INFLATION AND MONETARY POLICY Essay
One of the main economic concerns in the national and global economy is inflation. Generally speaking, inflation is the increase of prices for all goods and services during a given period of time. Consumer Price Index (CPI) is commonly considered as a measure of inflation (Mysmp.com, 2010). This index reflects the increase or decrease of prices for the set of basic consumer goods and services. While CPI reflects the price of a consumer basket which includes domestic and imported goods (and services), there is a ratio which allows to determine the changes of domestic goods, which is called GDP deflator (the value of domestic GDP in current prices divided by the value of domestic GDP using fixed prices) (Mysmp.com, 2010). These ratios allow to estimate the rate of inflation during a given period. It is commonly considered that inflation is a negative phenomenon because it leads to overall decrease of the purchasing power of the population (Mysmp.com, 2010). However, rising prices also allow companies to expand their operations, increase employment and offer better salaries. The purpose of this paper is to consider the causes of inflation and to determine whether the Federal Reserve should aim for a zero inflation rate.
There are different causes of inflation, which can be grouped into four main factors. The first factor causing inflation is the pull of demand (Mysmp.com, 2010), i.e. the situation when the economy consumes more than produces, and as a result, sellers increase prices above equilibrium rate. The second factor causing inflation is the shock of supply (Mysmp.com, 2010): when shortages for certain resources or goods emerge, shocks associated with these shortages lead to the increase of prices throughout the whole chain, and eventually cause price increase in the whole economy. A vivid example of this cause of inflation is the shortage of world oil supplies.
The balance between money and GDP is also an important factor: the Federal Reserve should adequately control the issue of money; otherwise, increasing volume of money in the economy will lead to overall price increase due to the growth of demand. An example of money supply driven inflation is the situation when fulfilling the requests of employees and increasing salaries to the high level will lead to overall price increase.
Finally, national macroeconomic balance and such variables as national debts and international lending in particular can drive up inflation (Truman, 2003). In order to keep up with foreign debts and to repay interest, the government might need to increase prices. One more international factor is the fluctuation of exchange rates which might affect the levels of import and export, and the prices of imported or exported goods (Truman, 2003).
There are both positive and negative consequences of inflation. High level of inflation creates price distortions, reduces purchasing power of the population and leads to high uncertainly in the economy. When the inflation is high, consumers prefer to purchase goods and services right away instead of making long-term investments, and the increasing level of consumption further speeds up the spiral of inflation. However, if the inflation is comparatively high, interest rates are also high, and tax brackets are indexed for inflation, which allows to save on tax bills. Social security benefits and other benefits are also adjusted to inflation rates, so to a certain extent the citizens are protected against the negative consequences of inflation (Mankiw, 2011). High inflation also encourages companies to expand operations, set higher prices and purchase additional supplies/equipment or increase employment. High interest rates also attract foreign investors and as a result the economy is reviving when the inflation rates are high (Mankiw, 2011). However, the most complex issue is to find the balance which would allow to avoid economic depression when zero inflation or deflation takes place, and inflation spiral when prices increase faster than GDP actually grows.
The Federal Reserve should not aim for a zero inflation rate because this approach will eventually lead to economic stagnation and will result in high unemployment. Indeed, zero inflation rates imply that companies cannot increase prices for their production. At the same time, there are two factors which might negatively affect employment in such situation. First of all, the population of the USA is consistently growing, both due to natural reasons and to immigration, and as a result, the workforce is increasing as well (Mankiw, 2011).
Fixed level of prices in the economy will also mean fixed number of employed people, thus causing high unemployment in the long-term period. Secondly, there are external supply shocks, such as shortage of oil reserves and other natural resources. If the companies would not be able to adjust prices to these shocks, they will eventually experience financial losses; thus, wages and employment rate would again be jeopardized. Thirdly, zero inflation rate would also mean that interest rates would be minimal, and people would prefer to transfer their deposit investments to other countries offering higher interest rates. Overall, zero inflation rates will eventually damage stability and will lead to economic depression. The Federal Reserve should rather focus on a non-zero inflation rate, and try to find the balance between acceptable growth rate and the consequences of inflation.
