The Biz of Pacelinebiz

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Inflation – part 1

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In this week’s discussion I will begin a series on inflation.  First, I will provide a brief explanation of what it is and what it isn’t.  Then I will discuss ways the Federal Reserve attempts to control inflation by controlling the money supply.

Definition: Inflation is a persistent rise in the overall (or average) level of prices of all goods and services. Not to be confused by an increase in relative prices such as oil or grain. These are known as supply shocks caused an oil embargo or crop failure. 

The demand-pull theory of Inflation is accepted by central banks such as the Federal Reserve.  It is based on the level of money supply.   This is known as “Too much money chasing too few goods” or demand growing faster than the supply. If demand is greater than supply, then prices will rise.

Since the Demand-Pull Theory of inflation is based on the money supply, the key to controlling inflation is to control the money supply.  If there is a persistent excess supply of money there will be inflation.  The Federal Reserve controls the money supply in 3 ways – all directly impact the interest rate.  The Federal Reserve can:

1) buy Government securities (open market operations)

2) change the Federal Discount Rate

3) change the amount of reserve requirement of banks.

 When the Fed buys securities on the open market, it causes the price of those securities to rise. (Selling causes the price to decrease) Bond prices and interest rates are inversely related. If bond price goes up interest rates go down and vice versa.

Raising or Lowering the Federal Discount Rate is the same as raising or lowering interest rates since it is the rate it charges banks.  

If the Fed changes reserve requirements (cash on hand or on deposit with the Federal Reserve), this will cause banks to have an increase or decrease in the amount of money they can invest. This causes the price of investments such as bonds to rise/fall, so interest rates will change inversely.

According to its web site: “The Fed changes reserve requirements for monetary policy purposes only infrequently. Reserve requirements impose a cost on the banks equal to the foregone interest on the amount by which required reserves exceed the reserves that banks would voluntarily hold in order to conduct their business, and the Fed has been hesitant to make changes that would increase that cost.”

Finally, an alternative definition of Inflation:  “when you pay fifteen dollars for the ten dollar haircut you used to get for five dollars when you had hair”.
Humorist, Sam Ewing

For next week’s discussion we will take a look at the rise of commodity prices over the past 5 years with comments made by Fed Chairman Ben Bernanke.

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Written by pacelinebiz

September 27, 2009 at 10:32 pm

Posted in Business

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