Causes and effects of inflation and Federal Reserve control measures

Inflation: Causes, Effects and the Federal Reserve Board

The objective of this work is to answer the questions of: (1) What causes inflation? (2) What are the main effects of inflation? (3) How does the Federal Reserve Board control inflation?

The first step in answering the questions set out in this research is to understand precisely what inflation actually is. Inflation can be described as "a rise in the general level of prices, as measured against some baseline of purchasing power." (Wikipedia, 2006) Furthermore inflation may be "regarded as a decline in the purchasing power of money." (Ibid) Therefore, this work will attempt to understand what causes the purchasing power of money to fall, what the effects are and what the Federal Reserve Board does to control inflation.

CAUSES OF INFLATION

According to the work entitled: "Understanding Inflation: So, What's To Worry About, Anyway? inflation is not just concerned with monetary purchasing power and in fact there are several aspects to inflation as follows: (1) Monetary inflation; (2) Price inflation; and (3) Real inflation. ((Understanding Inflation: So, What's To Worry About Anyway?, 2004) According to this work 'Real Inflation' is: "...the rate at which inflationary causes would impact price levels if all inflationary causes were considered and the time gap eliminated." (Understanding Inflation: So, What's To Worry About Anyway?, 2004) Inflationary forces are stated to be what should be actually spoken of in relation to inflation. Inflationary forces are stated to include: "all forces that increase demand without relationship to supply, or that decrease supply without any relationship to demand." (Understanding Inflation: So, What's To Worry About Anyway, 2006) Some of these 'inflationary forces' are: (1) increase in imports unaccompanied by an increase in exports; (2) Economic dependency and adverse credit shifts; and (3) a general liquidation of savings and reserve assets. (Ibid)

II. EFFECTS OF INFLATION

The work of Boyd & Champ entitled: "Inflation, Banking and Economic Growth" states several effects of inflation. The first being that: "Several economists have found that countries with high inflation rates have inefficiently small banking sectors and equity markets. This effect suggests that inflation reduces bank lending to the private sector, which is consistent with the view that a sufficiently high rate of inflation induces banks to ration credit." (2006) Another effect of inflation as stated by Boyd and Champ is that:."..inflation is negatively associated with real money market rates, real treasury bill rates, and real-time deposit rates; that is an inflation increases the real rate of return on these instruments falls." (2006) Last, but not least Boyd and Champ state that:."..most importantly, we find that inflation has a dramatic negative impact on the profitability of banks." (2006) Boyd and Champ additionally state that: "The world has seen a dramatic decline in inflation rates in recent decades, but concerns about inflation may still be warranted, especially in some countries. Evidence is mounting that inflation is harmful to economic activity even at fairly modest rates of inflation because of the way it adversely affects the banking sector and investment." (2006) In the private sector "high interest rates have their most dramatic impact on equity investments - both stock market and private." (Understanding Inflation: So What's to Worry About, Anyway?, 2006) Additionally stated is that: "High interest rates show their effects by: (1) direct competitor for the investor's dollar. By increasing the difficulty of raising equity capital, high interest rates directly undermine financial stability and slow the growth of economic capacity needed to meet inflationary demand. They reduce price/earnings ratios; (2) High interest rates increase economic costs and risks for the individual business and the economy as a whole. In addition, high interest rates can obviously reduce incentives for long-term economic projects; (3) High interest rates reduce borrowing for consumption, production and investment purposes. Ultimately efforts to keep interest rates down by means of rapid money supply increases must lead to higher interest rates than would otherwise occur." (paraphrased; 2006)