Question

Assume that the U.S. economy has recovered from the financial crisis and is growing rapidly. What types of monetary policies should be conducted to keep inflation low? Explain.

Answer 1

To understand this, we need to first understand the economic situation during recesssion and then we can analyse what monetary policies can be used to combat inflation once the economy has receoved from recession.

While in recession, consumers in an economy stop spending as much as they used to which inturn leads to decline in business production. With a fall in production, firms start to lay off workers and stop investing in new capacity, even country’s exports may also fall and other countries may not be very keen to buy products from other countries. In short, there is a decline in aggregate demand. In order to respond to this, government can implement a policy that leans against the direction in which the economy is headed. Monetary policy is often that countercyclical tool of choice.

Such a countercyclical policy would lead to the desired expansion of output and in turn increase employment, but at the same time it entails to an increase in the money supply and would also result in an increase in prices and will increase inflation. As an economy gets closer to producing at full capacity, increasing demand will put pressure on input costs, including wages. Workers then use their increased income to buy more goods and services, further bidding up prices and wages and pushing generalized inflation upward. That is an outcome policymakers usually want to avoid after the economy has recovered from the financial crisis.

The monetary policymaker at this time must balance price and output objectives. Even central banks that target only inflation would generally admit that they also pay attention to stabilizing output and keeping the economy near full employment. And at the Fed, which has an explicit “dual mandate” from the U.S. Congress, the employment goal is formally recognized and placed on an equal footing with the inflation goal.

Monetary policy is generally viewed as the first line of defense in stabilizing the economy. So now to address the question as how does a central bank go about changing monetary policy? The basic approach is simply to change the size of the money supply. This is usually done through open-market operations, in which short-term government debt is exchanged with the private sector. The Fed sells or lends treasury securities to banks, the payment it receives in exchange which will further reduce the money supply and bring in balance and keep inflation low.

In practical terms, central bank focuses on the interest rates it would like to see, rather than on any specific amount of money. Central banks hence tend to focus on one “policy rate”—generally a short-term, often overnight, rate that banks charge one another to borrow funds. When the central bank puts money into the system by buying or borrowing securities, colloquially called loosening policy, the rate declines. It usually rises when the central bank tightens by soaking up reserves. The central bank expects that changes in the policy rate will feed through to all the other interest rates that are relevant in the economy.

Monetary policy has an important additional effect on inflation through expectations—the self-fulfilling component of inflation. Many wage and price contracts are agreed to in advance, based on projections of inflation. If policymakers hike interest rates and communicate that further hikes are coming, this may convince the public that policymakers are serious about keeping inflation under control. Long-term contracts will then build in more modest wage and price increases over time, which in turn will keep actual inflation low.