Posts Tagged ‘Excess Demand’

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Combating demand-pull inflation

Monday, April 18th, 2011


To attack the basic cause of inflation, the government must restrain the growth of aggregate demand for goods and services, by using its monetary and fiscal policies.

Monetary policy

To combat inflation, the Bank of Canada should should impose a tight-money policy consisting of higher interest rates and reduced availability of credit. By slowing the growth of the money supply, such a policy will ease the pressures of excess demand on prices and thus help to restrain inflation. It is generally accepted among economists that no anti-inflation policy can succeed unless it includes control of the rate of growth of the money supply. Thus, whatever else is done to curb inflation, monetary restraint is essential, because if money is created too rapidly, its value will decline (because prices of goods and services will rise).

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The Money Supply and Inflation

Monday, April 4th, 2011


Excess demand is not merely the result of people wanting more: they must also have more money with which to buy, thus driving prices up. For society in general (consumers, businesses and governments) to be spending more money, there must be more money in circulation – the money supply must rise. Any period of rapid inflation is accompanied by rapid increases in the money supply. And, as we have seen, the growth of the money supply is controlled by the Bank of Canada, which is ultimately responsible to the federal government. Thus, the key factor underlying the rate of inflation – the money supply – is in the final analysis determined by the federal government. In determining its monetary policy, however, the Bank of Canada is not concerned solely with combating inflation. In particular, we have seen that increases in the money supply (easy money) can be used during recessions, to reduce unemployment. While easy money policies can help to lift the economy out of recession, there is a danger that the government will boost the money supply too quickly and/or for too long a time. Of course, this will result in a new surge of inflation, but only after a time lag.

Experts in the monetary aspects of economics say that if the money supply is increased excessively rapidly, inflation will probably begin to increase after about a year and will continue to work its way through the economy for another two years more. Thus, while rapid increases in the money supply may look like a good idea to a government faced with a recession and high unemployment, they are all too likely to cause a much worse inflation problem in the future. An excellent example of this was in Canada, where rapid increases in the money supply in 1972, 1973, and 1974 led to a very serious wave of inflation in 1973 and beyond. Following this experience, the Bank of Canada undertook to keep the rate of increase of the money supply within specified limits.

Generally then, the level of aggregate demand for goods and services is the key factor underlying the rate of inflation. Generally, inflation tends to be most severe during economic booms, when demand is high, and less severe during recessions, when demand is sluggish.

The growth rate of the money supply is, over time, the single most important determinant of the inflation rate.

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Excess Demand: The Basic Cause of Inflation (demand-pull inflation)

Monday, March 28th, 2011


This is the classic case of inflation, the situation in which aggregate demand (consumption plus investment plus government plus net export spending) exceeds the capacity of the economy to produce goods and services. The economy is at anytime only physically capable of producing goods and services at a certain (capacity) rate; should total spending exceed this level, the only possible outcome is that prices will rise as a result of the excess demand.

It is generally agreed among economists that excess demand is the most basic cause of inflation. The most common examples of demand-pull inflation are periods of wartime, when heavy government spending drives prices upward. Another case occurred after the Second World War, when house-holds cashed in their war bonds and went on a spending spree. In the second half of the 1960′s, US government spending on the Vietnam War and major domestic social security programs generated increasingly severe inflation, and in the 1972-73 worldwide economic boom – the strongest peacetime economic boom ever – prices rose at record rates as output simply could not keep up with booming demand. Each of these cases of inflation was accompanied by another phenomenon with which we will deal shortly – unusually rapid increases in the volume of money in circulation (the money supply).

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How Can Budget Deficits Cause Economic Stagnation?

Friday, January 22nd, 2010


This is a good question – how can deficits, which increase aggregate demand, contribute to economic stagnation? The problem concerning stagnation arises not on the demand side of the economy, but rather on the supply side. If large government budget deficits are financed by heavy borrowing by government, in competition with business borrowing, the result can be depressed capital investment by business.

Business investment spending could be depressed for two reasons. First, the excess demand for the limited volume of savings could drive interest considered appropriate to borrow to buy them and repay the loan in the future.

Another reason for federal government borrowing is to finance budget deficits to combat recessions. Thus, the federal government’s responsibility for minimizing the effects of recessions sometimes requires it to go into debt. Historically, another major reason for government borrowing and increases in the National Debt has been the financing of wartime expenditures. For example, the Second World War added over $10,000,000,000 to Canada’s National Debt.

Each of the above is generally considered to be a legitimate reason for borrowing by the government. However, ordinary operating expenses of the government, such as its payroll, should be paid for by tax revenues. It is not considered to be good financial practice to borrow (or even worse, print) money to cover operating expenses, or to avoid a necessary increase in taxes for political reasons, any more than it is considered appropriate for households to go into debt to pay their telephone or food bills.

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