How monetary policy controls inflation

We’ll answer this question: What can governments do to control inflation? And we’ll take a close look at something called monetary policy. 

First, inflation is largely driven by people’s increased demand to spend money, so if governments want to control inflation, they can suck some money out of the economy and keep it with the government. This will essentially take away people’s ability to spend so much money.

The Public & Private Sector

it’s important to understand that there is a public sector and a private sector in a country. Two organizations in the public sector have the means to fight inflation: the government and the central bank. Private companies and ordinary people belong to the private sector, and they are the guys who are spending a little too much money.

To control inflation, we want some of the money in the private sector to be pulled into the public sector. Let’s see how these two forces manage to do that. 

The government can raise taxes to virtually make prices of things higher and make it harder for people to buy stuff. Or, the government could reduce their spending on government projects for example by building fewer roads or other infrastructure. This will reduce the amount of money going into the economy because with fewer projects, construction companies will be paid less. But you can kind of imagine how unpopular these actions will be to ordinary people.

The governments of many countries are run by politicians who need votes to get in or stay in position, because they wouldn’t want to piss off voters, raising taxes and reducing government spending are usually last resorts. It’s usually the central bank that fights inflation directly. These are three of their main weapons: bonds, interest rates, and bank reserve requirements. 

Bonds are a certificate issued by the government that says something like: If you buy this piece of paper today for $700, you will get $1,000 back over the course of ten years. So the central bank has many of these government bonds in hand. If they sell these bonds to the private sector and people pay money to get them, cash goes out of the economy and into the central bank. Money is sucked out of the economy and people’s ability to spend money is reduced.

The interest rate is the percentage that represents the price for borrowing money. if you borrowed $10,000 from a bank to start up a bagpipe school, you can’t just return $10,000 after you succeed. You will additionally need to pay the interest. Now if the interest rate is low, say 0.1 percent, paying the interest won’t be so painful because you’re just paying back $10 extra. but if the interest rate is high, say 20 percent, you will need to pay back $2,000 extra. That high-interest rate may demotivate you from pursuing your passion for bagpipes. So, this is what the central bank can do to prevent people from borrowing too much money from banks. And to be precise, the central bank can raise its interest rate for the money it lends to regular banks, then, regular banks realize that the cost to borrow money has gone up, and to cover the costs, now regular banks raise their interest rates for the money they lend to their customers. Because loans have become more expensive, people borrow less money, and with less money going into the economy, people’s ability to spend money is reduced. Banks have a lot of money, but they can’t just go around spending this money freely. What if millions of people wanted to withdraw their savings all at once? No worries, banks are required to keep some cash as reserves so they can supply cash when asked. 

So how big are those reserves supposed to be? Well, the central bank gets to decide that. If they say “time to stock up, guys” literally, less money can go into the economy because there is more money banks are not supposed to use. These actions the central bank takes to fight inflation are called contractionary monetary policy. 

What the three actions have in common is that they all reduce the amount of money circulating in the economy. People don’t have as much money to spend as they did before, so prices of things need to go down. Otherwise, nobody will buy them. As a result, inflation is kept under control.

The government may not be too helpful in fighting inflation, but they play a very important role when it’s time for the country to grow its economy. In our next article, we will look at some ways the government helps to grow the economy.

Related Posts