Monetary & Fiscal Policy: Inflation & Deflation Impacts
Understanding Restrictive Monetary Policy
Restrictive monetary policy is a strategy used by central banks to slow down economic growth. It’s termed ‘restrictive’ because the central bank limits liquidity, reducing the amount of money and credit that banks can lend. This policy lowers the money supply by making loans, credit cards, and mortgages more expensive.
The effects typically include a higher exchange rate, a stronger financial account, and a weaker current account. The primary aim is often to reduce inflation. Higher interest rates generally lead to a slowdown in economic growth because they increase the cost of borrowing, which in turn reduces consumer spending and business investment.
How Higher Interest Rates Reduce Aggregate Demand
- More Expensive Borrowing: Higher interest rates discourage firms and consumers from investing and spending.
- More Attractive Saving: Increased rates make saving money in banks more appealing than spending.
- Reduced Disposable Income: Consumers with variable-rate mortgages face higher monthly payments, leaving less income for other spending.
- Exchange Rate Effect: Raising interest rates tends to strengthen the currency (appreciate the exchange rate) due to ‘hot money’ flows seeking better saving rates. A stronger exchange rate helps reduce inflationary pressure by making imports cheaper. However, it can also decrease demand for exports, leading to a decline in aggregate demand. Reduced competitiveness might encourage firms to become more efficient and cut costs.
Fiscal Policy: Government Economic Tools
Fiscal policy involves the government adjusting levels of taxation and spending to influence Aggregate Demand (AD) and overall economic activity.
Primary Goals of Fiscal Policy
- Stimulate economic growth during a recession.
- Maintain low inflation (e.g., the UK government targets 2%).
- Stabilize economic growth, avoiding extreme boom-and-bust cycles.
Inflation: Economic Effects and Consequences
Inflation erodes purchasing power when salaries do not rise as fast as the price of goods and services. This can lead to decreased demand as consumers buy less. It also increases costs for companies, which they may not be able to pass on to their clients, potentially reducing production and lowering GDP.
- Higher inflation generally makes a country’s exports less competitive in the global market and can reduce international demand for its currency.
Deflation: Understanding Falling Prices
Deflation occurs when prices fall. If wages fall slower than prices, or not at all, the real value of money increases. Initially, this might seem to increase demand and production, potentially boosting GDP.
Key Characteristics and Risks of Deflation
- Value of Money Increases: Unlike inflation, deflation means money buys more over time.
- Economic Stagnation Risk: While not always negative, deflation often correlates with economic stagnation and high unemployment. This is partly because falling prices can discourage spending, as consumers wait for items to become even cheaper.
- Discourages Consumer Spending: People often delay non-essential purchases (like luxury goods or electronics) anticipating lower future prices. This reduced spending slows economic growth.
- Increased Real Debt Burden: Deflation increases the real value of debt, reducing the spending power of indebted firms and consumers.