When dissecting today’s inflation situation and monetary policy, it’s essential to know what exactly each is. Inflation occurs when there is a decline in purchasing power of a given currency over time. This is often reflected in increasing the average price of certain goods and services. Consumer Price Index (CPI) and the Wholesale Price Index (WPI) are the most commonly used inflation indexes.
It is critical to ensure that the economic growth is sustainable by controlling the overall supply of money available to the United State’s banks, consumers, and businesses. A monetary policy provides a set of tools that a nation’s central bank has available. There are several ways to do this, including revising interest rates up or down, directly lending cash to banks, and changing bank reserve requirements.
So what do inflation and monetary policy have to do with one another?
Monetary Policy
Monetary policy is essentially a tool designed and controlled by a central bank. They control the money supply by monitoring and limiting cash flow between banks, consumers, and businesses.
This level of control is allowed as it ultimately serves a purpose. The goal is to keep the economy flowing smoothly. Monetary policies directly impact and are decided by supply and demand concerns, among other things.
Monetary Policy’s Influence
As already discussed, inflation is a gradual decline in monetary value over time. Monetary policies are generally highly concerned with inflation, as part of their goal is to help combat the decline from happening too rapidly.
A healthy economy typically has a 2-3 percent inflation target; that is to say: central banks aim for that level of stability within the economy. Thus, inflation is used as a metric for the economy’s health.
The methods used to influence inflation have changed slightly over the years. Instead of directly adjusting monetary aggregates, governments will typically affect interest rates and other measurable methods.
This switch has created a natural secondary effect: how governments adjust and monitor interest rates. There are several ways that this can be done, including controlling money stock, buying and selling bonds, and having the final say on the functionality of banks.