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Federal Reserve Board

1.0 Executive summary

This paper is going to take a critical look on inflation and the role of the Federal Reserve board in controlling inflation. It will explain what inflation is, the causes of inflation and problems associated with inflation. It will then examine the monetary policy measures usually taken by the Federal Reserve board on controlling the inflation rate. And then it will give a recommendation that Federal Reserve should not interfere which free markets, and make a conclusion that inflation can be controlled

 2.0 Introduction

In economic world the term inflation means constant increase of general price as compared against the normal standard of purchasing power. Since, various prices do affect various people; there are a lot of varying ways to measure inflation. The most commonly used way is the is the CPI  that is used to measure changes in nominal price of the consumer, and the other is the GDP deflator, this one measures amount of inflation in new produces and also new services created.

Economist view inflation as based on two categories, the “monetarists”; who view the inflation is caused by monetary effects, and the Keynesians who argue that inflation is brought about by relationships of money, interest together with

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output control over other inflation factors. These groups of economists seem to include capital goods inflation to the basic measure of the consumable goods inflation. Other school of economist seems to believe that inflation is caused by increased money supply by the central bank authorities.

3.0 Causes of inflation

Economists differ on factors that cause inflation; they have come up with two main theories that try to explain the causes of inflation. We have quality theory of inflation and the quantity theory of inflation. Some other theories of inflation mix the two. Inflation Quality theory, relies on assumption of a buyer to accept money then use that money at a later period to buy the individual desired goods. This theory depends on the relation of money that is supplied, the money velocity, and how it is exchanged. This theory was proposed by David Hume and Adam smith.

Another cause of inflation is caused by increase in quantity of currency being circulated in comparison to the capability of the financial market to supply the money; the theory of demand pull tries to explain this. This can easily be seen when governments print money in excess due to some crisis for example war. Another reason for this type of inflation can be high decline in demand of currency as it ones occurred in Europe when black plague occurred

4.0 Problems of inflations

Inflation leads to three main problems to the people; one. People who get a fixed amount of money such as employees suffer most because of increased prices of goods, yet they still have the same amount to spend. This directly results in reduced purchasing power of the people and thus affects the GDP of a country.

Secondly, if inflation rate in a country becomes too high, but the country manages to maintain currency exchange rates, it will result to the country’s exports being expensive for the other countries to buy; this will lead to a deficit on the country’s currency. And thirdly, inflation can lead to high wages of employees which will in turn cause wage spiral. This will lead to reduce production of the country’s products, and lead to high prices. In general, inflations have an over all impact of increase of prices on commodities.

5.0 The role of the Federal Reserve board in combating inflation

The role of the Federal Reserve board is to promote conducive environment for economic growth, this is achieved through sound monetary polices that encourage economic growth and social wellbeing. In combating inflation the Federal Reserve board will have to undertake certain measure to reduce or stop the inflation. This will include;

5.1 Implementing monetary policies

5.1.1 .Nominal anchor

The central element of reducing inflation is coming up with sound money policies. The Federal Reserve board undertakes nominal anchor policies which include use of financial policy actions and also statements to control inflation. For example, between 80s and 90s, the Federal Reserve was able to in reducing inflation down from double figures to a level of around 2% that has been maintained for over ten years. Thus the Federal Reserve has been able to maintain inflation by use of nominal anchor.

5.1 .2 Rising interest rates

In order to control inflation the Federal Reserve will raise the interest rate in government bills this of course will discourage the public from borrowing from the government, which will directly bring down money in circulation and thus, reduce inflation. This is normally a long term monetary policy by the Federal Reserve board. An example of this happened in 1994 to 1995 when the federal raised its fund rates up to 6% from 3%. Before, taking this measure the inflation was high but, after taking this measure the inflation did not just stop, but it did went down.

5.1.3 Price control measures

Another monetary policy that the Federal Reserve does undertake to control inflation is creating price stability. Many stake holders do agree that to maintain or reduce inflation they must be a stable price. In creating price stability, the economy will be more efficient and will contribute increase in production of a country resulting in more goods for sale, more money for the country and low inflation rates. Stability in prices also is an important advantage in terms of equity. For example, if inflation is high, it will lead to poverty because people will have little to spend. This experience occurred in America in 70s.

The graph was retrieved from:  http://research.stlouisfed.org/

The above graph shows two of measuring inflation from 1964-1984 using the consumer price index (CPI) and also the Core CPI which don’t include food and energy constituents. From the five it can be seen that for 15 years inflation in America went up, and worse in 1979 when it reached 10.75%. This lead to the then president of America Nixon to announce different policies that included price and wages control that reduced inflation.

6.0 Recommendations

The Federal Reserve board should come up with policies which will be central in improving economic growth. If the fiscal policies are good and encouraged economic growth, they will be more jobs created and more money to spend and they won’t be inflation. It is important to note that in modern free markets governments are not supposed to control markets but, rather to avail a favorable environment for business growth.

7.0 Conclusion

It is clear that inflation leads to increase in poverty levels for many, and reduces economy growth of a country. Due to inflation jobs are lost, production is reduced, if the inflation is hyper high it may lead to civil strive. The Federal Reserve has a role of ensuring that inflation is kept under control and it can do this by various monetary polices. But, the most important thing world is creating enabling economy. As Mishkin (1995) says the role of Federal Reserve in free markets economy is not to control it but, to creating an enabling environment for economic growth.

8.0 References

King, M (1996):How Should Central Banks Reduce Inflation?- Conceptual Issues,” in Achieving Price Stability, Federal Reserve Bank of Kansas City, Kansas City,

Mishkin, F.S. (1995): The Economics of Money, Banking, and Financial Markets, New York, Harper Collins.

Walsh, C. E. (2007): Inflation. Retrieved from: http://research.stlouisfed.org/ ; accessed on 8/8/2007 

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