Question

In: Economics

The Federal Reserve (Fed) exerts great control over the supply of money. Discuss the reasons the...

The Federal Reserve (Fed) exerts great control over the supply of money. Discuss the reasons the Fed favors inflation over deflation. Discuss the costs of even low rates of inflation for the economy. what are causes of deflation in an economy

Evaluate whether those causes are positive or negative for the economy.

Solutions

Expert Solution

Fed maintains a healthy inflation rate because:

  • Employees seek an annual increment which will raise cost of producers if there is no general rise in prices. Rise in price even induce producers to raise wages to employees which does not raise resentment among employees.
  • As per the Philips curve, a rise in Inflation rate will reduce unemployment level in the economy.
  • Inflation occurs when Fed raise money supply in the economy, a rise in money supply will raise willingness to pay for goods and raise aggregate demand in the economy.

Cause of deflation are:

  • It leads to recession where less goods are produced and result in high unemployment rate.
  • Consumers can expect that price will fall in future which induce them to postpone their consumption which result in fall in aggregate demand and economy stuck in recession spiral.
  • Fall in general price level reduce the overall profit of producers which induce them to invest less money in their technological advancement or innovation.
  • Reduction in general price level will reduce the rate of real estates making homes affordable for middle class people which is a benefit of deflation
  • Borrowers hurt while lenders benefits from deflation because borrowers have to pay return the money which have higher real purchasing capacity.

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