A:

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 slightly inflationary monetary policy to safeguard against deflation.

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. (For related reading, see: The Impact of a Fed Interest Rate Hike.)

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. (For related reading, see: How Central Banks Control the Supply of Money.)

RELATED FAQS
  1. How Central Banks Influence Money Supply

    Central banks use several different methods to increase (or decrease) the amount of money in the banking system. Learn more ... Read Answer >>
  2. What is the relationship between inflation and interest rates?

    As interest rates are lowered, more people are able to borrow more money, causing the economy to grow and inflation to increase. ... Read Answer >>
  3. What are some examples of expansionary monetary policy?

    Learn about expansionary monetary policy and how central banks use discount rates, reserve ratios and purchases of securities ... Read Answer >>
  4. How are interest rates related to open market operations?

    Learn about open market operations and how this monetary policy tool impacts interest rates. Find out how the Fed combats ... Read Answer >>
  5. How Do Fiscal and Monetary Policies Affect Aggregate Demand?

    Learn about the impact fiscal and monetary policy have on aggregate demand, and discover how the government influences economic ... Read Answer >>
  6. What happens if the Federal Reserve lowers the reserve ratio?

    If the Federal Reserve decides to lower the reserve ratio through an expansionary monetary policy, commercial banks are required ... Read Answer >>
Related Articles
  1. Insights

    The Top 6 Ways Governments Fight Deflation

    Here are six monetary and fiscal policy tools that governments use to fight deflation.
  2. Insights

    Is U.S. Inflation on the Horizon?

    Inflation, or the general price level of all goods and services in an economy, has remained subdued in the years following the Great Recession. Given recent developments, is the U.S. on the verge ...
  3. Investing

    How the Federal Reserve Devises Monetary Policy

    Learn about the tools the Federal Reserve uses to influence interest rates and economic conditions. Find out the types of action a central bank may take.
  4. Insights

    Understanding How the Federal Reserve Creates Money

    Read about how the Federal Reserve actually targets and creates new money in the economy, and find out why the savings and loans system magnifies this process.
  5. Trading

    How CPI Affects the Dollar Against Other Currencies

    Here's a look at the Consumer Price Index is a broad measure of inflation, and how it has a dramatic impact on a currency's value against rival currencies.
  6. Insights

    Why Deflation Is The Fed's Worst Nightmare

    The measures taken by central banks seem to be winning the battle against deflation, but it is too early to tell if they have won the war.
  7. Insights

    The Federal Reserve System Affects You More Than You Might Think

    How does the Federal Reserve System affect ordinary citizens? In more ways than you might realize.
  8. Insights

    Top 4 Central Banks Dominating the World Economy

    Central banks play an integral role in market economies by maintaining the stability and credibility of national currencies used in those economies.
RELATED TERMS
  1. Accommodative Monetary Policy

    Accommodative monetary policy occurs when a central bank attempts ...
  2. Monetary Base

    A monetary base is the total amount of a currency in general ...
  3. Quantitative Easing

    Quantitative easing is a monetary policy in which a central bank ...
  4. Key Rate

    The key rate is the specific interest rate that determines bank ...
  5. Bank Rate

    A bank rate is the interest rate at which a nation's central ...
  6. Federal Discount Rate

    The federal discount rate allows the central bank to control ...
Trading Center