Posts Tagged ‘Excess Demand’
Friday, January 20th, 2012
In Chapter 9, we saw how the federal government’s Department of Finance uses fiscal policy to influence the level of aggregate demand in the economy. Since the monetary policy of the Bank of Canada discussed in this chapter also influences aggregate demand, we should review briefly how monetary and fiscal policies can interact so as to affect the performance of the economy.
During a recession, when aggregate demand is inadequate, a budget deficit (achieved through increased government spending and/or tax reductions) is usually combined with an easy-money policy consisting of lower interest rates and increased availability of loans. The objective of these policies is to increase the demand for goods and services by households and businesses. This increase in spending will be added to by the respending effect of the multiplier, and will be in large part financed by increases in the money supply resulting from increased bank lending. Also, it is possible that increased consumer spending may cause businesses to increase their investment spending (the accelerator effect), a process which would also be financed by the increased money supply through bank lending, encouraged by reductions in interest on loans. The overall result would be to stimulate output and employment in the economy.
During a period of inflation, aggregate demand for goods and services is so high that the supply of them cannot keep pace, with the result that prices rice with unusual rapidity. To combat inflation, a combination of a budget surplus (tax revenues in excess of government spending) and tight money, with loans relatively scarce and interest rates high, is appropriate. The objective of these policies is to depress the demand for goods and services, so as to relieve the pressure of excess demand on the supply and on the prices of goods and services. Government spending will be held down, while tax increases and high interest rates will restrain borrowing and spending by consumers and businesses. With total demand depressed in these ways, the rate of inflation will tend to decrease.
By combining the the fiscal policy of the Department of Finance and the monetary policy of the Bank of Canada in these ways, the effect can be considerably stronger than if either were used by itself.
In summary, then, tight-money policies are used to combat inflation by depressing the level of aggregate demand. While these policies will slow down inflation, they also tend to slow down the economy and increase unemployment, and they have particularly severe effects upon certain industries.
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Tags: Aggregate Demand, Bank Of Canada, Budget Deficit, Budget Surplus, Chapter 9, Consumer Spending, Department Of Finance, Easy Money, Excess Demand, Fiscal Policies, Government Spending, High Interest Rates, Monetary And Fiscal Policy, Money Policy, Money Supply, Multiplier, Rapidity, Tax Increases, Tax Reductions, Tight Money
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Thursday, July 21st, 2011
The causes of inflation are complex, interwoven and difficult to separate. The most basic factor determining the rate of inflation is the rate of growth of the money supply, which in turn determines the degree of excess demand present in the economy. However, there are different reasons why the money supply might increase rapidly enough to generate rapid inflation. Some people view the basic cause as excessive stimulation of the economy by government monetary and fiscal policies, while others emphasize that cost-push pressures from big business and labor unions can virtually force the government to increase the money supply, in order to avoid a recession, by providing the economy with enough purchasing power to buy all of its output at the higher prices caused by the “wage-space spiral.” While there are elements of truth in both of these viewpoints, most economists tend to place more emphasis on demand-pull pressures originating in government policies as the basic cause of inflation, and view cost-push pressures as a contributing factor to inflation rather than the basic cause.
On a more fundamental level, both the demand-pull and cost-push theories of inflation are related to the unrealistic expectations of people and to their attempts – as workers, consumers, business persons and government leaders – to get more out of the economy than the economy can produce. When such unrealistic demands are placed on the economy – either in terms of excessive spending or in terms of excessive increases in incomes – the result will inevitably be inflation.
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Tags: Business Persons, Cause Of Inflation, Causes Of Inflation, Different Reasons, Excess Demand, Excessive Stimulation, Fiscal Policies, Fundamental Level, Government Leaders, Government Policies, Honda Cr V, Inflation Rate, Labor Unions, Money Supply, Purchasing Power, Rate Of Inflation, Theories Of Inflation, Unrealistic Demands, Unrealistic Expectations, Viewpoints
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Sunday, July 17th, 2011
We have seen that, in its capacity as “a bank for banks,” the Bank of Canada can make loans to chartered banks suffering a temporary shortage of cash reserves. The rate of interest paid by the banks for these loans is known as the “Bank Rate.” In theory, a higher Bank Rate would make the banks keep more excess cash reserves in order to avoid the need to borrow from the Bank of Canada, and would thus restrict the banks’ ability to make loans and increase the money supply. In fact, this is not of any real significance, since the chartered banks only very rarely borrow from the Bank of Canada.
Rather, the importance of the Bank Rate to monetary policy has arisen from the use of Bank Rate changes by the Bank of Canada as signals to the nation of the direction of the central bank’s policies. An announcement of an increase in the Bank Rate is a signal of “tighter money,” with loans less available and more costly, whereas an announcement by the central bank of a reduction in the Bank is interpreted as signalling a movement yet the underlying economics of the situation are often quite different. If, for example, consumer demand for lumber is very high, lumber stores will find their inventories depleting rapidly and will be anxious to replenish their stocks of lumber. With the purchases for all the various lumber stores bidding actively against each other for a limited supply of lumber from the sawmills, the price will be bid up.
When the lumber reaches the retail stores, it will have a higher price – which store managers describe as “an increase in our costs.” However, the real origin of the price increases lies in high consumer demand; it is really demand-pull in nature rather than cost-push, as it appears.
In a similar way, people tend to blame inflation generally on what they can see – increases in union wages and business profits. Yet these wage and profit increases are more the symptoms of inflation, the basic cause being excess demand. Early in a period of inflation caused by excess demand, prices tend to rise faster than wages, many of which are tied to union contracts that have not yet expired; as a result, profits increase rapidly (the catch-up phase), people blame unions for the inflation. In both cases, attention is focused not on the basic cause of inflation, but rather on the more visible symptoms.
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Tags: Bank Of Canada, Banks Canada, Business Profits, Cash Reserves, Chartered Banks, Excess Cash, Excess Demand, Limited Supply, Lumber Price, Lumber Retail, Lumber Stores, Monetary Policy, Money Supply, Price Increases, Profit Increases, Rate Changes, Rate Of Interest, Sawmills, Store Managers, Union Wages
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Tuesday, May 10th, 2011
When they believe controls are likely to be introduced, some businesses increase the list prices of their products, while leaving their actual selling prices unchanged. After the controls are imposed, the selling price (the actual price) can be increased as economic conditions permit, while the list price (the official price being watched by the government) remains unchanged. Another technique for evading price controls is to reduce the quality of the product while holding its price constant, thus implementing in effect a “hidden” price increase. Regarding wage controls, employers who have high sales may wish to raise wages in violation of the controls, in order to attract and retain workers. One way to achieve this is to reclassify employees, or create new job classifications. For example, a group of Grade C widget workers could be upgraded to Grade B ( even though they were still really Grade C), and thus given a pay raise in excess of that allowed under the controls.
The result of these evasions of the wage-price controls will be that there will exist, in effect, a black market for goods, services and labor – official (legal) prices, and the considerably higher prices that are actually paid. As long as there is excess demand in the economy, people will find a way to charge (and pay) more than the controls allow. Not even the death penalty has prevented the development of such black markets in many instances, because of the difficulties that authorities have in detecting violations of the law.
The examples described above represent only a few of the types of evasion of controls that are possible. These and other evasion techniques present any wage-price control agency with an impossible task of policing not only wage and price increases, but also whether new products are really “new,” whether “options” were standard features last year, whether product quality has been altered in any way, whether re-classifications of workers were really justified and so on. These problems illustrate another dilemma of wage and price controls: what starts out as an attempt to restrain inflation can broaden into attempts by government to control business decisions concerning new products, product design, product quality, classification of employees, and to police countless violations of the controls in black markets. Whether the government should involve itself n such matters is strongly disputed by many people.
- In 301 A.D., the Roman Emperor Diocletian imposed controls on all important wages and prices. To enforce his controls program, Diocletian used about half the population of Rome. The controls program failed.
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Saturday, May 7th, 2011
As we have seen, the basic cause of inflation is excess demand for goods, services and labor. The rapid price and wage increases that result are merely the symptoms of the problem. Unless the cause is attacked (by policies that restrain spending in the economy), the demand pressure on prices and wages will continue, as willing buyers compete for goods, services and labor.
Under these circumstances, both theory and experience suggest that the controls will not be effective because people will find ways to evade them. For example, some groups (such as professionals and skilled tradesmen) would be able toe evade the controls by receiving some of their income in cash or other forms that would go undetected by the government’s controllers. If the demand for the product is high, a business can find ways to increase prices despite the controls. By making minor changes in the product, it could be introduced as a “new” product with a new (and higher) price. In the same manner, previously standard features on a product such as an automobile could be made into options, available at additional cost, or a new feature, such as warranty, could be added.
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Thursday, April 21st, 2011
To dampen aggregate demand in the economy, the federal government can use a budget surplus, with government expenditures less than tax revenues.
The most likely approach to a budget surplus is for the government to curb the growth of (or even reduce) government expenditures. Such curbs on government spending will be especially helpful in slowing inflation if they reduce the need for the government to increase the money supply to finance its expenditures.
*Because interest payments are one of the cost of doing business, some people believe that the way to curb inflation is to reduce interest rates rather than to increase them through a tight-money policy. While lower interest rates would have a slight cost-reducing effect on business, the easy money associated with lower interest rates would more than offset this by increasing the money supply and aggravating the problem of excess demand. In short, reducing interest rates is exactly the reverse of what is needed to combat inflation.
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