Question

The basic function of the Central Bank is to achieve price stability. Consider the costs of inflation and discuss which instruments the central bank can use to lower the rate of inflation?

Answer 1

Cost of inflation are:

• Menu Cost: Restaurants, food courts have to change their menu as inflation occurs to cover their cost of producing and to earn profit. This will unnecessarily result in change in menu over time.
• Shoe Leather Cost: People who are holding cash will get reduction in the real value of their holdings. They will have to go to banks very frequently to withdraw cash which will result in depreciation of leather of shoes.
• Fall in Real Money: Inflation reduces the actual purchasing capacity of money which means they will be able to purchase less of the goods in real units.

To lower inflation, central bank can adopt contractionary monetary policy through which they reduce supply of money and raise rate of interest. Reduction in supply of money will reduce the cash holdings with people which reduces consumers willingness to pay for goods and ultimately reduce aggregate demand in the economy. Reduction in aggregate demand will reduce the overall price of goods and reduce the inflation rate in the economy.