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How Can the Government Control Inflation and Your Wealth

We often hear in the news that central banks will raise interest rates in order to slow down inflation. However, may of us are confused as to how the whole process works and how our wealth is affected by inflation. We do understand that it costs us more to borrow money when interest rates are high and our adjustable rate debt can spiral out of control. The cost of borrowing money is the least of our worries.

The European Central Bank recently announced that they will be raising rates to the highest level since 2001 in order to stem the fast paced economic growth. The goal is to raise rates to a level that no longer stimulates economic growth. Companies might start increasing the price of goods and labor unions have pushed through wage increases causing inflation.

When inflation occurs money loses is purchasing power. That is each dollar purchases less goods than it did prior. Therefore if you paid $3 dollars for a can of Lysol today it might cost you $3.20 by the end of the year. Without wage increases the purchasing power of worker declines.

The consumer price index shows the price of products throughout the U.S at any particular time. If we analyze the consumer price index from 1950 to 2003 we will find in 1950 the index was around 25 and in 2003 it was around 190. Thus products have moved upwards at spiraling rates.

Since 1970’s the average purchasing power of a middle class family was around $40,000 in today’s value. In 2006 that value was somewhere around $35,000 per annum. Thus inflation has eaten up people’s income cause a decline in the American standard of living. The trend doesn’t appear to be slowing so Americans should find themselves poorer in the future.

When the government wants to influence inflation rates they may raise or lower the interest rates. Let us say that inflation is moving upward and the government wants to keep it under control they may raise the interest rates so that it becomes more expensive to borrow money. Since capital for investment, building house, etc. is more expensive it is borrowed less and growth is slowed. When growth is slowed the inflation rate slows as well.

The government continually monitors the state of the economy and the cost of borrowing money because it must ensure the adequate living of its citizens. If inflation spirals out of control people lose their wealth and this causes social upheaval. Upheaval can lead to all types of major changes, riots and even the removal of government officials.

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  1. preetam chand

    On June 2, 2008 at 3:18 am

    The government continually monitors the state of the economy and the cost of borrowing money because it must ensure the adequate living of its citizens. If inflation spirals out of control people lose their wealth and this causes social upheaval. Upheaval can lead to all types of major changes, riots and even the removal of government officials.

  2. preeta chand

    On June 2, 2008 at 3:23 am

    Is the government getting needlessly hysterical about inflation? Many people think it is okay to tolerate some inflation if, in return, it is possible to sustain higher growth rates. Nothing matters as much for peace, prosperity and poverty alleviation as high GDP growth, so I would always advocate any policy which delivers higher sustained GDP growth. However, the link between inflation and growth is complex. High inflation does not give high growth. The growth miracles of Asia, where above-7% growth was sustained over a 25-year period, were not associated with high inflation. In fact, countries with high inflation have tended to have low growth.

    In the business cycle, an acceleration of inflation can support a temporary acceleration of growth. In India, expected inflation has gone up from roughly 3% in 2004 to roughly 7% today – a rise of 4 percentage points. Interest rates have risen by less than 4 percentage points. As a consequence, real interest rates have actually gone down. Borrowing has become cheaper; we have a credit boom; and this is giving heightened GDP growth.

    If inflation now stands still at 7%, this boost to GDP growth will fade away. Episodes where inflation went up are associated with a brief acceleration of GDP growth. A government can jolt an economy by raising the inflation rate. This heightened growth is not sustained. Conversely, achieving high sustained GDP growth is about fundamental issues of economic reform, and does not concomitantly require high inflation.

    One of the great strengths of India is that the political system just does not accept high inflation. This is one area where politicans have been ahead of the intellectuals. Inflation of 3% is politically acceptable, and inflation above 5% sets off alarm bells. The government that can jolt an economy by raising the inflation rate then has to go through the costly process of wringing out the inflation, to get back to 3%. Since there is no tradeoff between inflation and GDP growth, Parliament is right in demanding low inflation and high GDP growth.

    Currently, in India, we go through boom-and-bust cycles; sometimes GDP growth rates are very high and sometimes GDP growth rates drop sharply. This boom and bust cycle is unpleasant for every household. There is a powerful international consensus that stabilising inflation reduces this boom and bust cycle of GDP growth. The ideal combination, which has been achieved in all mature market economies, is one involving low inflation which is also predictable and non-volatile. Low inflation volatility induces low volatility of GDP growth. Low and predictable inflation also reduces the number of mistakes made by entrepreneurs in formulating investment plans. What India does not have is an institutional capacity for delivering predictable, non-volatile inflation of 3%.

    In socialist India, the way to deal with an outbreak of inflation was to do government interference in commodity markets. A few commodities that `cause’ inflation are identified, and the government swings into action: banning exports, giving out import licences, banning futures trading, sending the police to unearth `hoarding’, etc.

    This is deeply distortionary. Milk exports was banned, and milk prices fell. But why should milk farmers pay for a macroeconomic problem of inflation? The cost of bringing down inflation needs to be dispersed all across the economy.

    If milk prices had been allowed to rise, it would have elicited a supply response: more labour and capital would shift from unproductive cereals to high-value milk production. India has the potential to be the world’s biggest exporter of milk. But this requires a sophisticated web of producers, supply chain, exporters, factories, etc. This sophisticated ecosystem will not flourish when the government meddles in the milk industry. A meddlesome government will go through the whiplash of doing an MSP one day because milk prices are low and banning exports another day because milk prices are high.

    There is something profoundly wrong about a government that interferes in what can be imported and what can be exported. If the export of ball bearings were sometimes banned by the government, you can be sure there would be fewer factories to build ball bearings.

    India is evolving from a socialist past into a mature market economy. How can predictable, non-volatile inflation of 3% be achieved? The recipe that has been developed worldwide is to devote the entire power of monetary policy to this one task. In India, RBI has a complex mandate spanning over many contradictory roles. This has led to failures on inflation control.

    In a mature market economy, a modern central bank watches expected inflation with great interest. Active trading takes place on the spot and derivatives market, for both ordinary bonds and inflation-indexed bonds. Using these prices, a modern central bank is able to infer expected inflation.

    When the short-term interest rate is raised or lowered, in order to respond to changes in expected inflation, there is a slow impact on the economy, possibly spread over two to three years. A modern central bank has the economic knowledge required to watch out for expected inflation deep in the future, and respond to it ahead of time, so as to deliver inflation that is on target.

    In India’s case, the RBI Act of 1934 predates modern monetary economics. In other countries, fundamental reforms have been undertaken in order to refashion monetary institutions in the light of modern knowledge. As an example, in the late 1990s, when Tony Blair and Gordon Brown won the election, they refashioned the Bank of England as a focused central bank which has four core values. Independence: the Bank of England sets the short rate without involvement from the Ministry of Finance. Transparency: the entire process through which interest rate setting is done is fully transparent so that the financial markets always know exactly what is being done and why. Accountability: the Bank of England is accountable for hitting an inflation target. Focus: All tasks other than the inflation target were removed from the Bank of England.

    The bad drafting of the RBI Act of 1934 is the ultimate cause of the distress of milk producers today. These linkages are not immediately visible, but they are very real. It is because India does not have a proper institutional foundation for monetary policy that we are reduced to distortionary mechanisms for inflation control.

  3. Sumeet Dhar

    On June 22, 2008 at 10:45 pm

    Hi Preetam,
    Your comments are bang on…I wish there were more of these kind of extensively candid economic blogs available…


    On June 29, 2008 at 11:46 pm

    By controlling the land value, monitoring the growth of real estate business only we can control the inflation rate. This is what we had observed through research and statistical data taken from 3,000,000 peoples all over india.

  5. right-wingxtremist

    On June 25, 2009 at 7:57 am

    You can analyze this BS all you want on how inflation works. But you are missing the big picture. The Federal government does NOT in anyway control inflation or monetary policy. Inflation is controlled by the Federal Reserve. The federal reserve is a private global banking cartel that answers to NO ONE. They alone make the policies, print the money, loan the money etc…

    Since the Gold standard was abolished the federal reserve can make money out of thin air. It’s only backing is the GDP of the people. The lower the GDP the less the US Dollar is worth. Also the more Public Debt the less it it worth. Inflation has risen 28% since 1999. Income has not and in some cases been reduced.

    Another point I’d like to make is that the Federal Reserve pays off debts by using inflation. They borrow 10 Trillion today, let inflation jump 25%, then pay back the 10 Trillion. But that $10T is now worth 25% less or $7.5T in todays dollars. This has been going on for decades.

    Support HR-1207 and let’s stop the Federal Reserve and big Government from stealing from the people.

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