In a purely economic sense, inflation refers to a general increase in price levels due to an increase in the quantity of money; the growth of the money stock increases faster than the level of productivity in the economy. The exact nature of price increases is the subject of much economic debate, but the word inflation narrowly refers to a monetary phenomenon in this context.
Using these specific parameters, the term deflation is used to describe productivity increasing faster than the money stock. This leads to a general decrease in prices and the cost of living, which many economists paradoxically interpret to be harmful. The arguments against deflation trace back to John Maynard Keynes' paradox of thrift. Due to this belief, most central banks pursue a slightly inflationary monetary policy to safeguard against deflation.
- Central banks today primarily use inflation targeting in order to keep economic growth steady and prices stable.
- With a 2-3% inflation target, when prices in an economy deviate the central bank can enact monetary policy to try and restore that target.
- If inflation heats up, raising interest rates or restricting the money supply are both contractionary monetary policies designed to lower inflation.
Most modern central banks target the rate of inflation in a country as their primary metric for monetary policy - usually at a rate of 2-3% annual inflation. If prices rise faster than that, central banks tighten monetary policy by increasing interest rates or other hawkish policies. Higher interest rates make borrowing more expensive, curtailing both consumption and investment, both of which rely heavily on credit. Likewise, if inflation falls and economic output declines, the central bank will lower interest rates and make borrowing cheaper, along with several other possible expansionary policy tools.
As a strategy, inflation targeting views the primary goal of the central bank as maintaining price stability. All of the tools of monetary policy that a central bank has, including open market operations and discount lending, can be employed in a general strategy of inflation targeting. Inflation targeting can be contrasted to strategies of central banks aimed at other measures of economic performance as their primary goals, such as targeting currency exchange rates, the unemployment rate, or the rate of nominal Gross Domestic Product (GDP) growth.
How Central Banks Influence the Money Supply
Contemporary governments and central banks rarely ever print and distribute physical money to influence the money supply, instead relying on other controls such as interest rates for interbank lending. There are several reasons for this, but the two largest are: 1) new financial instruments, electronic account balances and other changes in the way individuals hold money make basic monetary controls less predictable; and 2) history has produced more than a handful of money-printing disasters that have led to hyperinflation and mass recession.
The U.S. Federal Reserve switched from controlling actual monetary aggregates, or number of bills in circulation, to implementing changes in key interest rates, which has sometimes been called the "price of money." Interest rate adjustments impact the levels of borrowing, saving, and spending in an economy.
When interest rates rise, for example, savers can earn more on their demand deposit accounts and are more likely to delay present consumption for future consumption. Conversely, it is more expensive to borrow money, which discourages lending. Since lending in a modern fractional reserve banking system actually creates "new" money, discouraging lending slows the rate of monetary growth and inflation. The opposite is true if interest rates are lowered; saving is less attractive, borrowing is cheaper, and spending is likely to increase, etc.
Increasing and Decreasing Demand
In short, central banks manipulate interest rates to either increase or decrease the present demand for goods and services, the levels of economic productivity, the impact of the banking money multiplier and inflation. However, many of the impacts of monetary policy are delayed and difficult to evaluate. Additionally, economic participants are becoming increasingly sensitive to monetary policy signals and their expectations about the future.
There are some ways in which the Federal Reserve controls the money stock; it participates in what is called "open market operations," by which federal banks purchase and sell government bonds. Buying bonds injects new dollars into the economy, while selling bonds drains dollars out of circulation. So-called quantitative easing (QE) measures are extensions of these operations. Additionally, the Federal Reserve can change the reserve requirements at other banks, limiting or expanding the impact of money multipliers. Economists continue to debate the usefulness of monetary policy, but it remains the most direct tool of central banks to combat or create inflation.