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Demand Supply and Market Equilibrium, Research Paper Example

Pages: 3

Words: 937

Research Paper

Since the beginning of 2014, monetary policy has been aimed at maintaining monetary conditions in line with the objective of containing inflation, while ensuring that liquidity conditions remain supportive of recovery. In this direction, the Reserve Bank used the available space to support growth by lowering the cash reserve ratio (CRR) by 150 basis points on a cumulative basis, the statutory liquidity ratio (SLR) by 100 bps, the repo rate by 50 basis points and infusing over `1.7 trillion of liquidity through outright open market purchases. As a result, liquidity in 2013-14 so far has stayed in line with policy objective (The Economist). Going forward, there is a need to calibrate monetary policy factoring in the evolving growth-inflation dynamics as also the progress that may be made in containing the twin deficits. Growth prospects, both in advanced economies (AEs) and emerging and developing economies (EDEs) have weakened in Q2 of 2012.This paper will analyze the article, “Low Inflation is a Choice” by The Economist.

Article Summary

The article, ECB Determined to Contain Low Inflation Risk by Juhana Rossi and Sean Carey, appears in the Wall Street Journal and is centered on the apparent risks that prolonged low inflation may pose to the economy. The authors appear to have made some grave errors in their economic analysis. They have managed to misrepresent the policies that the Fed employs in managing inflation. The authors wanted to establish if the 2% inflation target by the Fed is feasible. The authors found that this was not a feasible undertaking as over 14 years, the PCE has fallen by 4.7% (Bureau of Labor Statsics). However, their calculations were off the mark as there were some fundamental mathematical concepts that were misrepresented.

The authors hold that the Fed, in its policies, looks to handle core inflation. This is actually false, the Fed employs policies in a bid to handle and manage headline inflation. Since past core inflation is better than past headline inflation in predicting future headline inflation, core inflation is used an indicator.

As depicted in the graph above, when headline inflation (measured using the price index for all the personal consumption expenditure) is tracked against the 2% inflation from 2000, it is visible that PCE inflation has been above the 2% and has only come below the 2% trend after January 2012 when the Fed decide to adopt an inflation target officially (The Economist).

The authors hold that by virtue of there being a shortfall in inflation, monetary policy does not have the ability of hitting a given rate of inflation or level of price. They further hold that when the inflation shortfall is combined with a decline in employment, then monetary policy can be perceived to be dysfunctional (Rossi and Carney). The authors believe that the Fed has been intentionally ignoring unemployment and inflation. This is founded on the belief that the intervention of the Fed on these issues would lead to an unstable financial environment that is riddled with stability risks.

As the chart below suggests, the inflation expectation shot up when an open-ended quantitative easing program was introduced by the Fed. Interestingly, after a move by the Fed to initiate tapering was in the making, the inflation expectations dipped sharply. According to this evidence, it is quite clear that the Fed have a control on inflation, or they can at the least influence its direction and rate of movement.

One may be inclined to argue that the Fed cannot indeed control inflation to suit its needs. However, the ideology that low inflation can cause financial instability in an already unsure market is unfounded and lacks the statistical evidence to back it up. As all evidence points the Fed has intentionally chosen to employ a low inflation rate so as to create a positive financial environment that is stable. A higher rate of inflation is too risky, financially for the economy.

There has been a notion long held that the commercial banks expand or contract credit based on their reserves. This is actually not true. For the past 40 years, the rate at which commercial lend is not related in any way to the amount in reserves the bank has (Fender). Banks give credit according to their excess float once they meet the required reserve threshold set by the Fed.

The United States Banking industry expands credit according to the collective ability to find willing and qualified borrowers, risk aversion and the balance sheet. The amount of reserves that a bank holds does not in any way influence the rate of issuing credit. As it was evident between 1995 and 2007, the banks were able to expand credit on a massive scale despite having little reserves. Commercial banks arguably have bigger reserves presently as compared to the 1995 – 2007 period (Arixold). However, this has not prompted banks to become aggressive in expansion of their credit, and this seems to be the trend in the foreseeable future. By the authors insinuating that US commercial banks will soon launch a move to expand credit, they ignore the fundamental and theoretical framework upon which the Fed operates. Furthermore, in order for the banks to expand credit, they have to; adopt a risk averse approach as regards credit, gain a growing pool of qualified and willing borrowers, possess a balance sheet with the sufficient strength to back increased leverage.

Works Cited

Bureau of Labor Statsics. Consumer Price Index – March 2014. News Release. Washington: U.S. Department of Labor, 2014. Digital Source. 28 April 2014. <http://www.bls.gov/news.release/pdf/cpi.pdf>.

Rossi, Juhana and Sean Carney. “ECB Determined to Contain Low Inflation Risk.” The Wall Street Journal (2014).

The Economist. “Low inflation is a choice.” 31 March 2014. The Economist. Internet Source. 28 April 2014. <http://www.economist.com/blogs/freeexchange/2014/03/monetary-policy-3>.

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