Inflation is the result of the supply and demand for a currency. If additional money is injected into an economy that is not producing greater output, people will have more money to spend on the same amount of products as before. As growing demand for products outstrips stagnant supply, prices will rise and devour any increase in the amount of money that consumers have to spend. Therefore, inflation erodes people’s purchasing power.
IMPACT OF MONEY-SUPPLY DECISIONS
Because of the damaging effects of inflation, governments try to manage the supply of and demand for their currencies. They do this through the use of two types of policies designed to influence a nation’s money supply. Monetary policy refers to activities that directly affect a nation’s interest rates or money supply. Selling government securities reduces a nation’s money supply because investors pay money to the government’s treasury to acquire the securities. Conversely, when the government buys its own securities on the open market, cash is infused into the economy and the money supply increases.
Fiscal policy involves using taxes and government spending to influence the money supply indirectly. For example, to reduce the amount of money in the hands of consumers, governments increase taxes—people are forced to pay money to the government coffers. Conversely, lowering taxes increases the amount of money in the hands of consumers. Governments can also step up their own spending activities to increase the amount of money circulating in the economy or cut government spending to reduce it.
IMPACT OF UNEMPLOYMENT AND INTEREST RATES
Many industrialized countries are very effective at controlling inflation. Some economists claim that international competition is responsible for keeping inflation under control. They reason that global competition and the mobility of companies to move anywhere that costs are lowest keeps a lid on wages. Because wages are kept under control, companies do not raise prices on their products, thus containing inflation.
Other key factors in the inflation equation are a country’s unemployment and interest rates. When unemployment rates are low, there is a shortage of labor, and employers pay higher wages to attract employees. To maintain reasonable profit margins with higher labor costs, they then usually raise the prices of their products, passing the cost of higher wages on to the consumer and causing inflation.
Interest rates (discussed in detail later in this chapter) affect inflation because they affect the cost of borrowing money. Low interest rates encourage people to take out loans to buy items such as homes and cars and to run up debt on credit cards. High interest rates prompt people to cut down on the amount of debt they carry because higher rates mean larger monthly payments on debt. Thus one way to cool off an inflationary economy is to raise interest rates. Raising the cost of debt reduces consumer spending and makes business expansion more costly.