Does Monetary Policy Cause Inflation?

The assessment of the question of whether the monetary policy causes inflation is a debate that has been prevailing for a prolonged duration and with different parties

The economic, as well as financial situations of a country are greatly dependent on the monetary policy that is being implemented by the country’s central bank. The monetary policy of a nation deals with the regulation of the money stock which encompasses the liquidity and thus affecting the interest rates (Mishkin, 2011). Thus to be able to impact macroeconomic variables as employment, inflation, employment balance as well as the aggregate output in the desired direction, it imperative that diverse monetary policy measures have to be put into place. There exists no ideal and standard structure of the monetary policy target as well as instrument, with the common assertion being that the instrument varies from country to country and is dependent on the stage as well as the size of the development of the financial market (Österholm & Berger, 2012).  The research paper is going to implement a comprehensive assessment of the roles of the monetary policy in an economy. Additionally, the bulk of the paper is going to assess how the monetary policy that a nation adopts causes inflation in the economy.

Literature Review

One of the common assertions is that the monetary policy can contribute to the attainment of a sustainable growth via the maintenance of stability in the prices. Governments manage their economies through the employment of combined actions of their monetary actions in the context of the fiscal as well as monetary policies. The most notable as well as visible elements in the fiscal policy making is directly affected by the government’s expenditures in both their investments and recurrent, with governments adjusting their levels of spending to assess and influence their economies (Bernanke, 2003). Economists have for a prolonged duration been trying to map out the actual cause of inflation. The majority of the economists believe that it is not possible for inflation to be either high or low for a long duration without the fuel of either high or low growth of money.

The assessment of the issue on a purely economic platform leads to the assessment of inflation as refereeing to the overall increase in the prices as a result of the increment in the quantity of money. The case follows that the increase in the money stock is at a faster rate than the productivity level of the economy. The actual nature of the increments in price is subject to a lot of economic debates, with the term inflation referring to the monetary phenomenon in this assessment (Blanchard, Cerutti & Summers, 2015). Governments in the contemporary world rarely ever print and consequently distribute actual money with the objective of affecting the stock of money but instead, rely on alternative controls as the interest rates charged for interbank lending. Several reasons arise in trying to explain the state of affairs, as the electronic account balances, new financial instruments as well as the additional changes to the manner in which people hold money lead to the basic money controls becoming less predictable (Galí, 2015). The additional reason is that the assessment of history has led to the production of a considerable number of money printing disasters that have resulted in hyperinflation along with the mass recession.

The US Federal Reserve refrained from the controlling of the actual money aggregates about the number of bills in circulation with the intent of implementing modification in the key rates of interests which are occasionally referred to as the price of money.  The adjustment of the rates of interest affects the levels of saving, borrowing as well as spending in an economy. For example, when the rates of interest rise, the savers can earn more on their demand deposit accounts and consequently delay the present consumption for future consumption (Cúrdia & Woodford, 2015). On the other hand, it is more expensive to borrow money, an attribute that discourages lending. The fact that lending in a contemporary fractional reserve banking system creates new money, it discourages lending which in turn slow down the monetary growth rate (Davig, & Doh, 2014).  Conversely, when the rates of interest are lowered, saving becomes less attractive, while borrowing becomes cheaper and thus leading to an increase in the spending.

In this case, it is evident that the central governments manipulate the rates of interest with the objective of either increasing of decreasing the current demand of goods as well as services. It additionally leads to the manipulation of the economic productivity levels along with the impact of the banking money multiplier. It is, however, evident that most of the effects of the monetary policy are commonly delayed and are complex in the evaluation. It is additionally evident that most of the economic participants are becoming increasingly sensitive to the signals of the monetary policy along with their expectations of the future (Davig & Doh, 2014). It is thus evident that monetary policies are measures that are designed to regulate as well as control the volume, costs as well as a direction of money along with credit that is in the economy to attain specific objectives of the economic policy (De Gregorio, 2012).  These policy objectives can change from one time to another depending on the economic fortunes evident in a certain country. In general, the assessment of the objective of the monetary policy encompasses the attainment of full employment, fast economic development, maintenance of the stability of price along with the balancing the payment equilibrium.

 

The monetary policy encompasses the processes by which a country’s monetary authority controls the supply of money, on most occasions targeting the rate of interest for the objective of promoting the growth of the economy as well as its stability. The official role of the monetary policy is in the modification of the amount of base currency that is in circulation. The process of changing the liquidity of the base currency via the sales and purchases of credit instruments and debt issued by the government is known as the open market operations (Arias, Ascari, Branzol & Castelnuovo, 2014). The regular market transactions conducted through the monetary authority as they try to modify the supply of currency impacts the alternative market variables such as short-term rates of interest and the rate of exchange.

Monetary policy has a strong link with the rates of interest along with the availability of credit. The instruments of monetary policy have always encompassed the short-term rates of interest as well as the bank reserves via the monetary base. The core objectives of the monetary policy encompass the maintenance of low unemployment along with stable prices. In the adherence to the monetary policy instructs the supply of money by the central bank to attain the objectives of stabilizing the price in managing inflation, an accomplishment of full employment as well as promoting the growth in the aggregate income (Arias, Ascari, Branzol & Castelnuovo, 2014). It is a common attribute that the developing nations have a difficult time in developing an effective operating monetary policy. The core difficulty follows that some developing nations have deep markets that are in government debts. The issue is further complicated by the complexities in the forecasting of the demand for money along with the fiscal pressure to levy the inflation tax via the rapid expending of the monetary policy.  In general, the poor record of managing monetary policy in the developing nations is the main reason as to why they have constant struggles with inflation (Cúrdia & Woodford, 2015). Additionally, the reason behind the difficulty that the developing nations face in their management of the monetary policy is the fact that their monetary policy is not independent of the government. Thus it is necessary for the good monetary policy to implement a currency board as well as adopt dollarization.

Inflation is always and everywhere about a monetary phenomenon, with many scholars agreeing that monetary policy and inflation are interrelated. The additional assertion is that the expectation of a firm monetary policy has a direct impact on the inflation (Bils, Klenow & Malin, 2012).  For a monetary policy practiced in a country to exhibit the desired impact on inflation as well as their real economy, it is imperative that the changes in the short term market interest rate ultimately translate into changes in alternative changes in the economy’s interest rates. These changes to the economy’s interest rates lead to an impact in both the overall economic activities along with the prices. The additional assertion is that inflation can lead to an increase in the short run via the expansionary macroeconomic policies although the effect is not sustainable for a long duration (Komlan, 2013). The ultimate association that exists between growth and inflation is normally negative.

The changes to a country’s monetary policy predict huge declines in the slope of the reduced-form relations that exist between the variation in inflation as well as rates of employment. It is further asserted that the notion that it is the work of the monetary policy to impact the dynamics of inflation is outdated. Monetary policies serve to be meant to control the rate of inflation and additionally uphold the domestic pride along with the stability of the exchange rate (Bils, Klenow & Malin, 2012). It is additionally evident that they target the maintenance of a healthy balance position, seek the development of a healthy financial system and additionally promote the rapid and sustainable growth of the economy and development (Komlan, 2013). The attainment of these objectives is not a simple issue, with success being attained at the risk of recording failures in the attainment of certain objectives.

It is additionally evident that it is imperative that there is the emphasis on the fact that monetary policy is the core supportive mechanism of the national development strategy as well as policy, which further calls for application of exchange, fiscal and alternative sectoral policies (Gertler & Karadi, 2015).  Thus monetary policy should be designed with the objective of accomplishing a consistent and realistic set of objectives within the country’s general economy policy framework.

Discussion

In the short run, monetary policy impacts inflation along with the economy-wide demand for goods and services and thus the demand for employees who will be producing these goods and services. On the normal occasions, the Federal Reserve has mainly influenced the overall financial conditions via the adjustment of the federal funds rate. The changes that occur to the financial conditions impact the economic activity, with the example of low-interest rates making it cheaper to borrow and consequently allowing households to buy more goods as well as services. Additionally, companies are better placed to purchase items that are going to grow their businesses. The companies respond to these changes by employing more employees and consequently boosting this productivity. The implication of these effects is that the general household wealth increases, spurring more growth. These associations of the monetary policy on the productivity along with employment are not immediate and are additionally affected by many factors making it hard to evaluate with precision the impact of the monetary policy on the economy.

Regarding inflation, the monetary policy impact follows the reduction of the federal funds rate, resulting in a stronger demand for the goods along with services that end up pushing wages and other costs higher. The consequent situation offers a reflection of the greater demand for workers along with materials that are to be used in the production. Additionally, policy actions can impact the expectations of the manner in which the economy is going to perform in future the expectation of the prices as well as wages, with these expectations posting a huge likelihood of influencing the current inflation.

Conclusion

From the assessment that has been implemented throughout the paper, it is evident that the monetary policy plays a significant role in dictating the economic health of a nation. Among these impacts that the monetary policy has is in directing the interbank lending rates, an issue directly the accessibility to credit and funds in general. Depending on the state of the monetary policy, the impact it has on the accessibility to capital and the consequent purchase of goods and services is the main means to which it results in inflation in an economy. Thus the question of whether the monetary policy causes inflation is affirmative because the operations of the policy in trying to spur economic growth and low-interest rates lead to inflation owing to the excess access to capital.

 

References

Arias, J. E., Ascari, G., Branzoli, N., & Castelnuovo, E. (2014). Monetary Policy, Trend Inflation and the Great Moderation: An Alternative Interpretation-Comment (No. 1127). Accessed via https://www.federalreserve.gov/econresdata/ifdp/2015/files/ifdp1127.pdf

Bernanke, B. (2003). Constrained discretion and monetary policy. New York, NY: Remarks before the Money Marketeers of New York University.

Bils, M., Klenow, P. J., & Malin, B. A. (2012). Reset price inflation and the impact of monetary policy shocks. The American Economic Review, 102(6), 2798-2825. Accessed via http://klenow.com/Reset_Price_Inflation.pdf

Blanchard, O., Cerutti, E., & Summers, L. (2015). Inflation and activity�"Two explorations and their monetary policy implications (No. w21726). National Bureau of Economic Research. Accessed via https://www.imf.org/external/pubs/ft/wp/2015/wp15230.pdf

Cúrdia, V., & Woodford, M. (2015). Credit frictions and optimal monetary policy (No. w21820). National Bureau of Economic Research. Accessed via http://www.bis.org/publ/work278.pdf

Davig, T., & Doh, T. (2014). Monetary policy regime shifts and inflation persistence. Review of Economics and Statistics, 96(5), 862-875. Accessed via https://www.kansascityfed.org/publicat/reswkpap/pdf/rwp08-16.pdf

De Gregorio, J. (2012). Commodity Prices, Monetary Policy, and Inflation†.IMF Economic Review, 60(4), 600-633. Accessed via https://www.imf.org/external/np/seminars/eng/2011/tur/pdf/JDeG.pdf

Galí, J. (2015). Monetary policy, inflation, and the business cycle: an introduction to the new Keynesian framework and its applications. Princeton University Press. Accessed via http://down.cenet.org.cn/upfile/8/201012218164113.pdf

Gertler, M., & Karadi, P. (2015). Monetary policy surprises, credit costs, and economic activity. American Economic Journal: Macroeconomics, 7(1), 44-76. Accessed via https://www.aeaweb.org/articles?id=10.1257/mac.20130329

Komlan, F. (2013). The asymmetric reaction of monetary policy to inflation and the output gap: Evidence from Canada. Economic Modelling, 30, 911-923. Accessed via http://isiarticles.com/bundles/Article/pre/pdf/27839.pdf

Mishkin, F. S. (2011). Monetary policy strategy: Lessons from the crisis in approaches to monetary policy revisited‐lessons from the crisis (Sixth ECB Central Banking Conference) Frankfurt, Germany: European Central Bank. Accessed via https://www.imf.org/external/np/seminars/eng/2011/res2/pdf/fm.pdf

Österholm, P & Berger, H. (2012). Does Money Growth Granger-Cause Inflation in the Euro Area?. Accessed via https://books.google.com/books?isbn=1451913680

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Reducing spending is important during inflation, because it helps halt economic growth and, in turn, the rate of inflation.