How Do Governments Reduce Inflation?

Inflation occurs when the amount spent on products and services exceeds the production. Prices may rise due to limitations on supply, which increase the price of making products and services, or simply because consumers benefit from an economic boom, use more cash than producers are able to increase their production. Inflation usually occurs as a result of the combination of both.

 

The government generally tries to maintain inflation within the optimal range, which encourages growth without drastically diminishing the purchasing ability that the money. Within the U.S., much of the responsibility of controlling inflation rests with the Federal Open Market Committee (FOMC) the Federal Reserve committee that sets the monetary policy to meet the goals of the Fed of maintaining stability in prices and maximum job creation. 1

 

There are a variety of methods employed to manage inflation, and even though none is a sure bet however, certain methods have proven to be more efficient and have caused lesser collateral damage than others.

How Can the Government Control Inflation?

Price Controls

Prices controls are floor prices or price caps that are mandated by the government, and are used to regulate specific products. Pay controls can be implemented together with price control to limit inflation of wages..

 

The year 1971 was the first time U.S. President Richard Nixon implemented a broad-based price control in an effort to combat the rising rate of inflation. The price controls, while initially popular and believed to be efficient, were not able to control the price of goods when in 1973, inflation soared to the highest level ever since World War II.

 

Despite numerous intervening events (e.g. the end of Bretton Woods System as well as the poor harvests, Arab oil embargo and the complex 1971 price-control system) Many economists consider the 1970s as a sufficient evidence that price control is not a good tool to manage price inflation. 2 3 4

 

Contractionary Monetary Policy

The current monetary policy of contraction is becoming a popular means to control inflation. The aim of the contracting policy is to lower the quantity of money within an economy through increasing the rate of interest. 5 This can slow growth through making credit more expensive, which decreases the amount of business and consumer spending.

 

A higher rate of interest in Treasury securities can also slow growth by encouraging investors and banks to purchase Treasuries which provide the same rate of return instead of riskier equity investments that are benefited by low interest rates.

 

Below are a few methods that The U.S. central bank, the Federal Reserve, combats the rise in inflation.

 

Federal Funds Rate

The Federal Funds Rate refers to the amount banks are able to lend each other money over the course of a single day. The Fed Funds rate is not set directly in the hands of the Federal Reserve. Instead the FOMC announces an ideal range for the Fed funds rate, and then it adjusts two other interest rates – the interest reserve (IOR) in addition to the daily reverse purchase arrangement (ON RRP) rate — to push interbank rates to the optimal range for the fed funds. 6

 

IOR is the amount banks earn on their deposit in the Federal Reserve. 7 Because that the U.S. has never defaulted on its debt, IOR is considered a risk-free rate, and therefore it is the lowest rate of interest that any lender who is reasonable should be able to accept.

 

It is the same way that the ON RRP rate works similarly. It is because the majority of financial institutions do not have accounts in the Federal Reserve. On RRP ON RRP entitles those institutions to buy an official security during the night , and then sell it at the Fed the following day. The rate of ON RRP is the difference in price that the security purchased and then it is sold. 8

 

In raising rates by raising them, they encourage the Federal Reserve encourages banks and other lenders to increase rates for loans that are riskier and divert more of their cash to the non-risk Federal Reserve, thereby reducing the amount of money available and having the result of decreasing the rate of inflation.

 

1.5%-1.75%

The federal funds rate is the target is set at the FOMC at its June 2022 meeting. The 75 basis points (0.75 percent) rise came following an Bureau of Labor Statistics report indicated that inflation was rising in May, despite earlier rate increases. 9

Open Market Operations

Reverse buy-back agreements are an instance of open market operations (OMOs) that is the term used to describe the purchase as well as selling Treasury securities. OMOs are a method by that the Federal Reserve increases (by buying Treasuries) or reduces (by trading Treasuries) the amount of money available and also adjusts the interest rate.

 

The well-known Federal Reserve balance sheet is a huge increase when the Fed purchases securities, and shrinks when it sells the securities. Securities purchases increase liquidity in financial markets , and reduces interest rates , while selling securities can be the reverse. 10

 

Reserve Requirements

From March 26 to 2020 The Federal Reserve also managed the money supply by regulating reserve requirement which is the amount banks were legally obliged to hold to pay for withdrawals. The more cash banks had to hold back and hold, the less money they could afford to loan to customers. 11

 

Although reserve requirements were reduced by a quarter in the month of March, 2020 however, the Fed has the power to reinstate reserves in the near coming years. 12

 

Discount Rate

A discount rate is the interest rate charged for loans issued through the Federal Reserve to commercial banks and other financial institutions. The loan facility that the short-term loans are granted is known as”the discount window. The discount rate that is set, which is the same for the entire Reserve Banks, is set by the consensus of each Regional Bank’s Board of Directors, as well as The Fed’s board of Governors. 13

 

While the discount window’s main purpose is to satisfy the banks’ liquidity needs in the short term and ensure stability in the banking system however, the discount rate is a different interest rate that must be increased to help curb the rise in inflation.

 

The Bottom Line

The government has a limited number of options to stop the rise of inflation. They are able to place a ceiling on prices, however the large-scale price controls needed to curb inflation do not have an excellent performance. A monetary policy that is regressive is the preferred method for managing inflation in the present, but those who advocate “soft landings aren’t easy to achieve.

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