Controlling Inflation

INTRODUCTION Of the various ills the economy can face, inflation is simultaneously the worst for society as a whole. Inflation can be defined as the rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling (investopedia. com). Inflation is a sustained increase in the general level of prices. Since inflation is concerned with increases in the general level of prices, changes in the price of a single good or service cannot be characterized as inflation. The inflation rate is normally measured by percentage changes in the cost of a basket of consumer goods and services (central bank). Inflation in Trinidad has been fluctuating, as stated in the article Inflation rises to 5 per cent, found in the Saturday Guardian on the 27th February, 2010. The article gave the information given in the report done by the Central Statistical Office; it stated that headline inflation rose by 3. 7 per cent in the 12 months to January 2010 from the 1. 3 per cent a month earlier. Food price inflation rose by 2. per cent on a year on year basis in January following a decline of 0. 2 per cent in December 2009. Core inflation which excludes the impact of food prices, rose to 4. 2 per cent (year on year) in January from 2. 2 per cent in December. On a monthly basis, core inflation rose by 2. 2 per cent in January 2010, following an increase of 0. 1 per cent in December 2009 and three consecutive monthly declines. So we clearly see that inflation is present in the economy, and from the article it is quite unpredictable. What we need to ask ourselves is how we can deal with inflation? What we can do to make inflation easier? What can the government do what will the Central Bank do to deal with inflation? THE QUESTION INFLATION IS ON THE RISE, SO WHAT CAN BE DONE BY THE CENTRAL BANK OF TRINIDAD AND TOBAGO TO CONTROL INFLATION? LIMITATIONS/ CHALLENGES -My first challenge was that it was quite difficult to find an article that was appropriate, and dealt with the topics being covered this semester. -It was also a bit difficult to make sense of the article, and then to find literature to support it. Literature was found but making the link was quite difficult. LITERATURE REVIEW Austrian economists maintain that inflation is by definition always and everywhere simply an increase in the money supply (i. e. units of currency or means of exchange), which in turn leads to a higher nominal price level for assets (such as housing) and other goods and services in demand, as the real value of each monetary unit is eroded, loses purchasing power and thus buys fewer goods and services. Ludwig von Mises (cited in Wikiedia, 2010), the seminal scholar of the Austrian School, asserts that: â€Å"Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term `inflation' to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation. . . . As you cannot talk about something that has no name, you cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their ventures are doomed to failure because they do not attack the root of the evil. They try to keep prices low while firmly committed to a policy of increasing the quantity of money that must necessarily make them soar. As long as this terminological confusion is not entirely wiped out, there cannot be any question of stopping inflation. † Inflation is always and everywhere a monetary phenomenon. — Milton Friedman, (1963). Friedman maintained that there is a close and stable association between inflation and the money supply mainly that the phenomenon of inflation is to be regulated by controlling the amount of money put into the national economy by the Federal Reserve Bank. Friedman rejected the use of fiscal policy as a tool of demand management; and he held that the government's role in the guidance of the economy should be restricted severely. Friedman wrote extensively on the Great Depression, which he termed the Great Contraction, arguing that it had been caused by an ordinary financial shock whose duration and seriousness were greatly increased by the subsequent contraction of the money supply caused by the misguided policies of the directors of the Federal Reserve. Inflation and monetary policy are closely related concepts wherein the latter can be used efficiently to reduce the effect of the former. Inflation is thought of as the rise in prices and wages that reduces the purchasing power of money. Monetary policy is the regulation adopted by the central bank, currency board or other regulatory authority which stabilizes the prices and maximizes production and employment of the country. Inflation is characterized by an increase in the general level of prices for goods and services. As a consequence, the purchasing power of money will fall. Most of the countries in the world try to sustain an inflation rate between 2 and 3 percent. The Fisher's equation depicts that proportional relation that exists between money supply and the price level. Monetary policy is a regulation of a central bank or any regulatory authority, which ascertains the size and growth rate of the money supply. Monetary policy directly influences the interest rates which in turn has a negative relation with the price level. In the face of inflation the central bank of the country generally resorts to a rise in the cash reserve ratio, repo rate and reverse repo rate. So the basic idea is to reduce the money supply in the economy. To this end government securities are also issued so as to mop up the excess money supply from the mass. This would reduce aggregate demand. This reduction would again help reduce the price level. Monetary policy is adopted with an objective to make the most of production and employment and consequently stabilize the price level of a country. Monetary policy also regulates the interest rate, availability of credit and at the same time promotes the overall economic growth of a country. Monetary policy facilitates establishing trade relationships with other countries. The Central Bank conducts monetary policy with the objective of maintaining a low and stable rate of inflation, an orderly foreign exchange market and an adequate level of foreign exchange reserves. The conduct of monetary policy is influenced significantly by the pace of real economic activity, the fiscal operations of the government, capital flows and the operations of the commercial banks. In order to achieve the goals of monetary policy, the Central Bank’s actions are designed to influence the level of liquidity in the banking system, which indirectly affects the level of interest rates and, ultimately, the overall demand for goods and services in the economy. The Monetary Policy Committee comprising the Governor and Deputy Governor deals with monetary policy matters including the setting of the â€Å"repo rate† which is announced on the first Thursday of each month. The Monetary Policy Support Committee, which is chaired by the Deputy Governor, Research and Policy, and includes senior staff of the Research, Domestic Market and Financial Institutions Supervision Departments, provides advice to the Monetary Policy Committee. This information was taken from the central bank of Trinidad and Tobago website. Governments have different areas of policy which they can use to regulate the economy. Here we will look at how they affect inflation. One policy is fiscal policy. Fiscal policy is based upon demand management, i. e. raising or lowering the level of aggregate demand. The most obvious policy is that governments should reduce government expenditure and raise taxes. It should be stated here that this policy will be successful only against demand inflation. Fiscal policy was the chief counter- inflationary measure in the 1950’s and 1960’s. One of the reasons for its failure then was the clash of objectives. Another policy is monetary policy. For many years monetary policy was seen as only supplementary to fiscal policy. The Radcliffe report’s conclusion, that ‘money is not important’, was widened into ‘money does not matter’. If m0onetary policy had a role, Keynesians saw it as being through the rate of interest. The monetarist prescription is to control the supply of money. This, as we have seen, was believed to be the only way in which inflation could be controlled. Then there is the direct intervention: prices and income policy. A price and income policy is where the government takes measures to restrict the increase in wages (income) and prices. (Beardshaw, Brewster, Cormack and Ross. 2001, p. 559-62). GLOSSARY OF TERMS CORE INFLATION- The component of measured inflation that has no medium to long-run impact on real output. It is usually derived by omitting volatile changes in the prices of certain items such as food and energy. FISCAL POLICY- refers to the expenditure a government undertakes to provide goods and services and to the way in which the government finances these expenditures. HEADLINE INFLATION- Inflation, as measured by the change in the overall retail prices index, is sometimes called â€Å"headline† inflation. INFLATION- Inflation is a sustained increase in the general level of prices. Since inflation is concerned with increases in the general level of prices, changes in the price of a single good or service cannot be characterized as inflation. The inflation rate is normally measured by percentage changes in the cost of a basket of consumer goods and services. LIQUIDITY- The level of cash or near cash assets of financial institutions readily available to meet day-to-day transaction needs. REPO RATE- Discount rate at which a central bank repurchases government securities from the commercial banks, depending on the level of money supply it decides to maintain in the country's monetary system. MOVEMENT OF SELECTED CATEGORIES OF THE INDEX OF RETAIL PRICES /Percentage Change/ MonthlyYear-on-Year December 2009January 2010 December 2009 January 2010 Headline Inflation(0. 1)1. 91. 33. 7 Food Prices(0. 3)1. 3(0. 2)2. 7 Bread and Cereals(0. 9)(0. 2)(7. 7)(6. 6) Meat(0. 2) (0. 8)(1. 0)(2. 4) Fish4. 2 3. 23. 7(0. 8) Vegetables (0. 1) (1. 6)(1. 3)1. 0 Fruits0. 4 11. 728. 537. 2 Milk, Cheese & Eggs(0. 4)(0. 1)(10. 2)(9. 7) Oils and Fats(0. 8)0. 3(0. 7)(1. 5) Sugar, Jam, Confectionery, etc0. 2 0. 61. 70. 7 Core Inflation0. 1 2. 22. 24. 2 Alcoholic Beverages & Tobacco0. 60. 114. 014. 0 Clothing and Footwear0. 10. 7(1. 5)(1. 0) Furnishings, Household Equipment and Routine Maintenance0. 00. 32. 21. 0 Health0. 1 0. 26. 76. 6 Of which: Medical Services0. 0 0. 414. 114. 0 Housing, Water, Electricity, Gas & Other Fuels0. 0(0. 1)1. 41. 1 Of which:: Rent0. 0 4. 22. 86. 5 Home Ownership 0. 0 (0. 8)0. 7(0. 2) Water, Electricity, Gas & Other Fuels0. 00. 02. 92. 9 Education0. 0 0. 03. 23. 2 Recreation & Culture0. 0(0. 3)(5. 7)3. 1 Hotels, Cafes & Restaurants0. 0 0. 53. 83. 0 Transport0. 0 10. 04. 39. 5 Source: Central Statistical Office. BIBLIOGRAPHY 1)Inflation, http://www. vision2020. info. tt/pdf/Statistics/inflation. pdf, cited on13th March, 2010. 2)Monetary Inflation – quantity theory, http://tutor2u. net/economics/content/topics/inflation/quantity_theory. tm, cited on 13th March, 2010 3)Milton Friedman, http://en. wikipedia. org/wiki/Milton_Friedman, cited on 13th March, 2010 4)Inflation and Monetary policy, http://www. economywatch. com/inflation/economy/monetary-policy. html, cited on 13th March, 2010 5) Monetary policy, http://www. central-bank. org. tt/monetary_policy/index. php, cited on 13th March, 2010 6)Economics a Student’s Guide, (fifth edition), by Beardsh aw, Brewster, Cormack, Ross, pg 559-562. 7)The Basics Economics, by Tony Cleaver, pg 111-138 8)Economics, (11th edition), Lipsey and Crystal.