Posts Tagged ‘Money Supply’

The Debate Over Demand Management by Government

Thursday, January 12th, 2012


During the 1960′s, Keynesian fiscal policies (also known as “demand management” policies, since the government uses them to manage the level of aggregate demand in the economy) were regarded as unquestionably beneficial to the economy. In the early 1960′s, US President John F. Kennedy had implemented major tax cuts. These lifted the North American economy out of a recession and can be given credit for the economic boom that lasted through most of the 1960′s.

Following the late 1960′s, however, experience with government monetary and fiscal policy was much less satisfactory. Excessive stimulation in the late 1960′s led to rapid inflation; in response, strong anti-inflation policies were applied, causing unemployment to rise to high levels. Again in the 1970′s, excessive stimulation generated very severe inflation, followed by anti-inflation policies and a recession.

Clearly, something had gone wrong: the monetary and fiscal policies that were supposed to be used to reduce economic instability were being applied in a stop-go fashion that actually created instability, wrenching the economy from rapid inflation to recession and back again. The bad economic effects of these policy decisions have led some economists to argue that the government should not actively manage the level of demand in the economy with its monetary and fiscal policies. They believe that, due to political pressures and the problems of time lags, government attempts at “demand management” tend to become mismanagement, with negative effects on economic stability and prosperity.

To remedy this, these economists argue, governments should be required to followed fixed rules for monetary and fiscal policy rather than be allowed to adjust the federal budget and rate of growth of the money supply as they see fit. In particular, it is sometimes argued, the money supply as they see fit. In particular, it is sometimes argued, the money supply should be allowed to grow at only a certain rate and the federal budget should always be balanced. Such rules, these people say, would prevent governments from making major errors in economic policy, especially in the direction of overstimulation.

Other economists disagree with this view. They point out that our economic system has a history of instability, culminating in the Great Depression of the 1930′s. They argue that the government can and should actively intervene in the economy growth has been more rapid and recessions less frequent and less severe than before. They also argue that, if mistakes were made in the use of these policies, we should learn from those mistakes rather than abandon the policies altogether in the blind hope that it will all work out somehow.

Which view is correct? There seem to be elements of truth in both views. Management of demand by government can have either beneficial or negative effects on economic stability and prosperity, depending on whether the policies are used with the proper timing and strength. For such policies to benefit the economy, the government must base its decisions on the effectiveness of policies intended to stimulate the Canadian economy. Because so much (about 30 percent) of the respending effect of the multiplier is drained off by imports when Canadian authorities inject additional demand into the economy, the multiplier effect is quite small. As a result, policies intended to stimulate the Canadian economy have less impact on output and employment in Canada than Canadian authorities would like.

In summary, the heavy exposure of the Canadian economy to international economic forces creates special difficulties for Canadian economic policy-makers. In particular, the importance of exports and of foreign capital inflows places significant limitations on Canadian authorities in deciding monetary and fiscal policies, forcing them to consider not only domestic Canadian problems, but also international factors, when formulating policies.

 

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The Problem of “Inflation Psychology”

Sunday, January 8th, 2012


A more recent, but very serious problem for government policy-makers is the strong “inflation psychology” which has developed since the mid-1970′s, which causes people to seek large wage and salary increases in attempts to protect themselves against inflation. By adding substantially to cost-push inflationary pressures, “inflation psychology” creates special problems for monetary and fiscal policy.

First, by steadily increasing the cost of the GNP, these cost-push pressures force the Bank of Canada to continue to increase the money supply at inflationary rates in order to avoid an economic downturn due to inadequate demand, thus maintaining inflation at high rates. Furthermore, “inflation psychology” is strong risks touching off an explosion of wage demands and price increases, while strong cost-push pressures on prices make inflation very resistant to policies that depress aggregate demand.

Thus, “inflation psychology” tends to significantly reduce the effectiveness of monetary and fiscal policies in dealing with both inflation and recession. It is ironic that this problem resulted from excessive use of these policies in the late 1960′s and early 1970′s, when excessive monetary and fiscal stimulation in many nations generated the strong “inflation psychology” that has undermined the effectiveness of monetary and fiscal policies themselves.

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Easy Money, Tight Money and Interest Rates

Thursday, August 4th, 2011


During a period of “easy money,” when the banks have plentiful reserves and are ready to make numerous new loans, interest rates tend to fall, to encourage borrowers to borrow additional funds. Thus, “easy money” tends to involve two characteristics – increased availability of loans and lower interest rates – both of which tend to stimulate borrowing and spending by consumers and businesses.

During a period of “tight money,” the scarcity of loans causes interest rates to rise, so that the available loans tend to go better credit risks and the highest bidders among them. These two characteristics of “tight money” – reduced availability of loans and higher interest rates – both tend to depress borrowing and spending by consumers and businesses.

Thus, monetary policy can influence the money supply through either the supply of loans or the demand for them. By increasing or reducing the banks’ reserves, the Bank of Canada can influence the availability (or supply) of loans, and by altering interest rates, the Bank of Canada operates in both ways, influencing both the availability and the cost of credit.

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Moral Suasion

Monday, August 1st, 2011


“Moral suasion” refers to attempts by the Bank of Canada to persuade the managements of the chartered banks to voluntarily cooperate with the central bank’s objectives regarding lending policies, interest rates or any other aspect of monetary policy. Due to the fact that there are so few banks in Canada,it is relatively simple for the Bank of Canada to discuss its objectives with the banks with a view to enlisting their support, which they are expected to provide.

In summary, the Bank of Canada influences the nation’s money supply through various policy approaches including “open-market operations”, changes in the secondary reserve ratio, changes in the Bank Rate and “moral suasion.” By using these policy measures, the Bank of Canada can generate “easy money”, in which lending by the banks and the money supply expand more rapidly, or “tight money”, in which loans are scarce and the money supply rises slowly or even declines.

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The Causes of Inflation in Review

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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Changing the Bank Rate

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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