After a ‘sustained increase in general price level’.
June 3, 2019
After Britain’s ‘inflation hit its highest since 2012’, ‘majority of MPC members’ seem inclined to propose contractionary monetary policy to ‘increase interest rates’ to reduce rising inflation, which is a ‘sustained increase in general price level’. 1
With assumption that economy is below full employment level of potential output, Yp, initial equilibrium would be at E1 at output level Y1 and price level P1 shown in Figure 1. With devaluation in pound due to loss of business confidence after ‘Brexit’, imported inputs become more expensive, resulting in higher production costs for firms. Hence, cost-push inflation caused by higher production costs or supply-side shocks2 occurs as increase in production costs for firms results in leftward shift of SRAS from SRAS1 to SRAS2 because firms are less incentivized to produce goods and services. With fall in pound, exports become cheaper, providing foreigners incentives to purchase exports, thus increasing exports revenue. Imports become more expensive, causing domestic consumers to be less inclined to purchase them. Fall in import expenditure occurs as less quantity of imports is demanded. Net exports would rise which increases AD, causing demand-pull inflation as shown in rightward shift of AD from AD1 to AD2. Ceteris paribus, new equilibrium would be E2. GPL rises from P1 to P2, exacerbating inflation rates by increasing prices further. However, real GDP decreases from Y1 to Y2, shifting further away from full employment of resource at potential GDP at Yp.
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Due to inflation, even though nominal income has not changed for people who receive fixed wages due to contracts or people whose incomes rise slower than inflation rates, higher GPL mean purchasing power, ‘quantity of goods and services that can be bought with money’3, and real value of cash drops. As inflation ‘hit its highest since 2012’ and continues to rise, ‘squeeze on household budgets’ gets ‘tighter’, resulting in ‘cost-of-living crisis’.
Therefore, Bank of England aims to intervene to call for contractionary monetary policy to contract AD by reducing money supply to increase interest rates.4
From Figure 2, as money supply decreases from Sm1 to Sm2, interest rates rise from i1 to i2 following an upward movement along Dm curve as demand for money is constant, resulting in higher costs of borrowing. This decreases consumers’ and firms’ incentives to borrow money. Less money is borrowed, causing a drop in investment on capital goods from firms and consumer spending on big ticket items, which are components of AD. AD would fall, as seen in Figure 3, resulting in leftward shift from AD2 to AD3 where equilibrium E3 is reached. Real GDP demanded decreases further from Y2 to Ydefl, displaying higher unemployment as resource maximization reduces further. Hence, real GDP decreases, leading to downward pressure on economic growth. However, GPL is lowered from P2 to P3, decreasing inflation.
While monetary policy reduces inflation, some limitations are that more recession occurs and cyclical unemployment increases. Workers would be affected, requiring ‘British chancellor to relieve them using the government budget’. However, with governmental priorities to get out of inflation which causes ‘cost-of-living crisis’ and with assumption that there is currently ‘steady fall in unemployment’, this is effective in the long run as it directly impacts inflation rates and there is no worry about unemployment.
However, as monetary policy also results in negative economic growth, market-based supply-side policies may be introduced to promote positive economic growth. For example, trade liberalization, which strengthens trade ties while increasing competition between firms domestically and globally, causes firms to lower production costs by encouraging greater production efficiency, reducing inflation in short run. It also encourages greater resource allocation but there is time lag in materializing and affecting potential output, unlike monetary policy which has quicker implementation. Privatization, transfer of ownership of public firm to private sector, could also help by increasing efficiency in management and operation,5 which reduces production costs of firms, decreasing inflation rates. Ultimately, monetary policy is effective in resolving inflation and is able to target an inflation rate as interest rates can be adjusted incrementally. However, it could be complemented by aforementioned policies which tend towards long-run full employment equilibrium to promote positive economic growth.