Economy

How Do Governments Reduce Inflation?

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Inflation occurs when the amount spent on products and services exceeds the production. Prices may rise due to shortages of supply that raise the cost of manufacturing goods and providing services, or simply because consumers are enjoying the benefits of an economic boom, use more cash than producers could increase production. Inflation usually occurs as a result of the combination of both.

 

Governments usually try to maintain inflation within the optimal range, which encourages growth without drastically diminishing the purchasing ability of the currencies. The U.S., much of the responsibility for regulating inflation is borne by the Federal Open Market Committee (FOMC) which is a Federal Reserve committee that sets the policy of monetary policy to meet the goals of the Fed, which are stability in prices and maximum job creation. 1

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There are a variety of methods employed to manage inflation, and although none of them are guaranteed 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. The government can implement wage controls together with price control to limit inflation of wages..

 

As of 1971, U.S. President Richard Nixon introduced a wide-ranging price control in an effort to combat the rising rate of inflation. The price controls, while initially popular and believed to be effective, did not manage costs when, in 1973, inflation soared to the highest level ever since World War II.

 

Despite numerous intervening events (e.g. the ending of Bretton Woods System as well as the poor harvests, Arab oil embargo, as well as the complex 70s system of price controls) Most economists see the 1970s as proof that price control is unproductive in managing price inflation. 2 3 4

 

Contractionary Monetary Policy

In the present, monetary policy that is contractionary is becoming a popular means of reducing inflation. The purpose of the the policy of contraction is to decrease the amount of money available in an economy by increasing the rate of interest. 5 This slows economic growth by making credit costly, which in turn reduces the amount of business and consumer spending.

 

The higher interest rates in Treasury securities also slow growth , encouraging investors and banks to invest in Treasuries that guarantee an agreed-upon rate of return instead of riskier equity investments that profit from low interest rates.

 

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

 

Federal Funds Rate

The Federal funds rate can be described as the price banks lend one another money for overnight. 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 on reserve (IOR) as well as the overnight reverse purchase accord (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 through the Federal Reserve. 7 Because IOR is the only rate that has been paid by the U.S. has never defaulted on its debt, IOR is considered a risk-free rate, and therefore it is the most affordable interest rate that any lender who is reasonable should be able to accept.

 

On RRP rates work similarly. ON RRP rate is similar to the one used by the Federal Reserve. It is because there aren’t all financial institutions that have accounts in the Federal Reserve. On RRP ON RRP entitles those institutions to buy an federal security in the night , and then sell it at the Fed the following day. The rate of ON RRP is the difference between the cost at which the security was purchased and then it is sold. 8

 

Through raising these rates in this way, they encourage the Federal Reserve encourages banks and other lenders to increase rates on loans with higher risk and divert more of their funds to the risk-free 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 rate was set in 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) which is the term used to describe the purchase as well as selling Treasury securities. OMOs are an instrument with that the Federal Reserve increases (by buying Treasuries) or reduces (by the sale of Treasuries) the amount of money available and also adjusts the interest rate.

 

The famous Federal Reserve balance sheet increases when the Fed purchases securities and decreases when it sells the securities. The purchase of securities increases liquidity in the financial markets and creates downward pressure on the interest rate while selling them is the reverse. 10

 

Reserve Requirements

Between March 26 and 2020 until March 26, 2020, the Federal Reserve also managed the money supply by regulating reserves requirements which is the amount banks were legally obliged to hold to pay for withdrawals. The more cash banks had to hold back the less they were able to loan to customers. 11

 

Although reserve requirements were reduced until March of 2020, when they were reduced to zero However, the Fed is still able to reinstate reserves in the near in the future. 12

 

Discount Rate

Discount rate: The discount rate is the interest rate that is charged on loans granted to 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 throughout the entire Reserve Banks, is set by the consensus of each region’s bank’s directors as well as that of the Federal Governors’ Board of Governors. 13

 

Although the main purpose is to satisfy the short-term liquidity requirements of banks and ensure stability in the banking system however, the discount rate is a different interest rate that has to be increased to help curb the rise in inflation.

 

The Bottom Line

There are a few options for governments to stop the rise of inflation. They are able to place a ceiling on prices, however the general price control measures needed to reduce inflation haven’t got an excellent of success. A monetary policy that is regressive is the most popular method of managing inflation in the present, but those who advocate “soft landings” are difficult to implement.

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