prices of essential goods and services. Moreover, components of the consumer price index do not change in price at the same rates. For example, the amount of secondary education and housing has been on the rise as compared to other services (Davine, 2015b). Inflation leads people to invest, an example of a reason why people invest is when you have $1000 in the bank, after five years the money will have reduced to $903.2. Hence people prefer to spend their money which will ensure they will get more from it, instead of keeping it in the bank for it to reduce after some time.
The central bank’s role in controlling inflation
Central banks are responsible for providing currency and implementing the monetary policy to control inflation as shown in figure 1 below. Monetary policy refers to actions by the monetary authority to determine the conditions under which it supplies the money circulating in the economy. The central banks do not control prices directly because these are defined by the supply and demand of goods and services (Jim et al., 2014a).
However, they influence the price determination process through monetary policy. In general, central banks control monetary policy by affecting the conditions of a country’s liquidity needs. This is the first stage of the broadcast mechanism. The financial expert provides fluidity to money market participants by changing some central bank’s balance items. Monetary actions influence prices and employment through a number of multiple channels, the channels involve different forces in the financial markets. They include: 1 availability of capital for businesses and households, the value of family assets, and the foreign exchange rate of the dollar against other foreign currencies
Cash reserve ratio
The central bank may need deposit money banks to hold a grouping of their reserves as vault cash. Fractional Reserve limits the number of credits the banks make to the domestic economy hence limiting the supply. The amount is held in cash as cash equivalents and stored in bank vaults. The main aim is to ensure that banks do not run out of cash to pay the demands of their depositors. The cash reserve ratio is an important monetary policy in controlling the money supply in an economy (Li et al., 2014). They give greater control to the central bank in controlling the money supply. The assumption in this policy is that deposit money banks usually maintain a stable relationship between their reserve holdings and some loans they release to the public.
Interest rate policy
Financially stable deposit money banks lend money at favorable interest rates, known as minimum rediscount rate. One key aspect of interest rates is the term structure relationship between long and short-term rates. Interest rates play a crucial role in the monetary policy as informational indicators. Central banks like to obtain information about the current expectations from stable financial markets to help predict future lines for inflation and output (Rogers et al., 2014). Central banks rely on expectations theory to obtain information from these markets. The MRR determines the interest rates in the money market, hence controlling the supply of credit, the supply of investment, and the supply of savings (which affect a number of monetary aggregates and reserves).
The balance of payments can be in deficit or in surplus, hence influencing the supply of money in one direction or another (Rey, 2015). The central bank ensures the balance of exchange rates and money supply by selling or buying foreign exchange. When the real exchange rate is misaligned, it affects the current account balance since it affects external competitiveness.
Open market operations
In this policy, the central bank buys or sells securities to the banking and non-banking public on behalf of the Treasury. It involves the buying and selling of government securities in the secondary market by the government. When the government purchases securities from a broker, it pays by crediting and writing a check on its own and puts the reserve account of the dealer at the central reserve bank. Hence, the rise in reserves of the dealer’s bank leads to a rise in the aggregate volume of reserves in the monetary system (Jim et al., 2014b). The reverse happens when the government sells securities to a dealer. For example, in the United States, the Treasury stock market which trades at $160 billion a day is the most active. Its depth is crucial to prevent disruptions during transactions for the effectiveness of the open market operations. These characteristics of government securities enable it to buy and sell at its convenience and at any amount needed to keep inflation in balance.
The open market desk uses two main approaches to reduce or increase the money supply. When the money supply is expected to reduce for an extended period, the office makes an outright purchase or sale to keep the reserve system in balance. However, this happens for a limited number of times annually to accommodate long-term reserve needs. In recent years, purchases have been frequent because of expanded currency issuance (Shintani et al., 2013). The frequent purchases have resulted in the enlargement of the system’s portfolio of securities. Aside from the long-term market reserve trends, mostly they are expected to be short-lived. Reasons can either be because seasonal factors are supposed to be offset or because the outlook for reserves is uncertain. The desk undertakes transactions that only affect the supply of reserves for a short time. It uses repurchased agreements to increase reserves and drain reserves on a temporary basis. Such short-term purchases are aimed at minimizing fluctuations in the overall supply of reserves.
Investments are meant to stimulate growth while sales do the opposite. Open market operations are the most common tools used by most central banks to implement monetary policy. The most common way in open market transactions I the purchase and sale of government securities (Wolman, 2015). One example of security in such a situation is the treasury bills. When the central bank purchases the securities, it increases the supply of reserves. But when it sells securities, it reduces supply, thus affecting the supply of money.
A country’s central bank is responsible for implementing and formulating the monetary policy. This process involves the development of a plan that will lead to stable prices, employment, and a financial environment. During the implementation of this plan, the central bank uses tools of the monetary policy that help induce significant changes in interest rates and the amount of money in an economy. Fiscal policies influence spending, employment, prices, and output in a country.
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