How Do Governments Reduce Inflation?

Inflation occurs when the amount spent on items and services is greater than production. Prices may rise due to limitations on supply, which increase the cost of manufacturing products and services, or because customers are enjoying the benefits of the economy’s growth, consume their cash in a way that producers could increase production. Inflation usually occurs as a result of the combination of these two situations.

 

The government generally tries to limit inflation to an appropriate range that encourages growth without drastically diminishing the purchasing ability of the currencies. Within 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 monetary policy in order to reach the goals of the Fed of maintaining steady prices and maximum employment. 1

 

There are a variety of methods employed to limit inflation and, even though none is a sure bet but some have been more efficient and caused lesser collateral damage than others.

How Can the Government Control Inflation?

Price Controls

price controls are price limits or floors that are imposed by the government, and are used to regulate specific products. The government can implement wage controls together with price control to limit inflation in the wage market..

 

As of 1971, U.S. President Richard Nixon implemented a broad-based price control in an effort to combat the rising rate of inflation. The price controls, while initially popular and thought to be efficient, were not able to control costs when, in 1973, inflation soared to the highest level in the years since World War II.

 

Despite numerous intervening circumstances (e.g. the ending of Bretton Woods System as well as the poor harvests, Arab oil embargo and the complex 70s system of price controls) Most economists see the 1970s as proof that price control is not a good tool to manage price inflation. 2 3 4

 

Contractionary Monetary Policy

The current monetary policy of contraction is becoming a popular means to control inflation. The aim of the the policy of contraction is to lower the amount of money available within an economy through increasing the interest rate. 5 This slows economic growth through making credit more expensive, which decreases the amount of business and consumer spending.

 

A higher rate of interest in Treasury securities also slow growth , stimulating investors and banks to purchase Treasuries that guarantee an agreed-upon rate of return instead of riskier equity investments that are benefited by lower rates.

 

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

 

Federal Funds Rate

The Federal Funds Rate refers to the amount banks lend one another money for overnight. The federal funds rate is not set directly through the Federal Reserve. Instead the FOMC determines a rate 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 bring interbank rates to the optimal range for the fed funds. 6

 

IOR is the amount banks earn from their deposits through the Federal Reserve. 7 Because that the U.S. has never defaulted on its debt, IOR is considered a risk-free rate. It is, therefore it is the lowest rate of interest any reasonable lender would accept.

 

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

 

In raising rates by raising them, it is 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 which can have 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) increase was announced following an Bureau of Labor Statistics report that showed an increase in inflation in May, despite earlier rate increases. 9

Open Market Operations

Reverse purchase agreements are an example of open market operations (OMOs) which is the term used to describe the purchase and selling Treasury securities. OMOs are an instrument with that the Federal Reserve increases (by buying Treasuries) or reduces (by trading Treasuries) the quantity of money and also adjusts the interest rate.

 

The well-known Federal Reserve balance sheet is a huge increase when the Fed purchases securities, and shrinks when it sells the securities. Securities purchases increase liquidity in financial markets , and creates downward pressure on interest rates , while selling securities is the reverse. 10

 

Reserve Requirements

Between March 26 and 2020 The Federal Reserve also managed the money supply by regulating reserve requirement, which was the amount banks were legally required to hold to pay for withdrawals. The more cash banks were required to keep back and hold, the less money they could afford to loan to customers. 11

 

While reserve requirements were cut by a quarter in the month of March, 2020 However, the Fed is still able to reinstate reserve requirement in the coming years. 12

 

Discount Rate

A discount rate is the interest rate that is charged on loans issued through the Federal Reserve to commercial banks and other financial institutions. The loan facility that the loans for short-term are made is known as”the discount window. The discount rate that is set, which is the same throughout every Reserve Banks, is set by the consensus of each Regional Bank’s Board of Directors as well as that of the Federal board of Governors. 13

 

While the discount window’s main purpose is to satisfy the short-term liquidity requirements of banks and to ensure stability within the banking system however, the discount rate is an additional interest rate that must be increased in order to limit the rise in inflation.

 

The Bottom Line

The government has a limited number of options to stop the rise of inflation. They have the ability to put a limit on prices, but general price control measures needed to reduce inflation haven’t got an impressive of success. A monetary policy that is regressive is the preferred method for managing inflation in the present, but the so-called “soft landings aren’t easy to achieve.

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