Question

1) Why is it possible to change real economic factors in the short run simply by printing and distributing more money?

2) Explain why a stable 5% inflation rate can be preferable to one that averages 4% but varies between 1-7% regularly.

3) Explain the difference between active and passive monetary policy.

Answer 1

Answer 1.

Several decisions at individual, household and business level are made based on the cost of money. When the cost of money ( interest rate ) is high, consumption or investment spending in the economy can potentially be postponed by households and the corporate.

However, when ample money is printed and supplied to the banking system, the cost of money declines. This triggers more willingness to pursue leveraged consumption and investment spending. Therefore, economic growth trends higher.

At the same time, when ample money is printed in the economy, the inflation expectations trend higher. Since inflation negatively impacts the purchasing power of money, individuals prefer to spend than save.

These factors translate into higher economic growth in the short-term.

Answer 2.

It is better to have a stable rate of inflation than have inflation that is more dynamic ( even if its in a range). The reasons are as follows -

a. Stable inflation helps banks in correctly estimating the interest rate to be charged to consumers. On the other hand, dynamic inflation creates uncertainty and a bank can lose if inflation mores higher than expected. The borrowers loses out when inflation is lower than expected. This uncertainty is not good for borrowers and lenders and hence stability is more preferable.

b. Dynamic inflation also creates uncertainly for the corporate and the wage seeker. The objective is to have wages growth that is positive when adjusted for inflation. This helps in proving the purchasing power. However, if inflation trends higher than expected, the wage receiver tends to lose on purchasing power when wage growth is based on expected inflation. Similarly, a corporate loses when inflation is lower than expected.

Answer 3.

A passive monetary policy is one that has set rules on monetary policy decision. Just as an example, if GDP declines by 1%, the federal fund rate will also decline by 1%. Or if GDP increases by 1%, the federal fund rate will increase by 1%.

On the other hand, active monetary policy is continued review of inflation, growth, global factors, among others to determine the appropriate monetary policy and the extent of expansionary or contractionary monetary policy. While active monetary policy also involves inflation targeting, unemployment rate and GDP growth, there is a continued review of these factors to design policies than just allow automatic policies to work.

Just as an example, the financial crisis of 2008-09 needed ultra-expansionary monetary policies and active policy management helped in faster rate cuts and new tools like the interest paid on excess reserves for commercial banks.