In: Economics
Inflation has traditionally been a concern of the Federal Reserve. Recently, there has been the possibility of deflation. Should the Fed be concerned with deflation of prices? What about targeting 'nominal GDP'?
First lets understand what the two terms mean in simple language
Inflation : Prices go up.You have to pay more dollars to buy goods and services.In effective terms you buying power is down.you are left with less money as things are costly now.
Deflation : Deflation is exactly the opposite of inflation.The prices go down.Falling prices and the expectation of further declines can, in turn, exacerbate the weakness of demand. Consumers may delay some purchases in hopes of getting better prices. Potential home buyers and business investors are discouraged from borrowing for fear they will have to repay their debts out of earnings and revenues diminished by the decline in prices. In other terms you may lose your job or customer.So this is also not good for an economy.
Federal Reserve has to balance inflation and keep out deflation.
Causes of inflation are
1.Too much free money is available or incomes levels have risen so people have money to buy goods even if priced higher.
2.There is a gap in supply/demand leading to rising of prices.Say for example if sugar is less available in quantity then you have to pay more to buy it.
3.Artificial means where in prices are jacked up as people are ready to buy.Example includes the prices of real estate properties.
Now Fed is concerned with inflation because too much money can bring in devastation.Its like greed which brings in misery later.So Fed balances the interest rates it pays to Banks,interest rate the Banks can pay to depositors of money etc.It also formulates monetary and fiscal policy to keep inflation in safe limits.
Deflation means there is no economic growth and Banks dont have money to pay you,the citizens dont have money to foot bills.The chain in economy is weak since the producer and the consumer are both at risks.There could be risk of defaulting.The governement may also risk in not honouring the Bonds.Its a crisis even the givernement will not have taxes to run the country.So deflation is also a great concern.Deflation is followed by depression or economic lull.And the biggest problem for Fed is that since inflation can be controlled by keeping interest rates to zero levels,no further reduction is not possible at all.Though Fed can opt for QE or quantitive easing results may not be as expected.
Nominal GDP is gross domestic product (GDP) evaluated at current market prices, GDP being the monetary value of all the finished goods and services produced within a country's borders in a specific time period.
It gives a better picture of state of affairs of the economy.Hence the Fed targets the nominal GDP.A nominal income target is a monetary policy target. Such targets are adopted by central banks to manage national economic activity. Nominal aggregates are not adjusted for inflation.Central banks use a variety of techniques to hit their targets, including conventional tools such as interest rate targeting or open market operations, unconventional tools such as quantitative easing or interest rates on excess reserves and expectations management to hit its target.
Advantages of Targeting nominal GDP
A nominal income target or nominal GDP target is a rule that targets the level or growth of nominal spending in the economy. Unlike a Taylor rule, which requires knowledge of inflation, actual output, and potential output, a nominal GDP target requires knowledge only of overall spending. While targeting nominal GDP growth might be subject to measurement error, it likely minimizes the significance of this measurement error in real time.