5/15/12

Common question about inflation, the interest rate, and government policy



This post is going to go over a few of the most commonly asked questions regarding the interest rate, inflation and monetary policy.

The first asks:  If I have savings in a fixed interest rate account, what effect does high inflation have on it?

The answer to this question is that it lowers the value of your savings account, especially if you are unable to change accounts.  This is because the interest rate you are receiving is fixed, say at 10%, while inflation may be higher at 20%.  This means that even though you have MORE money in your account, it can be used to buy LESS goods and services when you take it out.  This means you are actually losing money (purchasing power) by keeping it in the bank.

What effect does high inflation have on a business repaying a long-term fixed interest rate loan?

In this scenario, the opposite occurs, you get to use money that is essentially worth less to repay a loan.  This lowers the real interest rate that is associated with your loan.

If a country were to experience high inflation for a substantial period of time, how will this affect the nominal interest rate?

The nominal interest rate (in the long run) is equal to the real interest rate plus the inflation rate.  So if inflation were to increase, we would see the nominal interest rate increase as well. 

What type of open market operation could be used to combat, or control inflation?

The Federal Reserve can do several things to control inflation, but only one is available through the use of open market operations.  The Federal Reserve can sell T-Bills, which will reduce the amount of money in circulation.  This reduces the supply of money, increases the interest rate, and puts downward pressure on inflation.

What can the Federal Reserve do to stimulate the economy during a recession?

The Federal Reserve can institute expansionary monetary policy, reduce the reserve requirement, or lower the discount rate.  Each of these policies increases the money supply which shifts the AD to the right increasing both real GDP and price level.


What about fiscal policies that can reduce inflation?

Two fiscal policies can be used to contract the economy and reduce inflation.  These include raising taxes, and reducing government expenditures.  Both result in a leftward shift of AD and lower prices.

What happens if the government increases government expenditures and taxes by the same amount?

Generally nothing will happen because the increase in expenditures shifts AD right, and the increase in taxes shifts AD left.  But if the multiplier is larger for taxes (as is shown empirically) this would result in lower GDP, inflation, and interest rates. 

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