Bartering is a medium in which goods or services are directly exchanged for other goods and/or services, without the use of money.[1] It can be bilateral or multilateral, and usually exists parallel to monetary systems in most developed countries, though to a very limited extent. Barter usually replaces money as the method of exchange in times of monetary crisis, when the currency is unstable and devalued by hyperinflation. Bartering is still common in the present, usually used within the Internet on sites like Craigslist.[2]
Contents
1 History
2 Trade exchanges
3 Corporate barter
4 Swapping
5 Tax implications
6 See also
7 References
[edit] History
An 1874 newspaper illustration from Harper's Weekly, showing a man engaging in barter: offering chickens in exchange for his yearly newspaper subscription.Contrary to popular conception, there is no evidence of a society or economy that relied primarily on barter.[3] Instead, non-monetary societies operated largely along the principles of gift economics. When barter did in fact occur, it was usually between either complete strangers or would-be enemies.[4]
While one-to-one bartering is practised between individuals and businesses on an informal basis, organized barter exchanges have developed to conduct third party bartering. The barter exchange operates as a broker and bank and each participating member has an account which is debited when purchases are made, and credited when sales are made. With the removal of one-to-one bartering, concerns over unequal exchanges are reduced.
Modern trade and barter has developed into a sophisticated tool to help businesses increase their efficiencies by monetizing their unused capacities and excess inventories. The worldwide organized barter exchange and trade industry has grown to an $8 billion a year industry and is used by thousands of businesses and individuals. The advent of the Internet and sophisticated relational database software programs has further advanced the barter industry's growth. Organized barter has grown throughout the world to the point now where virtually every country has a formalized barter and trade network of some kind. Complex business models based on the concept of barter are today possible since the advent of Web 2.0 technologies.
Bartering benefits companies and countries that see a mutual benefit in exchanging goods and services rather than cash, and it also enables those who are lacking hard currency to obtain goods and services. To make up for a lack of hard currency, Thailand's township, Amphoe Kut Chum, once issued its own local scrip called Bia Kut Chum: Bia is Thai for cowry shell, was once 1⁄6400 Baht, and is still current in metaphorical expressions. Running afoul of national currency laws, the community changed to barter coupons called Boon Kut Chum that bear a fixed value in baht, which they swap for goods and services within the community.[5]
[edit] Trade exchanges
A trade or barter exchange is a commercial organization that provides a trading platform and bookkeeping system for its members or clients. The member companies buy and sell products and services to each other using an internal currency known as barter or trade dollars. Modern barter and trade has evolved considerably to become an effective method of increasing sales, conserving cash, moving inventory, and making use of excess production capacity for businesses around the world. Businesses in a barter earn trade credits (instead of cash) that are deposited into their account. They then have the ability to purchase goods and services from other members utilizing their trade credits – they are not obligated to purchase from who they sold to, and vice versa. The exchange plays an important role because they provide the record-keeping, brokering expertise and monthly statements to each member. Commercial exchanges make money by charging a commission on each transaction either all on the buy side, all on the sell side, or a combination of both. Transaction fees typically run between 8 and 15%.
It is estimated that over 350,000 businesses in the United States are involved in barter exchange activities. There are approximately 400 commercial and corporate barter companies serving all parts of the world. There are many opportunities for entrepreneurs to start a barter exchange. Several major cities in the U.S. and Canada do not currently have a local barter exchange. There are two industry groups, the National Association of Trade Exchanges (NATE) and the International Reciprocal Trade Association (IRTA). Both offer training and promote high ethical standards among their members. Moreover, each has created it own currency through which its member barter companies can trade. NATE's currency is the known as the BANC and IRTA's currency is called Universal Currency (UC).
Exchange systems provide new sales and higher volumes of business, conserving cash for essential expenditures, exchange of unproductive assets for valuable products or services, reduction of unit costs, and opening new outlets for excess inventory and unused capacity. Reciprocal trade finance enables a firm to buy using its incremental cost of production. So long as incremental revenue exceeds incremental cost, it is worth it for a firm to trade using a barter exchange.
There are many reasons to use a good barter exchange:
Increased purchasing power
Increased revenue
Preserving cash
More clients (both from the barter exchange and from cash-business referrals from barter clients)
Better cash flow
Greater marketing opportunities
Improved efficiency
Organized barter companies also have many more benefits over conventional advertising methods since they are much more proactive. Barter members call into the exchange brokerage with things they need and the brokers match those needs with other members that can fill them.
The first exchange system was the Swiss WIR Bank. It was founded in 1934 as a result of currency shortages after the stock market crash of 1929. "WIR" is both an abbreviation of Wirtschaftsring and the word for "we" in German, reminding participants that the economic circle is also a community. Only SME can join WIR. Its purpose is to encourage participating members to put their buying power at each others disposal and keep it circulating within their ranks, thereby providing members with additional sales volume. WIR has grown to 62,000 members, trading approximately the value of 3 billion Swiss Franc. The offering of goods and services for WIR is promoted by the fact that every official participant is obligated to accept payment in WIR for at least 30% of the first 2000 francs of the selling price, and every loan holder must amortize his/her debt by selling goods/services for WIR.
[edit] Corporate barter
Corporate barter focuses on larger transactions, which is different from a traditional, retail oriented barter exchange. Corporate barter exchanges typically use media and advertising as leverage for their larger transactions. It entails the use of a currency unit called a "trade-credit". The trade-credit must be known and guaranteed (contract to eliminate ambiguity and risk).
[edit] Swapping
Swapping is the increasingly prevalent informal bartering system in which participants in Internet communities trade items of comparable value on a trust basis.
While swapping is an excellent way to find and obtain items that are inexpensive, it relies upon honesty. A dishonest participant might arrange a swap, and then never complete their end of the transaction, thus getting something for nothing. This practice is called swaplifting,[citation needed] a pun on shoplifting. The victim's recourse is often limited to shunning the swaplifter, or taking him to small claims court. One way that swaplifting may be combated is by arranging the deal through a third party web service such as FavorTree.net (for services) which has become a favorite among established business men and women, www.bookmooch.com (for books), or one of the other major bartering websites. Typically, these websites do not take on the risk of forcing the other party to follow through on its end of the deal, but they will provide recourse in the form of removing the violator from the site or allowing the wronged party to provide negative feedback (much like eBay or Amazon). Notwithstanding the risk of dishonesty, bartering sites are becoming increasingly popular during tight economic times.
[edit] Tax implications
In the United States, the sales a barter exchange makes are considered taxable revenue by the IRS and the gross amount of a barter exchange member's sales are reported to the IRS by the barter exchange via a 1099-B form. The requirement for barter exchanges to report members sales was enacted in the Tax Equity & Fair Responsibility Act of 1982. According to the IRS, "The fair market value of goods and services exchanged must be included in the income of both parties."[6] Other countries do not have the reporting requirement that the U.S. does concerning proceeds from barter transactions. However, if you barter for goods and/or services, you are taxed not more or less than if it were a cash transaction. In other words, it is handled the same way as a cash transaction regarding taxation. If you bartered for a profit, you pay the appropriate tax, if you generated a loss in the transaction, you have a loss. Bartering for business is also taxed accordingly as business income or business expense.
[edit] See also
Gift economy
Hyperinflation
International trade
List of international trade topics
Local currency
Local Exchange Trading System
Natural economy
Private currency
Reciprocity (cultural anthropology)
Simple living
Trading cards
[edit] References
^ O'Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in Action. Pearson Prentice Hall. p. 243. ISBN 0-13-063085-3.
^ http://www.huffingtonpost.com/tag/craigslist-bartering
^ Mauss, Marcel. 'The Gift: The Form and Reason for Exchange in Archaic Societies.' pp. 36-37.
^ Graeber, David. 'Toward an Anthropological Theory of Value'. pp. 153-154.
^ A Boon to Kut Chum archive
^ Tax Topics - Topic 420 Bartering Income, United States Internal Revenue Service, http://www.irs.gov/taxtopics/tc420.html
Retrieved from "http://en.wikipedia.org/wiki/Barter"
Tuesday, May 12, 2009
Price Revolution
Used generally to describe a series of economic events from the second half of the 15th century to the first half of the 17th, the price revolution refers most specifically to the high rate of inflation that characterized the period across Western Europe, with prices on average rising perhaps sixfold over 150 years.
It was once thought that this high inflation was caused by the large influx of gold and silver from the Spanish treasure fleet from the New World, especially the silver of Peru which began to be mined in large quantities from 1545. According to this theory, there was simply too much money for the amount of available goods.
The start of the price rises actually predated the large-scale influx of bullion from across the Atlantic, reflecting in part a quintupling of silver production in central Europe in 1460-1530: though this output fell by two-thirds by the 1610s, it was significant in fueling the early stages of inflation that were causing an undermining price regime in place since the previous upsurge in silver production in 1170-1320.
Demographic factors also contributed to upward pressure on prices, with the revival (from around the third quarter of the 15th century) of European population growth after the century of depopulation and demographic stagnation that had followed the Black Death. The price of food rose sharply during epidemic years, then began to fall very rapidly as there were fewer mouths to feed. At the same time prices of manufactured goods tended to rise because of dislocation of supply. Later on, increased population placed greater demands on an agricultural area that had contracted significantly after the 1340s, or had been converted from arable to less intensive livestock production.
The increase in the proportion of Europe's population living in towns, though slight (in the region of one percentage point a century) until the 19th century, coupled with economic diversification, meant that there were more people to feed, but proportionately slightly fewer producers of staple foods. Urbanization also contributed to increased trade between Europe's regions, which made prices more responsive to distant changes in demand, and provided a channel for the flow of silver from Spain through western and then central Europe.
Increased trade and availability of manufactured and luxury goods, especially in the 16th century, had also encouraged many landowners to convert their tenants' payments from produce to cash. Initially, this had helped the wealthy to accumulate more of the trappings of wealth, but as prices rose, those landlords who received payment in cash found themselves in financial straits. They often took extreme measures to combat the problem - measures that would add to social unrest and ultimately to a worsened financial position for themselves and their tenants.
In England, for example, many lands held as common lands (pastures, fields, etc.) were enclosed so that only the landlord could graze his animals. This forced his former tenants either to pay increased rents, which was close to impossible, or to leave their own farms. An increase in vagrancy meant more brigandage, a movement to the towns in search of employment and, where no employment could be found, an increase in urban poverty and crime.
The inflation of c.1470-1620 eventually petered out with the end of the initial rush of New World bullion, though prices remained around or slightly below the levels of the first half of the 17th century until the onset of new inflationary pressures in the latter decades of the 18th century.
[edit] References
Earl J. Hamilton, American Treasure and the Price Revolution in Spain, 1501-1650 Harvard Economic Studies, 43 (Cambridge, Massachusetts: Harvard University Press, 1934).
John Munro: The Monetary Origins of the 'Price Revolution':South Germany Silver Mining, Merchant Banking, and Venetian Commerce, 1470-1540, Toronto 2003
It was once thought that this high inflation was caused by the large influx of gold and silver from the Spanish treasure fleet from the New World, especially the silver of Peru which began to be mined in large quantities from 1545. According to this theory, there was simply too much money for the amount of available goods.
The start of the price rises actually predated the large-scale influx of bullion from across the Atlantic, reflecting in part a quintupling of silver production in central Europe in 1460-1530: though this output fell by two-thirds by the 1610s, it was significant in fueling the early stages of inflation that were causing an undermining price regime in place since the previous upsurge in silver production in 1170-1320.
Demographic factors also contributed to upward pressure on prices, with the revival (from around the third quarter of the 15th century) of European population growth after the century of depopulation and demographic stagnation that had followed the Black Death. The price of food rose sharply during epidemic years, then began to fall very rapidly as there were fewer mouths to feed. At the same time prices of manufactured goods tended to rise because of dislocation of supply. Later on, increased population placed greater demands on an agricultural area that had contracted significantly after the 1340s, or had been converted from arable to less intensive livestock production.
The increase in the proportion of Europe's population living in towns, though slight (in the region of one percentage point a century) until the 19th century, coupled with economic diversification, meant that there were more people to feed, but proportionately slightly fewer producers of staple foods. Urbanization also contributed to increased trade between Europe's regions, which made prices more responsive to distant changes in demand, and provided a channel for the flow of silver from Spain through western and then central Europe.
Increased trade and availability of manufactured and luxury goods, especially in the 16th century, had also encouraged many landowners to convert their tenants' payments from produce to cash. Initially, this had helped the wealthy to accumulate more of the trappings of wealth, but as prices rose, those landlords who received payment in cash found themselves in financial straits. They often took extreme measures to combat the problem - measures that would add to social unrest and ultimately to a worsened financial position for themselves and their tenants.
In England, for example, many lands held as common lands (pastures, fields, etc.) were enclosed so that only the landlord could graze his animals. This forced his former tenants either to pay increased rents, which was close to impossible, or to leave their own farms. An increase in vagrancy meant more brigandage, a movement to the towns in search of employment and, where no employment could be found, an increase in urban poverty and crime.
The inflation of c.1470-1620 eventually petered out with the end of the initial rush of New World bullion, though prices remained around or slightly below the levels of the first half of the 17th century until the onset of new inflationary pressures in the latter decades of the 18th century.
[edit] References
Earl J. Hamilton, American Treasure and the Price Revolution in Spain, 1501-1650 Harvard Economic Studies, 43 (Cambridge, Massachusetts: Harvard University Press, 1934).
John Munro: The Monetary Origins of the 'Price Revolution':South Germany Silver Mining, Merchant Banking, and Venetian Commerce, 1470-1540, Toronto 2003
Inflation
This article is about a general rise in the level of prices. For the expansion of the early universe, see Inflation (cosmology). For other uses, see Inflation (disambiguation).
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In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.[1] When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation is also a decline in the real value of money—a loss of purchasing power in the medium of exchange which is also the monetary unit of account in the economy.[2] A chief measure of general price-level inflation is the general inflation rate, which is the percentage change in a general price index (normally the Consumer Price Index) over time.[3]
Inflation can have adverse effects on an economy. For example, uncertainty about future inflation may discourage investment and saving. High inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future.
Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply.[4] Views on which factors determine low to moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities, as well as to growth in the money supply. However, the consensus view is that a long sustained period of inflation is caused by money supply growing faster than the rate of economic growth.[5][6]
Today, most economists favor a low steady rate of inflation.[7] Low (as opposed to zero or negative) inflation may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduce the risk that a liquidity trap prevents monetary policy from stabilizing the economy. The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.[8]
Contents
1 Origins
2 Related definitions
3 Measures
3.1 Issues in measuring
4 Effects
4.1 Negative
4.2 Positive
5 Causes
5.1 Keynesian view
5.2 Monetarist view
5.3 Rational expectations theory
5.4 Austrian theory
5.5 Real bills doctrine
5.6 Anti-classical or backing theory
6 Controlling inflation
6.1 Monetary policy
6.2 Fixed exchange rates
6.3 Gold standard
6.4 Wage and price controls
6.5 Cost-of-living allowance
7 See also
8 Notes
9 References
10 Further reading
11 External links
[edit] Origins
Inflation originally referred to the debasement of the currency. When gold was used as currency, gold coins could be collected by the government (e.g. the king or the ruler of the region), melted down, mixed with other metals such as silver, copper or lead, and reissued at the same nominal value. By diluting the gold with other metals, the government could increase the total number of coins issued without also needing to increase the amount of gold used to make them. When the cost of each coin is lowered in this way, the government profits from an increase in seigniorage.[9] This practice would increase the money supply but at the same time lower the relative value of each coin. As the relative value of the coins decrease, consumers would need more coins to exchange for the same goods and services. These goods and services would experience a price increase as the value of each coin is reduced.[10]
By the nineteenth century, economists categorized three separate factors that cause a rise or fall in the price of goods: a change in the value or resource costs of the good, a change in the price of money which then was usually a fluctuation in metallic content in the currency, and currency depreciation resulting from an increased supply of currency relative to the quantity of redeemable metal backing the currency. Following the proliferation of private bank note currency printed during the American Civil War, the term "inflation" started to appear as a direct reference to the currency depreciation that occurred as the quantity of redeemable bank notes outstripped the quantity of metal available for their redemption. The term inflation then referred to the devaluation of the currency, and not to a rise in the price of goods.[11]
This relationship between the over-supply of bank notes and a resulting depreciation in their value was noted by earlier classical economists such as David Hume and David Ricardo, who would go on to examine and debate to what effect a currency devaluation (later termed monetary inflation) has on the price of goods (later termed price inflation, and eventually just inflation).[12]
[edit] Related definitions
The term "inflation" usually refers to a measured rise in a broad price index that represents the overall level of prices in goods and services in the economy. The Consumer Price Index (CPI), the Personal Consumption Expenditures Price Index (PCEPI) and the GDP deflator are some examples of broad price indices. The term inflation may also be used to describe the rising level of prices in a narrow set of assets, goods or services within the economy, such as commodities (which include food, fuel, metals), financial assets (such as stocks, bonds and real estate), and services (such as entertainment and health care). The Reuters-CRB Index (CCI), the Producer Price Index, and Employment Cost Index (ECI) are examples of narrow price indices used to measure price inflation in particular sectors of the economy. Asset price inflation is a rise in the price of assets, as opposed to goods and services. Core inflation is a measure of price fluctuations in a sub-set of the broad price index which excludes food and energy prices. The Federal Reserve Board uses the core inflation rate to measure overall inflation, eliminating food and energy prices to mitigate against short term price fluctuations that could distort estimates of future long term inflation trends in the general economy.[13]
Other related economic concepts include: deflation – a fall in the general price level; disinflation – a decrease in the rate of inflation; hyperinflation – an out-of-control inflationary spiral; stagflation – a combination of inflation, slow economic growth and high unemployment; and reflation – an attempt to raise the general level of prices to counteract deflationary pressures.
[edit] Measures
Annual inflation rates in the United States from 1666 to 2004.Inflation is usually measured by calculating the inflation rate of a price index, usually the Consumer Price Index.[14] The Consumer Price Index measures prices of a selection of goods and services purchased by a "typical consumer".[15] The inflation rate is the percentage rate of change of a price index over time.
For example, in January 2007, the U.S. Consumer Price Index was 202.416, and in January 2008 it was 211.080. The formula for calculating the annual percentage rate inflation in the CPI over the course of 2007 is
The resulting inflation rate for the CPI in this one year period is 4.28%, meaning the general level of prices for typical U.S. consumers rose by approximately four percent in 2007.[16]
Other widely used price indices for calculating price inflation include the following:
Cost-of-living indices (COLI) are indices similar to the CPI which are often used to adjust fixed incomes and contractual incomes to maintain the real value of those incomes.
Producer price indices (PPIs) which measures average changes in prices received by domestic producers for their output. This differs from the CPI in that price subsidization, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid. There is also typically a delay between an increase in the PPI and any eventual increase in the CPI. Producer price index measures the pressure being put on producers by the costs of their raw materials. This could be "passed on" to consumers, or it could be absorbed by profits, or offset by increasing productivity. In India and the United States, an earlier version of the PPI was called the Wholesale Price Index.
Commodity price indices, which measure the price of a selection of commodities. In the present commodity price indices are weighted by the relative importance of the components to the "all in" cost of an employee.
Core price indices: because food and oil prices can change quickly due to changes in supply and demand conditions in the food and oil markets, it can be difficult to detect the long run trend in price levels when those prices are included. Therefore most statistical agencies also report a measure of 'core inflation', which removes the most volatile components (such as food and oil) from a broad price index like the CPI. Because core inflation is less affected by short run supply and demand conditions in specific markets, central banks rely on it to better measure the inflationary impact of current monetary policy.
Other common measures of inflation are:
GDP deflator is a measure of the price of all the goods and services included in Gross Domestic Product (GDP). The US Commerce Department publishes a deflator series for US GDP, defined as its nominal GDP measure divided by its real GDP measure.
Regional inflation The Bureau of Labor Statistics breaks down CPI-U calculations down to different regions of the US.
Historical inflation Before collecting consistent econometric data became standard for governments, and for the purpose of comparing absolute, rather than relative standards of living, various economists have calculated imputed inflation figures. Most inflation data before the early 20th century is imputed based on the known costs of goods, rather than compiled at the time. It is also used to adjust for the differences in real standard of living for the presence of technology.
Asset price inflation is an undue increase in the prices of real or financial assets, such as stock (equity) and real estate. While there is no widely-accepted index of this type, some central bankers have suggested that it would be better to aim at stabilizing a wider general price level inflation measure that includes some asset prices, instead of stabilizing CPI or core inflation only. The reason is that by raising interest rates when stock prices or real estate prices rise, and lowering them when these asset prices fall, central banks might be more successful in avoiding bubbles and crashes in asset prices.[dubious – discuss]
[edit] Issues in measuring
Measuring inflation in an economy requires objective means of differentiating changes in nominal prices on a common set of goods and services, and distinguishing them from those price shifts resulting from changes in value such as volume, quality, or performance. For example, if the price of a 10 oz. can of corn changes from $0.90 to $1.00 over the course of a year, with no change in quality, then this price difference represents inflation. This single price change would not, however, represent general inflation in an overall economy. To measure overall inflation, the price change of a large "basket" of representative goods and services is measured. This is the purpose of a price index, which is the combined price of a "basket" of many goods and services. The combined price is the sum of the weighted average prices of items in the "basket". A weighted price is calculated by multiplying the unit price of an item to the number of those items the average consumer purchases. Weighted pricing is a necessary means to measuring the impact of individual unit price changes on the economy's overall inflation. The Consumer Price Index, for example, uses data collected by surveying households to determine what proportion of the typical consumer's overall spending is spent on specific goods and services, and weights the average prices of those items accordingly. Those weighted average prices are combined to calculate the overall price. To better relate price changes over time, indexes typically choose a "base year" price and assign it a value of 100. Index prices in subsequent years are then expressed in relation to the base year price.[8]
Inflation measures are often modified over time, either for the relative weight of goods in the basket, or in the way in which goods and services from the present are compared with goods and services from the past. Over time adjustments are made to the type of goods and services selected in order to reflect changes in the sorts of goods and services purchased by 'typical consumers'. New products may be introduced, older products disappear, the quality of existing products may change, and consumer preferences can shift. Both the sorts of goods and services which are included in the "basket" and the weighted price used in inflation measures will be changed over time in order to keep pace with the changing marketplace.
Inflation numbers are often seasonally adjusted in order to differentiate expected cyclical cost shifts. For example, home heating costs are expected to rise in colder months, and seasonal adjustments are often used when measuring for inflation to compensate for cyclical spikes in energy or fuel demand. Inflation numbers may be averaged or otherwise subjected to statistical techniques in order to remove statistical noise and volatility of individual prices.
When looking at inflation economic institutions may focus only on certain kinds of prices, or special indices, such as the core inflation index which is used by central banks to formulate monetary policy.
[edit] Effects
[edit] Negative
An increase in the general level of prices implies a decrease in the purchasing power of the currency. That is, when the general level of prices rises, each monetary unit buys fewer goods and services.[17] The effect of inflation is not distributed evenly, and as a consequence there are hidden costs to some and benefits to others from this decrease in purchasing power. For example, with inflation lenders or depositors who are paid a fixed rate of interest on loans or deposits will lose purchasing power from their interest earnings, while their borrowers benefit. Individuals or institutions with cash assets will experience a decline in the purchasing power of their holdings. Increases in payments to workers and pensioners often lag behind inflation, especially for those with fixed payments.[8]
High or unpredictable inflation rates are regarded as harmful to an overall economy. They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services in order to focus on profit and losses from currency inflation.[8] Uncertainty about the future purchasing power of money discourages investment and saving.[18] And inflation can impose hidden tax increases, as inflated earnings push taxpayers into higher income tax rates.
With high inflation, purchasing power is redistributed from those on fixed incomes such as pensioners towards those with variable incomes whose earnings may better keep pace with the inflation.[8] This redistribution of purchasing power will also occur between international trading partners. Where fixed exchange rates are imposed, rising inflation in one economy will cause its exports to become more expensive and affect the balance of trade. There can also be negative impacts to trade from an increased instability in currency exchange prices caused by unpredictable inflation.
Cost-push inflation
Rising inflation can prompt employees to demand higher wages, to keep up with consumer prices. Rising wages in turn can help fuel inflation. In the case of collective bargaining, wages will be set as a factor of price expectations, which will be higher when inflation has an upward trend. This can cause a wage spiral.[19] In a sense, inflation begets further inflationary expectations.
Hoarding
People buy consumer durables as stores of wealth in the absence of viable alternatives as a means of getting rid of excess cash before it is devalued, creating shortages of the hoarded objects.
Hyperinflation
If inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply.
Allocative efficiency
A change in the supply or demand for a good will normally cause its price to change, signalling to buyers and sellers that they should re-allocate resources in response to the new market conditions. But when prices are constantly changing due to inflation, genuine price signals get lost in the noise, so agents are slow to respond to them. The result is a loss of allocative efficiency.
Shoe leather cost
High inflation increases the opportunity cost of holding cash balances and can induce people to hold a greater portion of their assets in interest paying accounts. However, since cash is still needed in order to carry out transactions this means that more "trips to the bank" are necessary in order to make withdrawals, proverbially wearing out the "shoe leather" with each trip.
Menu costs
With high inflation, firms must change their prices often in order to keep up with economy wide changes. But often changing prices is itself a costly activity whether explicitly, as with the need to print new menus, or implicitly.
Business cycles
According to the Austrian Business Cycle Theory, inflation sets off the business cycle. Austrian economists hold this to be the most damaging effect of inflation. According to Austrian theory, artificially low interest rates and the associated increase in the money supply lead to reckless, speculative borrowing, resulting in clusters of malinvestments, which eventually have to be liquidated as they become unsustainable.[20]
[edit] Positive
Labor-market adjustments
Keynesians believe that nominal wages are slow to adjust downwards. This can lead to prolonged disequilibrium and high unemployment in the labor market. Since inflation would lower the real wage if nominal wages are kept constant, Keynesians argue that some inflation is good for the economy, as it would allow labor markets to reach equilibrium faster.
Debt relief
Debtors who have debts with a fixed nominal rate of interest will see a reduction in the "real" interest rate as the inflation rate rises. The “real” interest on a loan is the nominal rate minus the inflation rate. (R=n-i) For example if you take a loan where the stated interest rate is 6% and the inflation rate is at 3%, the real interest rate that you are paying for the loan is 3%. It would also hold true that if you had a loan at a fixed interest rate of 6% and the inflation rate jumped to 20% you would have a real interest rate of -14%. Banks and other lenders adjust for this inflation risk either by including an inflation premium in the costs of lending the money by creating a higher initial stated interest rate or by setting the interest at a variable rate.
Room to maneuver
The primary tools for controlling the money supply are the ability to set the discount rate, the rate at which banks can borrow from the central bank, and open market operations which are the central bank's interventions into the bonds market with the aim of affecting the nominal interest rate. If an economy finds itself in a recession with already low, or even zero, nominal interest rates, then the bank cannot cut these rates further (since negative nominal interest rates are impossible) in order to stimulate the economy - this situation is known as a liquidity trap. A moderate level of inflation tends to ensure that nominal interest rates stay sufficiently above zero so that if the need arises the bank can cut the nominal interest rate.
Tobin effect
The Nobel prize winning economist James Tobin at one point had argued that a moderate level of inflation can increase investment in an economy leading to faster growth or at least higher steady state level of income. This is due to the fact that inflation lowers the return on monetary assets relative to real assets, such as physical capital. To avoid inflation, investors would switch from holding their assets as money (or a similar, susceptible to inflation, form) to investing in real capital projects. See Tobin monetary model[21]
[edit] Causes
The Bank of England, central bank of the United Kingdom, monitors causes and attempts to control inflation.Historically, a great deal of economic literature was concerned with the question of what causes inflation and what effect it has. There were different schools of thought as to the causes of inflation. Most can be divided into two broad areas: quality theories of inflation and quantity theories of inflation. The quality theory of inflation rests on the expectation of a seller accepting currency to be able to exchange that currency at a later time for goods that are desirable as a buyer. The quantity theory of inflation rests on the quantity equation of money, that relates the money supply, its velocity, and the nominal value of exchanges. Adam Smith and David Hume proposed a quantity theory of inflation for money, and a quality theory of inflation for production.[citation needed]
Currently, the quantity theory of money is widely accepted as an accurate model of inflation in the long run. Consequently, there is now broad agreement among economists that in the long run, the inflation rate is essentially dependent on the growth rate of money supply. However, in the short and medium term inflation may be affected by supply and demand pressures in the economy, and influenced by the relative elasticity of wages, prices and interest rates.[22] The question of whether the short-term effects last long enough to be important is the central topic of debate between monetarist and Keynesian economists. In monetarism prices and wages adjust quickly enough to make other factors merely marginal behavior on a general trend-line. In the Keynesian view, prices and wages adjust at different rates, and these differences have enough effects on real output to be "long term" in the view of people in an economy.
[edit] Keynesian view
Keynesian economic theory proposes that money is transparent to real forces in the economy, and that visible inflation is the result of pressures in the economy expressing themselves in prices.
There are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model":[23]
Demand-pull inflation: inflation caused by increases in aggregate demand due to increased private and government spending, etc. Demand inflation is constructive to a faster rate of economic growth since the excess demand and favourable market conditions will stimulate investment and expansion.
Cost-push inflation: also called "supply shock inflation," caused by drops in aggregate supply due to increased prices of inputs, for example. Take for instance a sudden decrease in the supply of oil, which would increase oil prices. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices.
Built-in inflation: induced by adaptive expectations, often linked to the "price/wage spiral" because it involves workers trying to keep their wages up (gross wages have to increase above the CPI rate to net to CPI after-tax) with prices and then employers passing higher costs on to consumers as higher prices as part of a "vicious circle." Built-in inflation reflects events in the past, and so might be seen as hangover inflation.
A major demand-pull theory centers on the supply of money: inflation may be caused by an increase in the quantity of money in circulation relative to the ability of the economy to supply (its potential output). This is most obvious when governments finance spending in a crisis, such as a civil war, by printing money excessively, often leading to hyperinflation, a condition where prices can double in a month or less. Another cause can be a rapid decline in the demand for money, as happened in Europe during the Black Death.
The money supply is also thought to play a major role in determining moderate levels of inflation, although there are differences of opinion on how important it is. For example, Monetarist economists believe that the link is very strong; Keynesian economics, by contrast, typically emphasize the role of aggregate demand in the economy rather than the money supply in determining inflation. That is, for Keynesians the money supply is only one determinant of aggregate demand. Some economists disagree with the notion that central banks control the money supply, arguing that central banks have little control because the money supply adapts to the demand for bank credit issued by commercial banks. This is the theory of endogenous money. Advocated strongly by post-Keynesians as far back as the 1960s, it has today become a central focus of Taylor rule advocates. This position is not universally accepted: banks create money by making loans, but the aggregate volume of these loans diminishes as real interest rates increase. Thus, central banks influence the money supply by making money cheaper or more expensive, and thus increasing or decreasing its production.
A fundamental concept in inflation analysis is the relationship between inflation and unemployment, called the Phillips curve. This model suggests that there is a trade-off between price stability and employment. Therefore, some level of inflation could be considered desirable in order to minimize unemployment. The Phillips curve model described the U.S. experience well in the 1960s but failed to describe the combination of rising inflation and economic stagnation (sometimes referred to as stagflation) experienced in the 1970s.
Thus, modern macroeconomics describes inflation using a Phillips curve that shifts (so the trade-off between inflation and unemployment changes) because of such matters as supply shocks and inflation becoming built into the normal workings of the economy. The former refers to such events as the oil shocks of the 1970s, while the latter refers to the price/wage spiral and inflationary expectations implying that the economy "normally" suffers from inflation. Thus, the Phillips curve represents only the demand-pull component of the triangle model.
Another concept of note is the potential output (sometimes called the "natural gross domestic product"), a level of GDP, where the economy is at its optimal level of production given institutional and natural constraints. (This level of output corresponds to the Non-Accelerating Inflation Rate of Unemployment, NAIRU, or the "natural" rate of unemployment or the full-employment unemployment rate.) If GDP exceeds its potential (and unemployment is below the NAIRU), the theory says that inflation will accelerate as suppliers increase their prices and built-in inflation worsens. If GDP falls below its potential level (and unemployment is above the NAIRU), inflation will decelerate as suppliers attempt to fill excess capacity, cutting prices and undermining built-in inflation.
However, one problem with this theory for policy-making purposes is that the exact level of potential output (and of the NAIRU) is generally unknown and tends to change over time. Inflation also seems to act in an asymmetric way, rising more quickly than it falls. Worse, it can change because of policy: for example, high unemployment under British Prime Minister Margaret Thatcher might have led to a rise in the NAIRU (and a fall in potential) because many of the unemployed found themselves as structurally unemployed (also see unemployment), unable to find jobs that fit their skills. A rise in structural unemployment implies that a smaller percentage of the labor force can find jobs at the NAIRU, where the economy avoids crossing the threshold into the realm of accelerating inflation.
[edit] Monetarist view
For more details on this topic, see Monetarists.
Monetarists believe the most significant factor influencing inflation or deflation is the management of money supply through the easing or tightening of credit. They consider fiscal policy, or government spending and taxation, as ineffective in controlling inflation.[24]
Monetarists assert that the empirical study of monetary history shows that inflation has always been a monetary phenomenon. The quantity theory of money, simply stated, says that the total amount of spending in an economy is primarily determined by the total amount of money in existence. This theory begins with the identity:
where
P is the general price level;
V is the velocity of money in final expenditures;
Q is an index of the real value of final expenditures;
M is the quantity of money.
In this formula, the general price level is affected by the level of economic activity (Q), the quantity of money (M) and the velocity of money (V). The formula is an identity because the velocity of money (V) is defined to be the ratio of final expenditure () to the quantity of money (M).
Velocity of money is often assumed to be constant, and the real value of output is determined in the long run by the productive capacity of the economy. Under these assumptions, the primary driver of the change in the general price level is changes in the quantity of money. With constant velocity, the money supply determines the value of nominal output (which equals final expenditure) in the short run. In practice, velocity is not constant, and can only be measured indirectly and so the formula does not necessarily imply a stable relationship between money supply and nominal output. However, in the long run, changes in money supply and level of economic activity usually dwarf changes in velocity. If velocity is relatively constant, the long run rate of increase in prices (inflation) is equal to the difference between the long run growth rate of money supply and the long run growth rate of real output.[5]
[edit] Rational expectations theory
Main article: Rational expectations theory
Rational expectations theory holds that economic actors look rationally into the future when trying to maximize their well-being, and do not respond solely to immediate opportunity costs and pressures. In this view, while generally grounded in monetarism, future expectations and strategies are important for inflation as well.
A core assertion of rational expectations theory is that actors will seek to "head off" central-bank decisions by acting in ways that fulfill predictions of higher inflation. This means that central banks must establish their credibility in fighting inflation, or have economic actors make bets that the economy will expand, believing that the central bank will expand the money supply rather than allow a recession.
[edit] Austrian theory
For more details on this topic, see The Austrian view of inflation
The Austrian School asserts that inflation is an increase in the money supply, rising prices are merely consequences and this semantic difference is important in defining inflation.[25] Austrian economists measure the inflation by calculating the growth of new units of money that are available for immediate use in exchange, that have been created over time.[26][27][28] This interpretation of inflation implies that inflation is always a distinct action taken by the central government or its central bank, which permits or allows an increase in the money supply.[29] In addition to state-induced monetary expansion, the Austrian School also maintains that the effects of increasing the money supply are magnified by credit expansion, as a result of the fractional-reserve banking system employed in most economic and financial systems in the world.[30]
Austrians argue that the state uses inflation as one of the three means by which it can fund its activities (inflation tax), the other two being taxation and borrowing.[31] Various forms of military spending is often cited as a reason for resorting to inflation and borrowing, as this can be a short term way of acquiring marketable resources and is often favored by desperate, indebted governments.[32]
In other cases, Austrians argue that the government actually creates economic recessions and depressions, by creating artificial booms that distort the structure of production. The central bank may try to avoid or defer the widespread bankruptcies and insolvencies which cause economic recessions or depressions by artificially trying to "stimulate" the economy through "encouraging" money supply growth and further borrowing via artificially low interest rates.[33] Accordingly, many Austrian economists support the abolition of the central banks and the fractional-reserve banking system, and advocate returning to a 100 percent gold standard, or less frequently, free banking.[34][35] They argue this would constrain unsustainable and volatile fractional-reserve banking practices, ensuring that money supply growth (and inflation) would never spiral out of control.[36][37]
[edit] Real bills doctrine
Main article: Real bills doctrine
Within the context of a fixed specie basis for money, one important controversy was between the quantity theory of money and the real bills doctrine (RBD). Within this context, quantity theory applies to the level of fractional reserve accounting allowed against specie, generally gold, held by a bank. Currency and banking schools of economics argue the RBD, that banks should also be able to issue currency against bills of trading, which is "real bills" that they buy from merchants. This theory was important in the 19th century in debates between "Banking" and "Currency" schools of monetary soundness, and in the formation of the Federal Reserve. In the wake of the collapse of the international gold standard post 1913, and the move towards deficit financing of government, RBD has remained a minor topic, primarily of interest in limited contexts, such as currency boards. It is generally held in ill repute today, with Frederic Mishkin, a governor of the Federal Reserve going so far as to say it had been "completely discredited." Even so, it has theoretical support from a few economists, particularly those that see restrictions on a particular class of credit as incompatible with libertarian principles of laissez-faire, even though almost all libertarian economists are opposed to the RBD.
The debate between currency, or quantity theory, and banking schools in Britain during the 19th century prefigures current questions about the credibility of money in the present. In the 19th century the banking school had greater influence in policy in the United States and Great Britain, while the currency school had more influence "on the continent", that is in non-British countries, particularly in the Latin Monetary Union and the earlier Scandinavia monetary union.
[edit] Anti-classical or backing theory
Another issue associated with classical political economy is the anti-classical hypothesis of money, or "backing theory". The backing theory argues that the value of money is determined by the assets and liabilities of the issuing agency.[38] Unlike the Quantity Theory of classical political economy, the backing theory argues that issuing authorities can issue money without causing inflation so long as the money issuer has sufficient assets to cover redemptions.
[edit] Controlling inflation
A variety of methods have been used in attempts to control inflation.
[edit] Monetary policy
Main article: Monetary policy
Please help improve this article or section by expanding it. Further information might be found on the talk page. (September 2008)
The U.S. effective federal funds rate charted over fifty years.Today the primary tool for controlling inflation is monetary policy. Most central banks are tasked with keeping the federal funds lending rate at a low level, normally to a target rate around 2% to 3% per annum, and within a targeted low inflation range, somewhere from about 2% to 6% per annum.
There are a number of methods that have been suggested to control inflation. Central banks such as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations. High interest rates and slow growth of the money supply are the traditional ways through which central banks fight or prevent inflation, though they have different approaches. For instance, some follow a symmetrical inflation target while others only control inflation when it rises above a target, whether express or implied.
Monetarists emphasize increasing interest rates (slowing the rise in the money supply, monetary policy) to fight inflation. Keynesians emphasize reducing demand in general, often through fiscal policy, using increased taxation or reduced government spending to reduce demand as well as by using monetary policy. Supply-side economists advocate fighting inflation by fixing the exchange rate between the currency and some reference currency such as gold. This would be a return to the gold standard. All of these policies are achieved in practice through a process of open market operations.
[edit] Fixed exchange rates
Main article: Fixed exchange rate
Under a fixed exchange rate currency regime, a country's currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value, such as gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis-a-vis the currency it is pegged to. It can also be used as a means to control inflation. However, as the value of the reference currency rises and falls, so does the currency pegged to it. This essentially means that the inflation rate in the fixed exchange rate country is determined by the inflation rate of the country the currency is pegged to. In addition, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability.
Under the Bretton Woods agreement, most countries around the world had currencies that were fixed to the US dollar. This limited inflation in those countries, but also exposed them to the danger of speculative attacks. After the Bretton Woods agreement broke down in the early 1970s, countries gradually turned to floating exchange rates. However, in the later part of the 20th century, some countries reverted to a fixed exchange rate as part of an attempt to control inflation. This policy of using a fixed exchange rate to control inflation was used in many countries in South America in the later part of the 20th century (e.g. Argentina (1991-2002), Bolivia, Brazil, and Chile).
[edit] Gold standard
Main article: Gold standard
Under a gold standard, paper notes are convertible into pre-set, fixed quantities of gold.The gold standard is a monetary system in which a region's common media of exchange are paper notes that are normally freely convertible into pre-set, fixed quantities of gold. The standard specifies how the gold backing would be implemented, including the amount of specie per currency unit. The currency itself has no innate value, but is accepted by traders because it can be redeemed for the equivalent specie. A U.S. silver certificate, for example, could be redeemed for an actual piece of silver.
Gold was a common form of representative money due to its rarity, durability, divisibility, fungibility, and ease of identification.[39] Representative money and the gold standard were used to protect citizens from hyperinflation and other abuses of monetary policy, as were seen in some countries during the Great Depression. However, they were not without their problems and critics, and so were partially abandoned via the international adoption of the Bretton Woods System. Under this system all other major currencies were tied at fixed rates to the dollar, which itself was tied to gold at the rate of $35 per ounce. That system eventually collapsed in 1971, which caused most countries to switch to fiat money, backed only by the laws of the country. Austrian economists strongly favor a return to a 100 percent gold standard.
Under a gold standard, the long term rate of inflation (or deflation) would be determined by the growth rate of the supply of gold relative to total output.[40] Critics argue that this will cause arbitrary fluctuations in the inflation rate, and that monetary policy would essentially be determined by gold mining,[41][42] which some believe contributed to the Great Depression.[43][44][42]
[edit] Wage and price controls
Main article: Incomes policies
Another method attempted in the past have been wage and price controls ("incomes policies"). Wage and price controls have been successful in wartime environments in combination with rationing. However, their use in other contexts is far more mixed. Notable failures of their use include the 1972 imposition of wage and price controls by Richard Nixon. More successful examples include the Prices and Incomes Accord in Australia and the Wassenaar Agreement in the Netherlands.
In general wage and price controls are regarded as a temporary and exceptional measure, only effective when coupled with policies designed to reduce the underlying causes of inflation during the wage and price control regime, for example, winning the war being fought. They often have perverse effects, due to the distorted signals they send to the market. Artificially low prices often cause rationing and shortages and discourage future investment, resulting in yet further shortages. The usual economic analysis is that any product or service that is under-priced is overconsumed. For example, if the official price of bread is too low, there will be too little bread at official prices, and too little investment in bread making by the market to satisfy future needs, thereby exacerbating the problem in the long term.
Temporary controls may complement a recession as a way to fight inflation: the controls make the recession more efficient as a way to fight inflation (reducing the need to increase unemployment), while the recession prevents the kinds of distortions that controls cause when demand is high. However, in general the advice of economists is not to impose price controls but to liberalize prices by assuming that the economy will adjust and abandon unprofitable economic activity. The lower activity will place fewer demands on whatever commodities were driving inflation, whether labor or resources, and inflation will fall with total economic output. This often produces a severe recession, as productive capacity is reallocated and is thus often very unpopular with the people whose livelihoods are destroyed (see creative destruction).
[edit] Cost-of-living allowance
For more details on this topic, see Cost of living.
The real purchasing-power of fixed payments is eroded by inflation unless they are inflation-adjusted to keep their real values constant. In many countries, employment contracts, pension benefits, and government entitlements (such as social security) are tied to a cost-of-living index, typically to the consumer price index.[45] A cost-of-living allowance (COLA) adjusts salaries based on changes in a cost-of-living index. Salaries are typically adjusted annually.[45] They may also be tied to a cost-of-living index that varies by geographic location if the employee moves.
Annual escalation clauses in employment contracts can specify retroactive or future percentage increases in worker pay which are not tied to any index. These negotiated increases in pay are colloquially referred to as cost-of-living adjustments or cost-of-living increases because of their similarity to increases tied to externally-determined indexes. Many economists and compensation analysts consider the idea of predetermined future "cost of living increases" to be misleading for two reasons: (1) For most recent periods in the industrialized world, average wages have increased faster than most calculated cost-of-living indexes, reflecting the influence of rising productivity and worker bargaining power rather than simply living costs, and (2) most cost-of-living indexes are not forward-looking, but instead compare current or historical data.
[edit] See also
Agflation
Constant Purchasing Power Accounting
Consumer Price Index
Deflation
Depreciation
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Devaluation
Hyperinflation
Inflation accounting
Inflation adjustment
International Financial Reporting Standards
List of countries by inflation rate
Macroeconomics
Price revolution
Real versus nominal value (economics)
Rule of 72
Stagflation
Steady state economy
Seignorage
United Nations Statistics Division
1920s German inflation
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In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.[1] When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation is also a decline in the real value of money—a loss of purchasing power in the medium of exchange which is also the monetary unit of account in the economy.[2] A chief measure of general price-level inflation is the general inflation rate, which is the percentage change in a general price index (normally the Consumer Price Index) over time.[3]
Inflation can have adverse effects on an economy. For example, uncertainty about future inflation may discourage investment and saving. High inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future.
Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply.[4] Views on which factors determine low to moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities, as well as to growth in the money supply. However, the consensus view is that a long sustained period of inflation is caused by money supply growing faster than the rate of economic growth.[5][6]
Today, most economists favor a low steady rate of inflation.[7] Low (as opposed to zero or negative) inflation may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduce the risk that a liquidity trap prevents monetary policy from stabilizing the economy. The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.[8]
Contents
1 Origins
2 Related definitions
3 Measures
3.1 Issues in measuring
4 Effects
4.1 Negative
4.2 Positive
5 Causes
5.1 Keynesian view
5.2 Monetarist view
5.3 Rational expectations theory
5.4 Austrian theory
5.5 Real bills doctrine
5.6 Anti-classical or backing theory
6 Controlling inflation
6.1 Monetary policy
6.2 Fixed exchange rates
6.3 Gold standard
6.4 Wage and price controls
6.5 Cost-of-living allowance
7 See also
8 Notes
9 References
10 Further reading
11 External links
[edit] Origins
Inflation originally referred to the debasement of the currency. When gold was used as currency, gold coins could be collected by the government (e.g. the king or the ruler of the region), melted down, mixed with other metals such as silver, copper or lead, and reissued at the same nominal value. By diluting the gold with other metals, the government could increase the total number of coins issued without also needing to increase the amount of gold used to make them. When the cost of each coin is lowered in this way, the government profits from an increase in seigniorage.[9] This practice would increase the money supply but at the same time lower the relative value of each coin. As the relative value of the coins decrease, consumers would need more coins to exchange for the same goods and services. These goods and services would experience a price increase as the value of each coin is reduced.[10]
By the nineteenth century, economists categorized three separate factors that cause a rise or fall in the price of goods: a change in the value or resource costs of the good, a change in the price of money which then was usually a fluctuation in metallic content in the currency, and currency depreciation resulting from an increased supply of currency relative to the quantity of redeemable metal backing the currency. Following the proliferation of private bank note currency printed during the American Civil War, the term "inflation" started to appear as a direct reference to the currency depreciation that occurred as the quantity of redeemable bank notes outstripped the quantity of metal available for their redemption. The term inflation then referred to the devaluation of the currency, and not to a rise in the price of goods.[11]
This relationship between the over-supply of bank notes and a resulting depreciation in their value was noted by earlier classical economists such as David Hume and David Ricardo, who would go on to examine and debate to what effect a currency devaluation (later termed monetary inflation) has on the price of goods (later termed price inflation, and eventually just inflation).[12]
[edit] Related definitions
The term "inflation" usually refers to a measured rise in a broad price index that represents the overall level of prices in goods and services in the economy. The Consumer Price Index (CPI), the Personal Consumption Expenditures Price Index (PCEPI) and the GDP deflator are some examples of broad price indices. The term inflation may also be used to describe the rising level of prices in a narrow set of assets, goods or services within the economy, such as commodities (which include food, fuel, metals), financial assets (such as stocks, bonds and real estate), and services (such as entertainment and health care). The Reuters-CRB Index (CCI), the Producer Price Index, and Employment Cost Index (ECI) are examples of narrow price indices used to measure price inflation in particular sectors of the economy. Asset price inflation is a rise in the price of assets, as opposed to goods and services. Core inflation is a measure of price fluctuations in a sub-set of the broad price index which excludes food and energy prices. The Federal Reserve Board uses the core inflation rate to measure overall inflation, eliminating food and energy prices to mitigate against short term price fluctuations that could distort estimates of future long term inflation trends in the general economy.[13]
Other related economic concepts include: deflation – a fall in the general price level; disinflation – a decrease in the rate of inflation; hyperinflation – an out-of-control inflationary spiral; stagflation – a combination of inflation, slow economic growth and high unemployment; and reflation – an attempt to raise the general level of prices to counteract deflationary pressures.
[edit] Measures
Annual inflation rates in the United States from 1666 to 2004.Inflation is usually measured by calculating the inflation rate of a price index, usually the Consumer Price Index.[14] The Consumer Price Index measures prices of a selection of goods and services purchased by a "typical consumer".[15] The inflation rate is the percentage rate of change of a price index over time.
For example, in January 2007, the U.S. Consumer Price Index was 202.416, and in January 2008 it was 211.080. The formula for calculating the annual percentage rate inflation in the CPI over the course of 2007 is
The resulting inflation rate for the CPI in this one year period is 4.28%, meaning the general level of prices for typical U.S. consumers rose by approximately four percent in 2007.[16]
Other widely used price indices for calculating price inflation include the following:
Cost-of-living indices (COLI) are indices similar to the CPI which are often used to adjust fixed incomes and contractual incomes to maintain the real value of those incomes.
Producer price indices (PPIs) which measures average changes in prices received by domestic producers for their output. This differs from the CPI in that price subsidization, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid. There is also typically a delay between an increase in the PPI and any eventual increase in the CPI. Producer price index measures the pressure being put on producers by the costs of their raw materials. This could be "passed on" to consumers, or it could be absorbed by profits, or offset by increasing productivity. In India and the United States, an earlier version of the PPI was called the Wholesale Price Index.
Commodity price indices, which measure the price of a selection of commodities. In the present commodity price indices are weighted by the relative importance of the components to the "all in" cost of an employee.
Core price indices: because food and oil prices can change quickly due to changes in supply and demand conditions in the food and oil markets, it can be difficult to detect the long run trend in price levels when those prices are included. Therefore most statistical agencies also report a measure of 'core inflation', which removes the most volatile components (such as food and oil) from a broad price index like the CPI. Because core inflation is less affected by short run supply and demand conditions in specific markets, central banks rely on it to better measure the inflationary impact of current monetary policy.
Other common measures of inflation are:
GDP deflator is a measure of the price of all the goods and services included in Gross Domestic Product (GDP). The US Commerce Department publishes a deflator series for US GDP, defined as its nominal GDP measure divided by its real GDP measure.
Regional inflation The Bureau of Labor Statistics breaks down CPI-U calculations down to different regions of the US.
Historical inflation Before collecting consistent econometric data became standard for governments, and for the purpose of comparing absolute, rather than relative standards of living, various economists have calculated imputed inflation figures. Most inflation data before the early 20th century is imputed based on the known costs of goods, rather than compiled at the time. It is also used to adjust for the differences in real standard of living for the presence of technology.
Asset price inflation is an undue increase in the prices of real or financial assets, such as stock (equity) and real estate. While there is no widely-accepted index of this type, some central bankers have suggested that it would be better to aim at stabilizing a wider general price level inflation measure that includes some asset prices, instead of stabilizing CPI or core inflation only. The reason is that by raising interest rates when stock prices or real estate prices rise, and lowering them when these asset prices fall, central banks might be more successful in avoiding bubbles and crashes in asset prices.[dubious – discuss]
[edit] Issues in measuring
Measuring inflation in an economy requires objective means of differentiating changes in nominal prices on a common set of goods and services, and distinguishing them from those price shifts resulting from changes in value such as volume, quality, or performance. For example, if the price of a 10 oz. can of corn changes from $0.90 to $1.00 over the course of a year, with no change in quality, then this price difference represents inflation. This single price change would not, however, represent general inflation in an overall economy. To measure overall inflation, the price change of a large "basket" of representative goods and services is measured. This is the purpose of a price index, which is the combined price of a "basket" of many goods and services. The combined price is the sum of the weighted average prices of items in the "basket". A weighted price is calculated by multiplying the unit price of an item to the number of those items the average consumer purchases. Weighted pricing is a necessary means to measuring the impact of individual unit price changes on the economy's overall inflation. The Consumer Price Index, for example, uses data collected by surveying households to determine what proportion of the typical consumer's overall spending is spent on specific goods and services, and weights the average prices of those items accordingly. Those weighted average prices are combined to calculate the overall price. To better relate price changes over time, indexes typically choose a "base year" price and assign it a value of 100. Index prices in subsequent years are then expressed in relation to the base year price.[8]
Inflation measures are often modified over time, either for the relative weight of goods in the basket, or in the way in which goods and services from the present are compared with goods and services from the past. Over time adjustments are made to the type of goods and services selected in order to reflect changes in the sorts of goods and services purchased by 'typical consumers'. New products may be introduced, older products disappear, the quality of existing products may change, and consumer preferences can shift. Both the sorts of goods and services which are included in the "basket" and the weighted price used in inflation measures will be changed over time in order to keep pace with the changing marketplace.
Inflation numbers are often seasonally adjusted in order to differentiate expected cyclical cost shifts. For example, home heating costs are expected to rise in colder months, and seasonal adjustments are often used when measuring for inflation to compensate for cyclical spikes in energy or fuel demand. Inflation numbers may be averaged or otherwise subjected to statistical techniques in order to remove statistical noise and volatility of individual prices.
When looking at inflation economic institutions may focus only on certain kinds of prices, or special indices, such as the core inflation index which is used by central banks to formulate monetary policy.
[edit] Effects
[edit] Negative
An increase in the general level of prices implies a decrease in the purchasing power of the currency. That is, when the general level of prices rises, each monetary unit buys fewer goods and services.[17] The effect of inflation is not distributed evenly, and as a consequence there are hidden costs to some and benefits to others from this decrease in purchasing power. For example, with inflation lenders or depositors who are paid a fixed rate of interest on loans or deposits will lose purchasing power from their interest earnings, while their borrowers benefit. Individuals or institutions with cash assets will experience a decline in the purchasing power of their holdings. Increases in payments to workers and pensioners often lag behind inflation, especially for those with fixed payments.[8]
High or unpredictable inflation rates are regarded as harmful to an overall economy. They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services in order to focus on profit and losses from currency inflation.[8] Uncertainty about the future purchasing power of money discourages investment and saving.[18] And inflation can impose hidden tax increases, as inflated earnings push taxpayers into higher income tax rates.
With high inflation, purchasing power is redistributed from those on fixed incomes such as pensioners towards those with variable incomes whose earnings may better keep pace with the inflation.[8] This redistribution of purchasing power will also occur between international trading partners. Where fixed exchange rates are imposed, rising inflation in one economy will cause its exports to become more expensive and affect the balance of trade. There can also be negative impacts to trade from an increased instability in currency exchange prices caused by unpredictable inflation.
Cost-push inflation
Rising inflation can prompt employees to demand higher wages, to keep up with consumer prices. Rising wages in turn can help fuel inflation. In the case of collective bargaining, wages will be set as a factor of price expectations, which will be higher when inflation has an upward trend. This can cause a wage spiral.[19] In a sense, inflation begets further inflationary expectations.
Hoarding
People buy consumer durables as stores of wealth in the absence of viable alternatives as a means of getting rid of excess cash before it is devalued, creating shortages of the hoarded objects.
Hyperinflation
If inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply.
Allocative efficiency
A change in the supply or demand for a good will normally cause its price to change, signalling to buyers and sellers that they should re-allocate resources in response to the new market conditions. But when prices are constantly changing due to inflation, genuine price signals get lost in the noise, so agents are slow to respond to them. The result is a loss of allocative efficiency.
Shoe leather cost
High inflation increases the opportunity cost of holding cash balances and can induce people to hold a greater portion of their assets in interest paying accounts. However, since cash is still needed in order to carry out transactions this means that more "trips to the bank" are necessary in order to make withdrawals, proverbially wearing out the "shoe leather" with each trip.
Menu costs
With high inflation, firms must change their prices often in order to keep up with economy wide changes. But often changing prices is itself a costly activity whether explicitly, as with the need to print new menus, or implicitly.
Business cycles
According to the Austrian Business Cycle Theory, inflation sets off the business cycle. Austrian economists hold this to be the most damaging effect of inflation. According to Austrian theory, artificially low interest rates and the associated increase in the money supply lead to reckless, speculative borrowing, resulting in clusters of malinvestments, which eventually have to be liquidated as they become unsustainable.[20]
[edit] Positive
Labor-market adjustments
Keynesians believe that nominal wages are slow to adjust downwards. This can lead to prolonged disequilibrium and high unemployment in the labor market. Since inflation would lower the real wage if nominal wages are kept constant, Keynesians argue that some inflation is good for the economy, as it would allow labor markets to reach equilibrium faster.
Debt relief
Debtors who have debts with a fixed nominal rate of interest will see a reduction in the "real" interest rate as the inflation rate rises. The “real” interest on a loan is the nominal rate minus the inflation rate. (R=n-i) For example if you take a loan where the stated interest rate is 6% and the inflation rate is at 3%, the real interest rate that you are paying for the loan is 3%. It would also hold true that if you had a loan at a fixed interest rate of 6% and the inflation rate jumped to 20% you would have a real interest rate of -14%. Banks and other lenders adjust for this inflation risk either by including an inflation premium in the costs of lending the money by creating a higher initial stated interest rate or by setting the interest at a variable rate.
Room to maneuver
The primary tools for controlling the money supply are the ability to set the discount rate, the rate at which banks can borrow from the central bank, and open market operations which are the central bank's interventions into the bonds market with the aim of affecting the nominal interest rate. If an economy finds itself in a recession with already low, or even zero, nominal interest rates, then the bank cannot cut these rates further (since negative nominal interest rates are impossible) in order to stimulate the economy - this situation is known as a liquidity trap. A moderate level of inflation tends to ensure that nominal interest rates stay sufficiently above zero so that if the need arises the bank can cut the nominal interest rate.
Tobin effect
The Nobel prize winning economist James Tobin at one point had argued that a moderate level of inflation can increase investment in an economy leading to faster growth or at least higher steady state level of income. This is due to the fact that inflation lowers the return on monetary assets relative to real assets, such as physical capital. To avoid inflation, investors would switch from holding their assets as money (or a similar, susceptible to inflation, form) to investing in real capital projects. See Tobin monetary model[21]
[edit] Causes
The Bank of England, central bank of the United Kingdom, monitors causes and attempts to control inflation.Historically, a great deal of economic literature was concerned with the question of what causes inflation and what effect it has. There were different schools of thought as to the causes of inflation. Most can be divided into two broad areas: quality theories of inflation and quantity theories of inflation. The quality theory of inflation rests on the expectation of a seller accepting currency to be able to exchange that currency at a later time for goods that are desirable as a buyer. The quantity theory of inflation rests on the quantity equation of money, that relates the money supply, its velocity, and the nominal value of exchanges. Adam Smith and David Hume proposed a quantity theory of inflation for money, and a quality theory of inflation for production.[citation needed]
Currently, the quantity theory of money is widely accepted as an accurate model of inflation in the long run. Consequently, there is now broad agreement among economists that in the long run, the inflation rate is essentially dependent on the growth rate of money supply. However, in the short and medium term inflation may be affected by supply and demand pressures in the economy, and influenced by the relative elasticity of wages, prices and interest rates.[22] The question of whether the short-term effects last long enough to be important is the central topic of debate between monetarist and Keynesian economists. In monetarism prices and wages adjust quickly enough to make other factors merely marginal behavior on a general trend-line. In the Keynesian view, prices and wages adjust at different rates, and these differences have enough effects on real output to be "long term" in the view of people in an economy.
[edit] Keynesian view
Keynesian economic theory proposes that money is transparent to real forces in the economy, and that visible inflation is the result of pressures in the economy expressing themselves in prices.
There are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model":[23]
Demand-pull inflation: inflation caused by increases in aggregate demand due to increased private and government spending, etc. Demand inflation is constructive to a faster rate of economic growth since the excess demand and favourable market conditions will stimulate investment and expansion.
Cost-push inflation: also called "supply shock inflation," caused by drops in aggregate supply due to increased prices of inputs, for example. Take for instance a sudden decrease in the supply of oil, which would increase oil prices. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices.
Built-in inflation: induced by adaptive expectations, often linked to the "price/wage spiral" because it involves workers trying to keep their wages up (gross wages have to increase above the CPI rate to net to CPI after-tax) with prices and then employers passing higher costs on to consumers as higher prices as part of a "vicious circle." Built-in inflation reflects events in the past, and so might be seen as hangover inflation.
A major demand-pull theory centers on the supply of money: inflation may be caused by an increase in the quantity of money in circulation relative to the ability of the economy to supply (its potential output). This is most obvious when governments finance spending in a crisis, such as a civil war, by printing money excessively, often leading to hyperinflation, a condition where prices can double in a month or less. Another cause can be a rapid decline in the demand for money, as happened in Europe during the Black Death.
The money supply is also thought to play a major role in determining moderate levels of inflation, although there are differences of opinion on how important it is. For example, Monetarist economists believe that the link is very strong; Keynesian economics, by contrast, typically emphasize the role of aggregate demand in the economy rather than the money supply in determining inflation. That is, for Keynesians the money supply is only one determinant of aggregate demand. Some economists disagree with the notion that central banks control the money supply, arguing that central banks have little control because the money supply adapts to the demand for bank credit issued by commercial banks. This is the theory of endogenous money. Advocated strongly by post-Keynesians as far back as the 1960s, it has today become a central focus of Taylor rule advocates. This position is not universally accepted: banks create money by making loans, but the aggregate volume of these loans diminishes as real interest rates increase. Thus, central banks influence the money supply by making money cheaper or more expensive, and thus increasing or decreasing its production.
A fundamental concept in inflation analysis is the relationship between inflation and unemployment, called the Phillips curve. This model suggests that there is a trade-off between price stability and employment. Therefore, some level of inflation could be considered desirable in order to minimize unemployment. The Phillips curve model described the U.S. experience well in the 1960s but failed to describe the combination of rising inflation and economic stagnation (sometimes referred to as stagflation) experienced in the 1970s.
Thus, modern macroeconomics describes inflation using a Phillips curve that shifts (so the trade-off between inflation and unemployment changes) because of such matters as supply shocks and inflation becoming built into the normal workings of the economy. The former refers to such events as the oil shocks of the 1970s, while the latter refers to the price/wage spiral and inflationary expectations implying that the economy "normally" suffers from inflation. Thus, the Phillips curve represents only the demand-pull component of the triangle model.
Another concept of note is the potential output (sometimes called the "natural gross domestic product"), a level of GDP, where the economy is at its optimal level of production given institutional and natural constraints. (This level of output corresponds to the Non-Accelerating Inflation Rate of Unemployment, NAIRU, or the "natural" rate of unemployment or the full-employment unemployment rate.) If GDP exceeds its potential (and unemployment is below the NAIRU), the theory says that inflation will accelerate as suppliers increase their prices and built-in inflation worsens. If GDP falls below its potential level (and unemployment is above the NAIRU), inflation will decelerate as suppliers attempt to fill excess capacity, cutting prices and undermining built-in inflation.
However, one problem with this theory for policy-making purposes is that the exact level of potential output (and of the NAIRU) is generally unknown and tends to change over time. Inflation also seems to act in an asymmetric way, rising more quickly than it falls. Worse, it can change because of policy: for example, high unemployment under British Prime Minister Margaret Thatcher might have led to a rise in the NAIRU (and a fall in potential) because many of the unemployed found themselves as structurally unemployed (also see unemployment), unable to find jobs that fit their skills. A rise in structural unemployment implies that a smaller percentage of the labor force can find jobs at the NAIRU, where the economy avoids crossing the threshold into the realm of accelerating inflation.
[edit] Monetarist view
For more details on this topic, see Monetarists.
Monetarists believe the most significant factor influencing inflation or deflation is the management of money supply through the easing or tightening of credit. They consider fiscal policy, or government spending and taxation, as ineffective in controlling inflation.[24]
Monetarists assert that the empirical study of monetary history shows that inflation has always been a monetary phenomenon. The quantity theory of money, simply stated, says that the total amount of spending in an economy is primarily determined by the total amount of money in existence. This theory begins with the identity:
where
P is the general price level;
V is the velocity of money in final expenditures;
Q is an index of the real value of final expenditures;
M is the quantity of money.
In this formula, the general price level is affected by the level of economic activity (Q), the quantity of money (M) and the velocity of money (V). The formula is an identity because the velocity of money (V) is defined to be the ratio of final expenditure () to the quantity of money (M).
Velocity of money is often assumed to be constant, and the real value of output is determined in the long run by the productive capacity of the economy. Under these assumptions, the primary driver of the change in the general price level is changes in the quantity of money. With constant velocity, the money supply determines the value of nominal output (which equals final expenditure) in the short run. In practice, velocity is not constant, and can only be measured indirectly and so the formula does not necessarily imply a stable relationship between money supply and nominal output. However, in the long run, changes in money supply and level of economic activity usually dwarf changes in velocity. If velocity is relatively constant, the long run rate of increase in prices (inflation) is equal to the difference between the long run growth rate of money supply and the long run growth rate of real output.[5]
[edit] Rational expectations theory
Main article: Rational expectations theory
Rational expectations theory holds that economic actors look rationally into the future when trying to maximize their well-being, and do not respond solely to immediate opportunity costs and pressures. In this view, while generally grounded in monetarism, future expectations and strategies are important for inflation as well.
A core assertion of rational expectations theory is that actors will seek to "head off" central-bank decisions by acting in ways that fulfill predictions of higher inflation. This means that central banks must establish their credibility in fighting inflation, or have economic actors make bets that the economy will expand, believing that the central bank will expand the money supply rather than allow a recession.
[edit] Austrian theory
For more details on this topic, see The Austrian view of inflation
The Austrian School asserts that inflation is an increase in the money supply, rising prices are merely consequences and this semantic difference is important in defining inflation.[25] Austrian economists measure the inflation by calculating the growth of new units of money that are available for immediate use in exchange, that have been created over time.[26][27][28] This interpretation of inflation implies that inflation is always a distinct action taken by the central government or its central bank, which permits or allows an increase in the money supply.[29] In addition to state-induced monetary expansion, the Austrian School also maintains that the effects of increasing the money supply are magnified by credit expansion, as a result of the fractional-reserve banking system employed in most economic and financial systems in the world.[30]
Austrians argue that the state uses inflation as one of the three means by which it can fund its activities (inflation tax), the other two being taxation and borrowing.[31] Various forms of military spending is often cited as a reason for resorting to inflation and borrowing, as this can be a short term way of acquiring marketable resources and is often favored by desperate, indebted governments.[32]
In other cases, Austrians argue that the government actually creates economic recessions and depressions, by creating artificial booms that distort the structure of production. The central bank may try to avoid or defer the widespread bankruptcies and insolvencies which cause economic recessions or depressions by artificially trying to "stimulate" the economy through "encouraging" money supply growth and further borrowing via artificially low interest rates.[33] Accordingly, many Austrian economists support the abolition of the central banks and the fractional-reserve banking system, and advocate returning to a 100 percent gold standard, or less frequently, free banking.[34][35] They argue this would constrain unsustainable and volatile fractional-reserve banking practices, ensuring that money supply growth (and inflation) would never spiral out of control.[36][37]
[edit] Real bills doctrine
Main article: Real bills doctrine
Within the context of a fixed specie basis for money, one important controversy was between the quantity theory of money and the real bills doctrine (RBD). Within this context, quantity theory applies to the level of fractional reserve accounting allowed against specie, generally gold, held by a bank. Currency and banking schools of economics argue the RBD, that banks should also be able to issue currency against bills of trading, which is "real bills" that they buy from merchants. This theory was important in the 19th century in debates between "Banking" and "Currency" schools of monetary soundness, and in the formation of the Federal Reserve. In the wake of the collapse of the international gold standard post 1913, and the move towards deficit financing of government, RBD has remained a minor topic, primarily of interest in limited contexts, such as currency boards. It is generally held in ill repute today, with Frederic Mishkin, a governor of the Federal Reserve going so far as to say it had been "completely discredited." Even so, it has theoretical support from a few economists, particularly those that see restrictions on a particular class of credit as incompatible with libertarian principles of laissez-faire, even though almost all libertarian economists are opposed to the RBD.
The debate between currency, or quantity theory, and banking schools in Britain during the 19th century prefigures current questions about the credibility of money in the present. In the 19th century the banking school had greater influence in policy in the United States and Great Britain, while the currency school had more influence "on the continent", that is in non-British countries, particularly in the Latin Monetary Union and the earlier Scandinavia monetary union.
[edit] Anti-classical or backing theory
Another issue associated with classical political economy is the anti-classical hypothesis of money, or "backing theory". The backing theory argues that the value of money is determined by the assets and liabilities of the issuing agency.[38] Unlike the Quantity Theory of classical political economy, the backing theory argues that issuing authorities can issue money without causing inflation so long as the money issuer has sufficient assets to cover redemptions.
[edit] Controlling inflation
A variety of methods have been used in attempts to control inflation.
[edit] Monetary policy
Main article: Monetary policy
Please help improve this article or section by expanding it. Further information might be found on the talk page. (September 2008)
The U.S. effective federal funds rate charted over fifty years.Today the primary tool for controlling inflation is monetary policy. Most central banks are tasked with keeping the federal funds lending rate at a low level, normally to a target rate around 2% to 3% per annum, and within a targeted low inflation range, somewhere from about 2% to 6% per annum.
There are a number of methods that have been suggested to control inflation. Central banks such as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations. High interest rates and slow growth of the money supply are the traditional ways through which central banks fight or prevent inflation, though they have different approaches. For instance, some follow a symmetrical inflation target while others only control inflation when it rises above a target, whether express or implied.
Monetarists emphasize increasing interest rates (slowing the rise in the money supply, monetary policy) to fight inflation. Keynesians emphasize reducing demand in general, often through fiscal policy, using increased taxation or reduced government spending to reduce demand as well as by using monetary policy. Supply-side economists advocate fighting inflation by fixing the exchange rate between the currency and some reference currency such as gold. This would be a return to the gold standard. All of these policies are achieved in practice through a process of open market operations.
[edit] Fixed exchange rates
Main article: Fixed exchange rate
Under a fixed exchange rate currency regime, a country's currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value, such as gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis-a-vis the currency it is pegged to. It can also be used as a means to control inflation. However, as the value of the reference currency rises and falls, so does the currency pegged to it. This essentially means that the inflation rate in the fixed exchange rate country is determined by the inflation rate of the country the currency is pegged to. In addition, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability.
Under the Bretton Woods agreement, most countries around the world had currencies that were fixed to the US dollar. This limited inflation in those countries, but also exposed them to the danger of speculative attacks. After the Bretton Woods agreement broke down in the early 1970s, countries gradually turned to floating exchange rates. However, in the later part of the 20th century, some countries reverted to a fixed exchange rate as part of an attempt to control inflation. This policy of using a fixed exchange rate to control inflation was used in many countries in South America in the later part of the 20th century (e.g. Argentina (1991-2002), Bolivia, Brazil, and Chile).
[edit] Gold standard
Main article: Gold standard
Under a gold standard, paper notes are convertible into pre-set, fixed quantities of gold.The gold standard is a monetary system in which a region's common media of exchange are paper notes that are normally freely convertible into pre-set, fixed quantities of gold. The standard specifies how the gold backing would be implemented, including the amount of specie per currency unit. The currency itself has no innate value, but is accepted by traders because it can be redeemed for the equivalent specie. A U.S. silver certificate, for example, could be redeemed for an actual piece of silver.
Gold was a common form of representative money due to its rarity, durability, divisibility, fungibility, and ease of identification.[39] Representative money and the gold standard were used to protect citizens from hyperinflation and other abuses of monetary policy, as were seen in some countries during the Great Depression. However, they were not without their problems and critics, and so were partially abandoned via the international adoption of the Bretton Woods System. Under this system all other major currencies were tied at fixed rates to the dollar, which itself was tied to gold at the rate of $35 per ounce. That system eventually collapsed in 1971, which caused most countries to switch to fiat money, backed only by the laws of the country. Austrian economists strongly favor a return to a 100 percent gold standard.
Under a gold standard, the long term rate of inflation (or deflation) would be determined by the growth rate of the supply of gold relative to total output.[40] Critics argue that this will cause arbitrary fluctuations in the inflation rate, and that monetary policy would essentially be determined by gold mining,[41][42] which some believe contributed to the Great Depression.[43][44][42]
[edit] Wage and price controls
Main article: Incomes policies
Another method attempted in the past have been wage and price controls ("incomes policies"). Wage and price controls have been successful in wartime environments in combination with rationing. However, their use in other contexts is far more mixed. Notable failures of their use include the 1972 imposition of wage and price controls by Richard Nixon. More successful examples include the Prices and Incomes Accord in Australia and the Wassenaar Agreement in the Netherlands.
In general wage and price controls are regarded as a temporary and exceptional measure, only effective when coupled with policies designed to reduce the underlying causes of inflation during the wage and price control regime, for example, winning the war being fought. They often have perverse effects, due to the distorted signals they send to the market. Artificially low prices often cause rationing and shortages and discourage future investment, resulting in yet further shortages. The usual economic analysis is that any product or service that is under-priced is overconsumed. For example, if the official price of bread is too low, there will be too little bread at official prices, and too little investment in bread making by the market to satisfy future needs, thereby exacerbating the problem in the long term.
Temporary controls may complement a recession as a way to fight inflation: the controls make the recession more efficient as a way to fight inflation (reducing the need to increase unemployment), while the recession prevents the kinds of distortions that controls cause when demand is high. However, in general the advice of economists is not to impose price controls but to liberalize prices by assuming that the economy will adjust and abandon unprofitable economic activity. The lower activity will place fewer demands on whatever commodities were driving inflation, whether labor or resources, and inflation will fall with total economic output. This often produces a severe recession, as productive capacity is reallocated and is thus often very unpopular with the people whose livelihoods are destroyed (see creative destruction).
[edit] Cost-of-living allowance
For more details on this topic, see Cost of living.
The real purchasing-power of fixed payments is eroded by inflation unless they are inflation-adjusted to keep their real values constant. In many countries, employment contracts, pension benefits, and government entitlements (such as social security) are tied to a cost-of-living index, typically to the consumer price index.[45] A cost-of-living allowance (COLA) adjusts salaries based on changes in a cost-of-living index. Salaries are typically adjusted annually.[45] They may also be tied to a cost-of-living index that varies by geographic location if the employee moves.
Annual escalation clauses in employment contracts can specify retroactive or future percentage increases in worker pay which are not tied to any index. These negotiated increases in pay are colloquially referred to as cost-of-living adjustments or cost-of-living increases because of their similarity to increases tied to externally-determined indexes. Many economists and compensation analysts consider the idea of predetermined future "cost of living increases" to be misleading for two reasons: (1) For most recent periods in the industrialized world, average wages have increased faster than most calculated cost-of-living indexes, reflecting the influence of rising productivity and worker bargaining power rather than simply living costs, and (2) most cost-of-living indexes are not forward-looking, but instead compare current or historical data.
[edit] See also
Agflation
Constant Purchasing Power Accounting
Consumer Price Index
Deflation
Depreciation
Disinflation
Devaluation
Hyperinflation
Inflation accounting
Inflation adjustment
International Financial Reporting Standards
List of countries by inflation rate
Macroeconomics
Price revolution
Real versus nominal value (economics)
Rule of 72
Stagflation
Steady state economy
Seignorage
United Nations Statistics Division
1920s German inflation
2007-2008 world food price crisis
Capital Formation
Capital formation is a term used in national accounts statistics and macroeconomics. It basically refers to the net additions to the (physical) capital stock in an accounting period, or, to the value of the increase of the capital stock; though it may occasionally also refer to the (growth of the) total stock of capital formed.
Thus, in UNSNA, capital formation equals fixed capital investment, the increase in the value of inventories held, plus (net) lending to foreign countries, during an accounting period. Capital is said to be "formed" when savings are used for investment purposes, often investment in production.
Capital formation is often equated with, or used as an abbreviation for gross fixed capital formation but strictly speaking this is an error, since the latter is only a component of the former.
Contents
1 Origin of the concept
2 Different interpretations
3 Gross and net capital formation
4 Technical measurement issues
5 Perpetual Inventory Method
6 Controversy
7 Example of capital estimates
8 See also
9 References
[edit] Origin of the concept
In the USA, statistical estimates for capital formation were pioneered by Simon Kuznets in the 1930s and 1940s, and from the 1950s onwards the standard accounting system devised to measure capital flows was adopted officially by the governments of most countries.
[edit] Different interpretations
The use of the term "capital formation" can be somewhat confusing, partly because the concept of capital itself can be understood in different ways.
Firstly, capital formation is frequently thought of as a measure of total "investment", in the sense of that portion of capital which is actually used for investment purposes and not saved or consumed. But in fact the concept refers only to the accounting value of the additions of assets to the capital stock less the disposals of assets; and often capital formation is used to refer only to investment in fixed assets, not investment in all types of assets. "Investment" includes investment in all kinds of capital assets, whether physical property or financial assets.
Secondly, capital formation may be used synonymously with the notion of capital accumulation in the sense of a reinvestment of profits into capital assets. But "capital accumulation" is not an accounting concept, and contains the ambiguity that an amassment of wealth could occur either through a redistribution of capital assets from one person or institution to another, or through a net addition to the total stock of capital in existence. As regards capital accumulation, it can flourish, so that some people get much wealthier, even although society as a whole becomes poorer, and the net capital formation decreases. In other words the gain could be a net total gain, or a gain at the expense of loss by others which cancels out (or more than cancels out) the gain in aggregate.
Thirdly, capital formation is often used synonymously with Gross fixed capital formation but strictly speaking this is an error, for two reasons: (a) capital formation as such can in principle refer to more assets than just fixed capital, and (b) capital formation can be stated "gross" (before deduction of depreciation write-offs or Consumption of fixed capital) or it can be stated "net" (after deduction of depreciation charges). So, capital formation could mean gross capital formation or net capital formation.
In a broader meaning or vaguer sense, capital formation is nowadays also used to refer to savings drives, setting up financial institutions, fiscal measures, public borrowing, development of capital markets, privatization of financial institutions, development of secondary financial markets. In this broad sense, it refers to any method for increasing the amount of capital owned or under one's control, or any method in utilising or mobilizing capital resources for investment purposes. Thus, capital could be "formed" in the sense of "being brought together for investment purposes" in many different ways.
[edit] Gross and net capital formation
In economic statistics and accounts, capital formation can be valued gross (without deductions for depreciation) or net (adjusted for depreciation write-offs). The gross valuation method views depreciation as a portion of the new income or wealth earned or created by the enterprise, and hence as part of the formation of new capital by the enterprise. The net valuation method views depreciation as the compensation for the cost of replacing fixed equipment used up or worn out, which must be deducted from the total investment volume to obtain a measure of the "real" value of investments; the depreciation write-off compensates and cancels out the loss in capital value of assets used due to wear & tear, obsolescence, etc.
[edit] Technical measurement issues
Capital formation is notoriously difficult to measure statistically, mainly because of the valuation problems involved in establishing what the value of capital assets is. Capital assets can for instance be valued at:
historic (acquisition) cost,
current replacement cost,
current sale value,
average market value,
business value assuming a certain profit yield
value for tax purposes,
purchasing power parity value
scrap value.
A business owner may in fact not even know what his business is "worth" as a going concern, in terms of its current market value. The "book value" of a capital stock may differ greatly from its "market value", and another figure may apply for taxation purposes. The value of capital assets may also be overstated or understated using various legal constructions.
During an accounting period, additions may be made to capital assets (including those which are of a type that disproportionately increase the value of the capital stock) and capital assets are also disposed of; at the same time, physical assets also incur depreciation or Consumption of fixed capital. Also, price inflation may affect the value of the capital stock.
In national accounts, there is an additional problem, since the sales/purchases of one enterprise can be the investment of another enterprise. Therefore, to obtain a measure of the total net capital formation, a system of grossing and netting of capital flows is required. Without this, double counting would occur. Capital expenditure must be distinguished from intermediate expenditure and other operating expenditure, but the boundaries are sometimes difficult to draw.
[edit] Perpetual Inventory Method
A method often used in econometrics to estimate the value of the physical capital stock is the so-called Perpetual Inventory Method (PIM). Starting off from a benchmark stock value for capital held, and expressing all values in constant dollars using a price index, additions to the stock are added, and disposals as well as depreciation are subtracted year by year (or quarter by quarter). Thus, an historical data series is obtained for the growth of the capital stock over a period of time. In so doing, assumptions are made about the real rate of price inflation, realistic depreciation rates, average service lives of physical capital assets, and so on.
[edit] Controversy
According to one popular kind of macro-economic definition in textbooks, capital formation refers to "the transfer of savings from households and governments to the business sector, resulting in increased output and economic expansion". The idea here is that individuals and governments save money, and then invest that money in the private sector, which produces more wealth with it. This definition is however incomplete on two counts.
Firstly, many larger corporations engage in corporate self-financing, i.e. financing from their own reserves, or through loans from (or share issues bought by) other corporations. In other words, the textbook definition ignores that the largest source of investment capital consists of financial institutions, not individuals or households or governments.
Admittedly, financial institutions are, "in the last instance", mostly owned by individuals, but those individuals have little control over this transfer of funds, nor do they accomplish the transfer themselves. Few individuals can say they "own" a corporation, anymore than individuals "own" the public sector. (Poterba (1987) found that changes in corporate saving are only partly offset (between 25% and 50%) by changes in household saving in the United States).
Social accountants Richard Ruggles and Nancy D. Ruggles established for the USA that "almost all financial savings done by households is used to pay for household capital formation - particularly, housing and consumer durables. On net, the household sector channels almost no financial savings to the enterprise sector. Conversely, almost all the capital formation done by enterprises is financed through enterprise savings - particularly, undistributed gross profits." (cited from Edward N. Wolff, "In Memoriam: Richard Ruggles 1916-2001", in: Review of Income and Wealth, Series 47, Number 3, September 2001, p. 414).
Secondly, the transfer of funds to corporations may not result in increased output or economic expansion at all; given excess capacity, a low rate of return and/or lacklustre demand, corporations may not in fact invest those funds to expand output, and engage in asset speculation instead, to obtain property income that boosts shareholder returns.
To illustrate, New Zealand's Finance Minister Michael Cullen stated (NZ Herald, 24 February 2005) that "My sense is that there are definite gains to be made, both economic and social, in increasing the savings level of New Zealanders and in encouraging diversification in assets away from the residential property market."
This idea is based on a flawed understanding of capital formation, ignoring the real issue - which is that the flow of mortgage repayments by households to financial institutions is not being used to expand output and employment on a scale that could repay escalating private sector debts. In reality, more and more local capital value drains to foreign share-holders and creditors.
The concept of "household saving" must itself also be looked at critically, since a lot of this "saving" in reality consists precisely of investing in housing, which, given low interest rates and rising real estate prices, yields a better return than if you kept your money in the bank (or, in some cases, if you invested in shares). In other words, a mortgage from a bank can effectively function as a "savings scheme" although officially it is not regarded as "savings".
[edit] Example of capital estimates
In the 2005 Analytical Perspectives document, an annex to the US Budget (Table 12-4: National Wealth, p. 201), an annual estimate is provided for the value of total tangible capital assets of the USA, which doubled since 1980 (stated in trillions of dollars, at September 30, 2003):
Thus, in UNSNA, capital formation equals fixed capital investment, the increase in the value of inventories held, plus (net) lending to foreign countries, during an accounting period. Capital is said to be "formed" when savings are used for investment purposes, often investment in production.
Capital formation is often equated with, or used as an abbreviation for gross fixed capital formation but strictly speaking this is an error, since the latter is only a component of the former.
Contents
1 Origin of the concept
2 Different interpretations
3 Gross and net capital formation
4 Technical measurement issues
5 Perpetual Inventory Method
6 Controversy
7 Example of capital estimates
8 See also
9 References
[edit] Origin of the concept
In the USA, statistical estimates for capital formation were pioneered by Simon Kuznets in the 1930s and 1940s, and from the 1950s onwards the standard accounting system devised to measure capital flows was adopted officially by the governments of most countries.
[edit] Different interpretations
The use of the term "capital formation" can be somewhat confusing, partly because the concept of capital itself can be understood in different ways.
Firstly, capital formation is frequently thought of as a measure of total "investment", in the sense of that portion of capital which is actually used for investment purposes and not saved or consumed. But in fact the concept refers only to the accounting value of the additions of assets to the capital stock less the disposals of assets; and often capital formation is used to refer only to investment in fixed assets, not investment in all types of assets. "Investment" includes investment in all kinds of capital assets, whether physical property or financial assets.
Secondly, capital formation may be used synonymously with the notion of capital accumulation in the sense of a reinvestment of profits into capital assets. But "capital accumulation" is not an accounting concept, and contains the ambiguity that an amassment of wealth could occur either through a redistribution of capital assets from one person or institution to another, or through a net addition to the total stock of capital in existence. As regards capital accumulation, it can flourish, so that some people get much wealthier, even although society as a whole becomes poorer, and the net capital formation decreases. In other words the gain could be a net total gain, or a gain at the expense of loss by others which cancels out (or more than cancels out) the gain in aggregate.
Thirdly, capital formation is often used synonymously with Gross fixed capital formation but strictly speaking this is an error, for two reasons: (a) capital formation as such can in principle refer to more assets than just fixed capital, and (b) capital formation can be stated "gross" (before deduction of depreciation write-offs or Consumption of fixed capital) or it can be stated "net" (after deduction of depreciation charges). So, capital formation could mean gross capital formation or net capital formation.
In a broader meaning or vaguer sense, capital formation is nowadays also used to refer to savings drives, setting up financial institutions, fiscal measures, public borrowing, development of capital markets, privatization of financial institutions, development of secondary financial markets. In this broad sense, it refers to any method for increasing the amount of capital owned or under one's control, or any method in utilising or mobilizing capital resources for investment purposes. Thus, capital could be "formed" in the sense of "being brought together for investment purposes" in many different ways.
[edit] Gross and net capital formation
In economic statistics and accounts, capital formation can be valued gross (without deductions for depreciation) or net (adjusted for depreciation write-offs). The gross valuation method views depreciation as a portion of the new income or wealth earned or created by the enterprise, and hence as part of the formation of new capital by the enterprise. The net valuation method views depreciation as the compensation for the cost of replacing fixed equipment used up or worn out, which must be deducted from the total investment volume to obtain a measure of the "real" value of investments; the depreciation write-off compensates and cancels out the loss in capital value of assets used due to wear & tear, obsolescence, etc.
[edit] Technical measurement issues
Capital formation is notoriously difficult to measure statistically, mainly because of the valuation problems involved in establishing what the value of capital assets is. Capital assets can for instance be valued at:
historic (acquisition) cost,
current replacement cost,
current sale value,
average market value,
business value assuming a certain profit yield
value for tax purposes,
purchasing power parity value
scrap value.
A business owner may in fact not even know what his business is "worth" as a going concern, in terms of its current market value. The "book value" of a capital stock may differ greatly from its "market value", and another figure may apply for taxation purposes. The value of capital assets may also be overstated or understated using various legal constructions.
During an accounting period, additions may be made to capital assets (including those which are of a type that disproportionately increase the value of the capital stock) and capital assets are also disposed of; at the same time, physical assets also incur depreciation or Consumption of fixed capital. Also, price inflation may affect the value of the capital stock.
In national accounts, there is an additional problem, since the sales/purchases of one enterprise can be the investment of another enterprise. Therefore, to obtain a measure of the total net capital formation, a system of grossing and netting of capital flows is required. Without this, double counting would occur. Capital expenditure must be distinguished from intermediate expenditure and other operating expenditure, but the boundaries are sometimes difficult to draw.
[edit] Perpetual Inventory Method
A method often used in econometrics to estimate the value of the physical capital stock is the so-called Perpetual Inventory Method (PIM). Starting off from a benchmark stock value for capital held, and expressing all values in constant dollars using a price index, additions to the stock are added, and disposals as well as depreciation are subtracted year by year (or quarter by quarter). Thus, an historical data series is obtained for the growth of the capital stock over a period of time. In so doing, assumptions are made about the real rate of price inflation, realistic depreciation rates, average service lives of physical capital assets, and so on.
[edit] Controversy
According to one popular kind of macro-economic definition in textbooks, capital formation refers to "the transfer of savings from households and governments to the business sector, resulting in increased output and economic expansion". The idea here is that individuals and governments save money, and then invest that money in the private sector, which produces more wealth with it. This definition is however incomplete on two counts.
Firstly, many larger corporations engage in corporate self-financing, i.e. financing from their own reserves, or through loans from (or share issues bought by) other corporations. In other words, the textbook definition ignores that the largest source of investment capital consists of financial institutions, not individuals or households or governments.
Admittedly, financial institutions are, "in the last instance", mostly owned by individuals, but those individuals have little control over this transfer of funds, nor do they accomplish the transfer themselves. Few individuals can say they "own" a corporation, anymore than individuals "own" the public sector. (Poterba (1987) found that changes in corporate saving are only partly offset (between 25% and 50%) by changes in household saving in the United States).
Social accountants Richard Ruggles and Nancy D. Ruggles established for the USA that "almost all financial savings done by households is used to pay for household capital formation - particularly, housing and consumer durables. On net, the household sector channels almost no financial savings to the enterprise sector. Conversely, almost all the capital formation done by enterprises is financed through enterprise savings - particularly, undistributed gross profits." (cited from Edward N. Wolff, "In Memoriam: Richard Ruggles 1916-2001", in: Review of Income and Wealth, Series 47, Number 3, September 2001, p. 414).
Secondly, the transfer of funds to corporations may not result in increased output or economic expansion at all; given excess capacity, a low rate of return and/or lacklustre demand, corporations may not in fact invest those funds to expand output, and engage in asset speculation instead, to obtain property income that boosts shareholder returns.
To illustrate, New Zealand's Finance Minister Michael Cullen stated (NZ Herald, 24 February 2005) that "My sense is that there are definite gains to be made, both economic and social, in increasing the savings level of New Zealanders and in encouraging diversification in assets away from the residential property market."
This idea is based on a flawed understanding of capital formation, ignoring the real issue - which is that the flow of mortgage repayments by households to financial institutions is not being used to expand output and employment on a scale that could repay escalating private sector debts. In reality, more and more local capital value drains to foreign share-holders and creditors.
The concept of "household saving" must itself also be looked at critically, since a lot of this "saving" in reality consists precisely of investing in housing, which, given low interest rates and rising real estate prices, yields a better return than if you kept your money in the bank (or, in some cases, if you invested in shares). In other words, a mortgage from a bank can effectively function as a "savings scheme" although officially it is not regarded as "savings".
[edit] Example of capital estimates
In the 2005 Analytical Perspectives document, an annex to the US Budget (Table 12-4: National Wealth, p. 201), an annual estimate is provided for the value of total tangible capital assets of the USA, which doubled since 1980 (stated in trillions of dollars, at September 30, 2003):
Pricing
There are many ways in which the price of a product can be determined. The following are the foremost strategies that businesses are likely to use.
Contents
1 Competition-based pricing
2 Cost-plus pricing
3 Creaming or skimming
4 Limit pricing
5 Loss leader
6 Market-oriented pricing
7 Penetration pricing
8 Price discrimination
9 Premium pricing
10 Predatory pricing
11 Contribution margin-based pricing
12 Psychological pricing
13 Dynamic pricing
14 Price leadership
15 Target pricing
16 Absorption pricing
17 Marginal-cost pricing
18 References
[edit] Competition-based pricing
Setting the price based upon prices of the similar competitor products.
Competitive pricing is based on three types of competitive product:
Products have long distinctiveness from competitor's product. Here we can assume
The product has low price elasticity.
The product has low cross elasticity.
The demand of the product will rise.
Products have perishable distinctiveness from competitor's product, assuming the product features are medium distinctiveness.
Products have little distinctiveness from competitor's product. assuming that:
The product has high price elasticity.
The product has some cross elasticity.
No expectation that demand of the product will rise.
The pricing is done based on these three factors.
[edit] Cost-plus pricing
Main article: cost-plus pricing
Cost-plus pricing is the simplest pricing method. The firm calculates the cost of producing the product and adds on a percentage (profit) to that price to give the selling price. This method although simple has two flaws; it takes no account of demand and there is no way of determining if potential customers will purchase the product at the calculated price.
Price = Cost of Production + Margin of Profit.
[edit] Creaming or skimming
Selling a product at a high price, sacrificing high sales to gain a high profit, therefore ‘skimming’ the market. Usually employed to reimburse the cost of investment of the original research into the product - commonly used in electronic markets when a new range, such as DVD players, are firstly dispatched into the market at a high price. This strategy is often used to target "early adopters" of a product/service. These early adopters are relatively less price sensitive because either their need for the product is more than others or they understand the value of the product better than others. This strategy is employed only for a limited duration to recover most of investment made to build the product. To gain further market share, a seller must use other pricing tactics such as economy or penetration.[1]
[edit] Limit pricing
Main article: Limit price
A limit price is the price set by a monopolist to discourage economic entry into a market, and is illegal in many countries. The limit price is the price that the entrant would face upon entering as long as the incumbent firm did not decrease output. The limit price is often lower than the average cost of production or just low enough to make entering not profitable. The quantity produced by the incumbent firm to act as a deterrent to entry is usually larger than would be optimal for a monopolist, but might still produce higher economic profits than would be earned under perfect competition. The problem with limit pricing as strategic behavior is that once the entrant has entered the market, the quantity used as a threat to deter entry is no longer the incumbent firm's best response. This means that for limit pricing to be an effective deterrent to entry, the threat must in some way be made credible. A way to achieve this is for the incumbent firm to constrain itself to produce a certain quantity whether entry occurs or not. An example of this would be if the firm signed a union contract to employ a certain (high) level of labor for a long period of time.
[edit] Loss leader
Main article: loss leader
Loss Leader:
In the majority of cases, this pricing strategy is illegal under EU and US Competition rules. No market leader would wish to sell below cost unless this is part of its overall strategy. The idea of selling at a loss may appear to be in the public interest and therefore not often challenged. Only when the leader pushes up prices, it then becomes suspicious. Loss leadership can be similar to predatory pricing or cross subsidisation; both seen as anticompetitive practices.
[edit] Market-oriented pricing
Setting a price based upon analysis and research compiled from the targeted market. Also with the cost price.
[edit] Penetration pricing
Main article: penetration pricing
The price is deliberately set at low level to gain customer's interest and establishing a foot-hold in the market.[2]
[edit] Price discrimination
Main article: price discrimination
Setting a different price for the same product in different segments to the market. For example, this can be for different ages or for different opening times, such as cinema tickets. Market orientated pricing is also a very simple form of pricing used by very new businesses. What it involves is, setting the price of your product/service according to research conducted on your target market.
[edit] Premium pricing
Main article: Premium pricing
Premium pricing is the practice of keeping the price of a product or service artificially high in order to encourage favorable perceptions among buyers, based solely on the price. The practice is intended to exploit the (not necessarily justifiable) tendency for buyers to assume that expensive items enjoy an exceptional reputation or represent exceptional quality and distinction.
[edit] Predatory pricing
Main article: predatory pricing
Aggressive pricing intended to drive out competitors from a market. It is illegal in some places.
[edit] Contribution margin-based pricing
Main article: contribution margin-based pricing
Contribution margin-based pricing maximizes the profit derived from an individual product, based on the difference between the product's price and variable costs (the product's contribution margin per unit), and on one’s assumptions regarding the relationship between the product’s price and the number of units that can be sold at that price. The product's contribution to total firm profit (i.e., to operating income) is maximized when a price is chosen that maximizes the following: (contribution margin per unit) X (number of units sold).
[edit] Psychological pricing
Main article: psychological pricing
Pricing designed to have a positive psychological impact. For example, selling a product at £3.95 rather than £4.
[edit] Dynamic pricing
Main article: dynamic pricing
A flexible pricing mechanism made possible by advances in information technology, and employed mostly by Internet based companies. By responding to market fluctuations or large amounts of data gathered from customers - ranging from where they live to what they buy to how much they have spent on past purchases - dynamic pricing allows online companies to adjust the prices of identical goods to correspond to a customer’s willingness to pay. The airline industry is often cited as a dynamic pricing success story. In fact, it employs the technique so artfully that most of the passengers on any given airplane have paid different ticket prices for the same flight.
[edit] Price leadership
Main article: price leadership
An observation made of oligopic business behavior in which one company, usually the dominant competitor among several, leads the way in determining prices, the others soon following.
[edit] Target pricing
Pricing method whereby the selling price of a product is calculated to produce a particular rate of return on investment for a specific volume of production. The target pricing method is used most often by public utilities, like electric and gas companies, and companies whose capital investment is high, like automobile manufacturers.
Target pricing is not useful for companies whose capital investment is low because, according to this formula, the selling price will be understated. Also the target pricing method is not keyed to the demand for the product, and if the entire volume is not sold, a company might sustain an overall budgetary loss on the product.
[edit] Absorption pricing
Method of pricing in which all costs are recovered. The price of the product includes the variable cost of each item plus a proportionate amount of the fixed costs. A form of cost plus pricing
[edit] Marginal-cost pricing
In business, the practice of setting the price of a product to equal the extra cost of producing an extra unit of output. By this policy, a producer charges, for each product unit sold, only the addition to total cost resulting from materials and direct labour. Businesses often set prices close to marginal cost during periods of poor sales. If, for example, an item has a marginal cost of $1.00 and a normal selling price is $2.00, the firm selling the item might wish to lower the price to $1.10 if demand has waned. The business would choose this approach because the incremental profit of 10 cents from the transaction is better than no sale at all.
[edit] References
^ Kent B. Monroe, [The Pricing Strategy Audit]http://www.cambridgestrategy.com/content/pricing_strategy_audit.php, 2003, Cambridge Strategy Publications, p.40
^ Kent B. Monroe, [The Pricing Strategy Audit]http://www.cambridgestrategy.com/content/pricing_strategy_audit.php, 2003, Cambridge Strategy Publications, p.41
Retrieved from "http://en.wikipedia.org/wiki/Pricing_strategies"
Contents
1 Competition-based pricing
2 Cost-plus pricing
3 Creaming or skimming
4 Limit pricing
5 Loss leader
6 Market-oriented pricing
7 Penetration pricing
8 Price discrimination
9 Premium pricing
10 Predatory pricing
11 Contribution margin-based pricing
12 Psychological pricing
13 Dynamic pricing
14 Price leadership
15 Target pricing
16 Absorption pricing
17 Marginal-cost pricing
18 References
[edit] Competition-based pricing
Setting the price based upon prices of the similar competitor products.
Competitive pricing is based on three types of competitive product:
Products have long distinctiveness from competitor's product. Here we can assume
The product has low price elasticity.
The product has low cross elasticity.
The demand of the product will rise.
Products have perishable distinctiveness from competitor's product, assuming the product features are medium distinctiveness.
Products have little distinctiveness from competitor's product. assuming that:
The product has high price elasticity.
The product has some cross elasticity.
No expectation that demand of the product will rise.
The pricing is done based on these three factors.
[edit] Cost-plus pricing
Main article: cost-plus pricing
Cost-plus pricing is the simplest pricing method. The firm calculates the cost of producing the product and adds on a percentage (profit) to that price to give the selling price. This method although simple has two flaws; it takes no account of demand and there is no way of determining if potential customers will purchase the product at the calculated price.
Price = Cost of Production + Margin of Profit.
[edit] Creaming or skimming
Selling a product at a high price, sacrificing high sales to gain a high profit, therefore ‘skimming’ the market. Usually employed to reimburse the cost of investment of the original research into the product - commonly used in electronic markets when a new range, such as DVD players, are firstly dispatched into the market at a high price. This strategy is often used to target "early adopters" of a product/service. These early adopters are relatively less price sensitive because either their need for the product is more than others or they understand the value of the product better than others. This strategy is employed only for a limited duration to recover most of investment made to build the product. To gain further market share, a seller must use other pricing tactics such as economy or penetration.[1]
[edit] Limit pricing
Main article: Limit price
A limit price is the price set by a monopolist to discourage economic entry into a market, and is illegal in many countries. The limit price is the price that the entrant would face upon entering as long as the incumbent firm did not decrease output. The limit price is often lower than the average cost of production or just low enough to make entering not profitable. The quantity produced by the incumbent firm to act as a deterrent to entry is usually larger than would be optimal for a monopolist, but might still produce higher economic profits than would be earned under perfect competition. The problem with limit pricing as strategic behavior is that once the entrant has entered the market, the quantity used as a threat to deter entry is no longer the incumbent firm's best response. This means that for limit pricing to be an effective deterrent to entry, the threat must in some way be made credible. A way to achieve this is for the incumbent firm to constrain itself to produce a certain quantity whether entry occurs or not. An example of this would be if the firm signed a union contract to employ a certain (high) level of labor for a long period of time.
[edit] Loss leader
Main article: loss leader
Loss Leader:
In the majority of cases, this pricing strategy is illegal under EU and US Competition rules. No market leader would wish to sell below cost unless this is part of its overall strategy. The idea of selling at a loss may appear to be in the public interest and therefore not often challenged. Only when the leader pushes up prices, it then becomes suspicious. Loss leadership can be similar to predatory pricing or cross subsidisation; both seen as anticompetitive practices.
[edit] Market-oriented pricing
Setting a price based upon analysis and research compiled from the targeted market. Also with the cost price.
[edit] Penetration pricing
Main article: penetration pricing
The price is deliberately set at low level to gain customer's interest and establishing a foot-hold in the market.[2]
[edit] Price discrimination
Main article: price discrimination
Setting a different price for the same product in different segments to the market. For example, this can be for different ages or for different opening times, such as cinema tickets. Market orientated pricing is also a very simple form of pricing used by very new businesses. What it involves is, setting the price of your product/service according to research conducted on your target market.
[edit] Premium pricing
Main article: Premium pricing
Premium pricing is the practice of keeping the price of a product or service artificially high in order to encourage favorable perceptions among buyers, based solely on the price. The practice is intended to exploit the (not necessarily justifiable) tendency for buyers to assume that expensive items enjoy an exceptional reputation or represent exceptional quality and distinction.
[edit] Predatory pricing
Main article: predatory pricing
Aggressive pricing intended to drive out competitors from a market. It is illegal in some places.
[edit] Contribution margin-based pricing
Main article: contribution margin-based pricing
Contribution margin-based pricing maximizes the profit derived from an individual product, based on the difference between the product's price and variable costs (the product's contribution margin per unit), and on one’s assumptions regarding the relationship between the product’s price and the number of units that can be sold at that price. The product's contribution to total firm profit (i.e., to operating income) is maximized when a price is chosen that maximizes the following: (contribution margin per unit) X (number of units sold).
[edit] Psychological pricing
Main article: psychological pricing
Pricing designed to have a positive psychological impact. For example, selling a product at £3.95 rather than £4.
[edit] Dynamic pricing
Main article: dynamic pricing
A flexible pricing mechanism made possible by advances in information technology, and employed mostly by Internet based companies. By responding to market fluctuations or large amounts of data gathered from customers - ranging from where they live to what they buy to how much they have spent on past purchases - dynamic pricing allows online companies to adjust the prices of identical goods to correspond to a customer’s willingness to pay. The airline industry is often cited as a dynamic pricing success story. In fact, it employs the technique so artfully that most of the passengers on any given airplane have paid different ticket prices for the same flight.
[edit] Price leadership
Main article: price leadership
An observation made of oligopic business behavior in which one company, usually the dominant competitor among several, leads the way in determining prices, the others soon following.
[edit] Target pricing
Pricing method whereby the selling price of a product is calculated to produce a particular rate of return on investment for a specific volume of production. The target pricing method is used most often by public utilities, like electric and gas companies, and companies whose capital investment is high, like automobile manufacturers.
Target pricing is not useful for companies whose capital investment is low because, according to this formula, the selling price will be understated. Also the target pricing method is not keyed to the demand for the product, and if the entire volume is not sold, a company might sustain an overall budgetary loss on the product.
[edit] Absorption pricing
Method of pricing in which all costs are recovered. The price of the product includes the variable cost of each item plus a proportionate amount of the fixed costs. A form of cost plus pricing
[edit] Marginal-cost pricing
In business, the practice of setting the price of a product to equal the extra cost of producing an extra unit of output. By this policy, a producer charges, for each product unit sold, only the addition to total cost resulting from materials and direct labour. Businesses often set prices close to marginal cost during periods of poor sales. If, for example, an item has a marginal cost of $1.00 and a normal selling price is $2.00, the firm selling the item might wish to lower the price to $1.10 if demand has waned. The business would choose this approach because the incremental profit of 10 cents from the transaction is better than no sale at all.
[edit] References
^ Kent B. Monroe, [The Pricing Strategy Audit]http://www.cambridgestrategy.com/content/pricing_strategy_audit.php, 2003, Cambridge Strategy Publications, p.40
^ Kent B. Monroe, [The Pricing Strategy Audit]http://www.cambridgestrategy.com/content/pricing_strategy_audit.php, 2003, Cambridge Strategy Publications, p.41
Retrieved from "http://en.wikipedia.org/wiki/Pricing_strategies"
Product Strategy
Product Strategy is perhaps the most important function of a company. It must take in account the capabilities in terms of engineering, of production, of distribution (sales) existing in the company or of time to acquire them (by hiring or by mergers). It must evaluate the customers expectations at the time of delivery. It must guestimate the competition (including new entrants) probable moves to enter the same market.
Product strategy by Bull appeared sometimes erratic and not coordinated, specially during the periods where product lines run independently. However, it has been dominated by very old trends rooted in the Sales Network during the 1950s defining Bull's market around the business applications, and fighting against the sole IBM as competitor.
So, the company adopted its version of IBM's business model, following IBM with a variable delay, in the domain of products, price and market following. Sometimes new opportunities appeared and some innovative products were developed, (e.g. time-sharing in GE time, smart card applications) but they faded as marginalized by the Sales Network. In fact, the Sales Network was not conscious of the pressure it exerted on Planning and Engineering. Often, it focalized on IBM's short term moves, ignoring the reasons for those moves (sometimes due to legal constraints, sometimes by internal fighting inside IBM, other times because other competitors moves).
While IBM's influence on Bull was extremely important, the reverse existed sometimes (1). Dispute between IBM World Trade and IBM US domestic may have been fueled by some worry of IBM European salesmen about some Bull's (and GE's or Honeywell's) products.
The capability of Bull to match IBM's offer on the market never existed. Before the GE's merger, Bull did not address the US market directly and by consequence excluded itself from the market segments needing the quantities only addressed by a worldwide market (such as large scientific computers). Another market that was ignored (knowledgeably) early was the small scientific market; its margins did not matched the corporate model.
Bull never did a comparable investment to IBM's in the technology area. Each time it (or its American associates) tries a significant move, the success did not reward it. The reasons of the failure were multiple: overestimation of the return on investment, lack of a long term perspective (that existed in architecture and software), size of market. Some more specific problems were due to the lack of experience in fundamental physics, themselves related to the isolation of the engineers.
For historical reasons related to the acquisition of a park of customers and for "political" reasons, Bull did not succeed to shut down a product line before the 1990s. Its resource limitations did not allow to embark in the simultaneous developments of more than one or a couple of compatible processors at the same time. Product Planning had to prepare several product line plans and to invent models within each product line to match the competition prices and performances. Models were developed from a single engineering design with the same manufacturing cost by slowing down the processor clock or adding dummy cycles and/or by reducing the "connectivity" of the system.
When the performances exceeded IBM's target, the system was not sold at full speed to avoid the risk of undercutting IBM future announcements' price and keeping some reserve power to react against a competition "mid-life kicker".
New higher models were also created by unleashing the design constraints after one year. New lower models were created by slowing down a bit already shipped processors.
This strategy worked well as far as the manufacturer controlled completely the customer configuration by leasing the systems. The first evolution of the model was the advent of clones manufacturers. They obviously attacked IBM's market but GE, Honeywell and Bull strategists ordered to take all measures, sometimes detrimental to product and service costs, to escape cloners. The architecture or the assembler of the machines remained confidential, source and object code of programs was secrete, network architecture was not available even to peripheral suppliers, peripheral interfaces were modified and the differences kept in vaults... Bull argued to the persons objecting the strategy (suppliers, other manufacturers, customers ) that it would respect the "de jure" standards (such as ISO's or ANSI's) but that it did not have to follow the "de facto" standards (such as IBM's). That changed in the 1980s when "Open Systems" became Bull's religion.
Another IBM decision impacted the business model, it was unbundling. While the IBM pricing was more or less related to development and manufacturing costs, adopting the same price for Bull's items where software, for instance, was reproduced in far smaller number of copies, lead to a disconnect between decisions to produce and customers acceptation. Specially in the late 1970s and the 1980s, Bull embarked in many developments with a very low production rate, but they were asked to match the IBM's catalog. Later, in the late 1980s, the competition with open systems, lead to some re-bundling of the offer (the word was "packaging") where for instance associate a purchased data base system with a memory bank and even an additional processor.
Product strategy by Bull appeared sometimes erratic and not coordinated, specially during the periods where product lines run independently. However, it has been dominated by very old trends rooted in the Sales Network during the 1950s defining Bull's market around the business applications, and fighting against the sole IBM as competitor.
So, the company adopted its version of IBM's business model, following IBM with a variable delay, in the domain of products, price and market following. Sometimes new opportunities appeared and some innovative products were developed, (e.g. time-sharing in GE time, smart card applications) but they faded as marginalized by the Sales Network. In fact, the Sales Network was not conscious of the pressure it exerted on Planning and Engineering. Often, it focalized on IBM's short term moves, ignoring the reasons for those moves (sometimes due to legal constraints, sometimes by internal fighting inside IBM, other times because other competitors moves).
While IBM's influence on Bull was extremely important, the reverse existed sometimes (1). Dispute between IBM World Trade and IBM US domestic may have been fueled by some worry of IBM European salesmen about some Bull's (and GE's or Honeywell's) products.
The capability of Bull to match IBM's offer on the market never existed. Before the GE's merger, Bull did not address the US market directly and by consequence excluded itself from the market segments needing the quantities only addressed by a worldwide market (such as large scientific computers). Another market that was ignored (knowledgeably) early was the small scientific market; its margins did not matched the corporate model.
Bull never did a comparable investment to IBM's in the technology area. Each time it (or its American associates) tries a significant move, the success did not reward it. The reasons of the failure were multiple: overestimation of the return on investment, lack of a long term perspective (that existed in architecture and software), size of market. Some more specific problems were due to the lack of experience in fundamental physics, themselves related to the isolation of the engineers.
For historical reasons related to the acquisition of a park of customers and for "political" reasons, Bull did not succeed to shut down a product line before the 1990s. Its resource limitations did not allow to embark in the simultaneous developments of more than one or a couple of compatible processors at the same time. Product Planning had to prepare several product line plans and to invent models within each product line to match the competition prices and performances. Models were developed from a single engineering design with the same manufacturing cost by slowing down the processor clock or adding dummy cycles and/or by reducing the "connectivity" of the system.
When the performances exceeded IBM's target, the system was not sold at full speed to avoid the risk of undercutting IBM future announcements' price and keeping some reserve power to react against a competition "mid-life kicker".
New higher models were also created by unleashing the design constraints after one year. New lower models were created by slowing down a bit already shipped processors.
This strategy worked well as far as the manufacturer controlled completely the customer configuration by leasing the systems. The first evolution of the model was the advent of clones manufacturers. They obviously attacked IBM's market but GE, Honeywell and Bull strategists ordered to take all measures, sometimes detrimental to product and service costs, to escape cloners. The architecture or the assembler of the machines remained confidential, source and object code of programs was secrete, network architecture was not available even to peripheral suppliers, peripheral interfaces were modified and the differences kept in vaults... Bull argued to the persons objecting the strategy (suppliers, other manufacturers, customers ) that it would respect the "de jure" standards (such as ISO's or ANSI's) but that it did not have to follow the "de facto" standards (such as IBM's). That changed in the 1980s when "Open Systems" became Bull's religion.
Another IBM decision impacted the business model, it was unbundling. While the IBM pricing was more or less related to development and manufacturing costs, adopting the same price for Bull's items where software, for instance, was reproduced in far smaller number of copies, lead to a disconnect between decisions to produce and customers acceptation. Specially in the late 1970s and the 1980s, Bull embarked in many developments with a very low production rate, but they were asked to match the IBM's catalog. Later, in the late 1980s, the competition with open systems, lead to some re-bundling of the offer (the word was "packaging") where for instance associate a purchased data base system with a memory bank and even an additional processor.
Fiscal Policy
In economics, fiscal policy is the use of government spending and revenue collection to influence the economy.[1]
Fiscal policy can be contrasted with the other main type of economic policy, monetary policy, which attempts to stabilize the economy by controlling interest rates and the supply of money. The two main instruments of fiscal policy are government spending and taxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:
Aggregate demand and the level of economic activity;
The pattern of resource allocation;
The distribution of income.
Fiscal policy refers to the overall effect of the budget outcome on economic activity. The three possible stances of fiscal policy are neutral, expansionary and contractionary:
A neutral stance of fiscal policy implies a balanced budget where G = T (Government spending = Tax revenue). Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.
An expansionary stance of fiscal policy involves a net increase in government spending (G > T) through rises in government spending or a fall in taxation revenue or a combination of the two. This will lead to a larger budget deficit or a smaller budget surplus than the government previously had, or a deficit if the government previously had a balanced budget. Expansionary fiscal policy is usually associated with a budget deficit.
A contractionary fiscal policy (G < title="Surplus" than the government previously had, or a surplus if the government previously had a balanced budget. Contractionary fiscal policy is usually associated with a surplus.
Fiscal policy was invented by John Maynard Keynes in the 1930s.
Contents
1 Methods of funding
1.1 Funding the deficit
1.2 Consuming the surplus
2 Economic effects of fiscal policy
3 See also
4 References
5 Bibliography
6 External links
//
[edit] Methods of funding
Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payments such as welfare benefits.
This expenditure can be funded in a number of different ways:
Taxation
Seignorage, the benefit from printing money
Borrowing money from the population, resulting in a fiscal deficit.
Consumption of fiscal reserves.
Sale of assets (e.g., land).
[edit] Funding the deficit
A fiscal deficit is often funded by issuing bonds, like treasury bills or consols. These pay interest, either for a fixed period or indefinitely. If the interest and capital repayments are too large, a nation may default on its debts, usually to foreign creditors.
[edit] Consuming the surplus
A fiscal surplus is often saved for future use, and may be invested in local (same currency) financial instruments, until needed. When income from taxation or other sources falls, as during an economic slump, reserves allow spending to continue at the same rate, without incurring a deficit.
[edit] Economic effects of fiscal policy
Fiscal policy is used by governments to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment and economic growth. Keynesian economics suggests that adjusting government spending and tax rates are the best ways to stimulate aggregate demand. This can be used in times of recession or low economic activity as an essential tool in providing the framework for strong economic growth and working toward full employment. The government can implement these deficit-spending policies due to its size and prestige and stimulate trade. In theory, these deficits would be paid for by an expanded economy during the boom that would follow; this was the reasoning behind the New Deal.
During periods of high economic growth, a budget surplus can be used to decrease activity in the economy. A budget surplus will be implemented in the economy if inflation is high, in order to achieve the objective of price stability. The removal of funds from the economy will, by Keynesian theory, reduce levels of aggregate demand in the economy and contract it, bringing about price stability.
Some classical and neoclassical economists argue that fiscal policy can have no stimulus effect; this is known as the Treasury View, and categorically rejected by Keynesian economics. The Treasury View refers to the theoretical positions of classical economists in the British Treasury who opposed Keynes call for fiscal stimulus in the 1930s. The same general argument has been repeated by neoclassical economists up to the present day. From their point of view, when government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing or the printing of new money. When governments fund a deficit with the release of government bonds, an increase in interest rates across the market can occur. This is because government borrowing creates higher demand for credit in the financial markets, causing a lower aggregate demand (AD), contrary to the objective of a budget deficit. This concept is called crowding out.
Other possible problems with fiscal stimulus include the time lag between the implementation of the policy and detectable effects in the economy and inflationary effects driven by increased demand. In theory, fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle. For instance, if a fiscal stimulus employs a worker who otherwise would have been unemployed, there is no inflationary effect; however, if the stimulus employs a worker who otherwise would have had a job, the stimulus is increasing demand while labor supply remains fixed, leading to inflation
Fiscal policy can be contrasted with the other main type of economic policy, monetary policy, which attempts to stabilize the economy by controlling interest rates and the supply of money. The two main instruments of fiscal policy are government spending and taxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:
Aggregate demand and the level of economic activity;
The pattern of resource allocation;
The distribution of income.
Fiscal policy refers to the overall effect of the budget outcome on economic activity. The three possible stances of fiscal policy are neutral, expansionary and contractionary:
A neutral stance of fiscal policy implies a balanced budget where G = T (Government spending = Tax revenue). Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.
An expansionary stance of fiscal policy involves a net increase in government spending (G > T) through rises in government spending or a fall in taxation revenue or a combination of the two. This will lead to a larger budget deficit or a smaller budget surplus than the government previously had, or a deficit if the government previously had a balanced budget. Expansionary fiscal policy is usually associated with a budget deficit.
A contractionary fiscal policy (G < title="Surplus" than the government previously had, or a surplus if the government previously had a balanced budget. Contractionary fiscal policy is usually associated with a surplus.
Fiscal policy was invented by John Maynard Keynes in the 1930s.
Contents
1 Methods of funding
1.1 Funding the deficit
1.2 Consuming the surplus
2 Economic effects of fiscal policy
3 See also
4 References
5 Bibliography
6 External links
//
[edit] Methods of funding
Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payments such as welfare benefits.
This expenditure can be funded in a number of different ways:
Taxation
Seignorage, the benefit from printing money
Borrowing money from the population, resulting in a fiscal deficit.
Consumption of fiscal reserves.
Sale of assets (e.g., land).
[edit] Funding the deficit
A fiscal deficit is often funded by issuing bonds, like treasury bills or consols. These pay interest, either for a fixed period or indefinitely. If the interest and capital repayments are too large, a nation may default on its debts, usually to foreign creditors.
[edit] Consuming the surplus
A fiscal surplus is often saved for future use, and may be invested in local (same currency) financial instruments, until needed. When income from taxation or other sources falls, as during an economic slump, reserves allow spending to continue at the same rate, without incurring a deficit.
[edit] Economic effects of fiscal policy
Fiscal policy is used by governments to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment and economic growth. Keynesian economics suggests that adjusting government spending and tax rates are the best ways to stimulate aggregate demand. This can be used in times of recession or low economic activity as an essential tool in providing the framework for strong economic growth and working toward full employment. The government can implement these deficit-spending policies due to its size and prestige and stimulate trade. In theory, these deficits would be paid for by an expanded economy during the boom that would follow; this was the reasoning behind the New Deal.
During periods of high economic growth, a budget surplus can be used to decrease activity in the economy. A budget surplus will be implemented in the economy if inflation is high, in order to achieve the objective of price stability. The removal of funds from the economy will, by Keynesian theory, reduce levels of aggregate demand in the economy and contract it, bringing about price stability.
Some classical and neoclassical economists argue that fiscal policy can have no stimulus effect; this is known as the Treasury View, and categorically rejected by Keynesian economics. The Treasury View refers to the theoretical positions of classical economists in the British Treasury who opposed Keynes call for fiscal stimulus in the 1930s. The same general argument has been repeated by neoclassical economists up to the present day. From their point of view, when government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing or the printing of new money. When governments fund a deficit with the release of government bonds, an increase in interest rates across the market can occur. This is because government borrowing creates higher demand for credit in the financial markets, causing a lower aggregate demand (AD), contrary to the objective of a budget deficit. This concept is called crowding out.
Other possible problems with fiscal stimulus include the time lag between the implementation of the policy and detectable effects in the economy and inflationary effects driven by increased demand. In theory, fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle. For instance, if a fiscal stimulus employs a worker who otherwise would have been unemployed, there is no inflationary effect; however, if the stimulus employs a worker who otherwise would have had a job, the stimulus is increasing demand while labor supply remains fixed, leading to inflation
Monetary Policy
Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy.[1] Monetary theory provides insight into how to craft optimal monetary policy.
Monetary policy is referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates in order to combat inflation. Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation.[2]
Contents
1 Overview
1.1 Theory
2 History of monetary policy
2.1 Trends in central banking
2.2 Developing countries
3 Types of monetary policy
3.1 Inflation targeting
3.2 Price level targeting
3.3 Monetary aggregates
3.4 Fixed exchange rate
3.5 Gold standard
3.6 Policy of various nations
4 Monetary policy tools
4.1 Monetary base
4.2 Reserve requirements
4.3 Discount window lending
4.4 Interest rates
4.5 Currency board
5 See also
6 References
//
[edit] Overview
Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (in order to achieve policy goals). The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard.
A policy is referred to as contractionary if it reduces the size of the money supply or raises the interest rate. An expansionary policy increases the size of the money supply, or decreases the interest rate. Furthermore, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation.
There are several monetary policy tools available to achieve these ends: increasing interest rates by fiat; reducing the monetary base; and increasing reserve requirements. All have the effect of contracting the money supply; and, if reversed, expand the money supply. Since the 1970s, monetary policy has generally been formed separately from fiscal policy. Even prior to the 1970s, the Bretton Woods system still ensured that most nations would form the two policies separately.
Within almost all modern nations, special institutions (such as the Bank of England, the European Central Bank, Reserve Bank of India, the Federal Reserve System in the United States, the Bank of Japan, the Bank of Canada or the Reserve Bank of Australia) exist which have the task of executing the monetary policy and often independently of the executive. In general, these institutions are called central banks and often have other responsibilities such as supervising the smooth operation of the financial system.
The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various credit instruments, foreign currencies or commodities. All of these purchases or sales result in more or less base currency entering or leaving market circulation.
Usually, the short term goal of open market operations is to achieve a specific short term interest rate target. In other instances, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency or else relative to gold. For example, in the case of the USA the Federal Reserve targets the federal funds rate, the rate at which member banks lend to one another overnight; however, the monetary policy of China is to target the exchange rate between the Chinese renminbi and a basket of foreign currencies.
The other primary means of conducting monetary policy include: (i) Discount window lending (lender of last resort); (ii) Fractional deposit lending (changes in the reserve requirement); (iii) Moral suasion (cajoling certain market players to achieve specified outcomes); (iv) "Open mouth operations" (talking monetary policy with the market).
[edit] Theory
Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy.[1] Monetary theory provides insight into how to craft optimal monetary policy.
Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (in order to achieve policy goals). The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard. A policy is referred to as contractionary if it reduces the size of the money supply or raises the interest rate. An expansionary policy increases the size of the money supply, or decreases the interest rate. Furthermore, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation.
It is important for policymakers to make credible announcements and degrade interest rates as they are non-important and irrelevant in regarding to monetary policies. If private agents (consumers and firms) believe that policymakers are committed to lowering inflation, they will anticipate future prices to be lower than otherwise (how those expectations are formed is an entirely different matter; compare for instance rational expectations with adaptive expectations). If an employee expects prices to be high in the future, he or she will draw up a wage contract with a high wage to match these prices. Hence, the expectation of lower wages is reflected in wage-setting behavior between employees and employers (lower wages since prices are expected to be lower) and since wages are in fact lower there is no demand pull inflation because employees are receiving a smaller wage and there is no cost push inflation because employers are paying out less in wages.
In order to achieve this low level of inflation, policymakers must have credible announcements; that is, private agents must believe that these announcements will reflect actual future policy. If an announcement about low-level inflation targets is made but not believed by private agents, wage-setting will anticipate high-level inflation and so wages will be higher and inflation will rise. A high wage will increase a consumer's demand (demand pull inflation) and a firm's costs (cost push inflation), so inflation rises. Hence, if a policymaker's announcements regarding monetary policy are not credible, policy will not have the desired effect.
If policymakers believe that private agents anticipate low inflation, they have an incentive to adopt an expansionist monetary policy (where the marginal benefit of increasing economic output outweighs the marginal cost of inflation); however, assuming private agents have rational expectations, they know that policymakers have this incentive. Hence, private agents know that if they anticipate low inflation, an expansionist policy will be adopted that causes a rise in inflation. Consequently, (unless policymakers can make their announcement of low inflation credible), private agents expect high inflation. This anticipation is fulfilled through adaptive expectation (wage-setting behavior);so, there is higher inflation (without the benefit of increased output). Hence, unless credible announcements can be made, expansionary monetary policy will fail.
Announcements can be made credible in various ways. One is to establish an independent central bank with low inflation targets (but no output targets). Hence, private agents know that inflation will be low because it is set by an independent body. Central banks can be given incentives to meet their targets (for example, larger budgets, a wage bonus for the head of the bank) in order to increase their reputation and signal a strong commitment to a policy goal. Reputation is an important element in monetary policy implementation. But the idea of reputation should not be confused with commitment. While a central bank might have a favorable reputation due to good performance in conducting monetary policy, the same central bank might not have chosen any particular form of commitment (such as targeting a certain range for inflation). Reputation plays a crucial role in determining how much would markets believe the announcement of a particular commitment to a policy goal but both concepts should not be assimilated. Also, note that under rational expectations, it is not necessary for the policymaker to have established its reputation through past policy actions; as an example, the reputation of the head of the central bank might be derived entirely from his or her ideology, professional background, public statements, etc. In fact it has been argued (add citation to Kenneth Rogoff, 1985. "The Optimal Commitment to an Intermediate Monetary Target" in 'Quarterly Journal of Economics' #100, pp. 1169-1189) that in order to prevent some pathologies related to the time-inconsistency of monetary policy implementation (in particular excessive inflation), the head of a central bank should have a larger distaste for inflation than the rest of the economy on average. Hence the reputation of a particular central bank is not necessary tied to past performance, but rather to particular institutional arrangements that the markets can use to form inflation expectations.
Despite the frequent discussion of credibility as it relates to monetary policy, the exact meaning of credibility is rarely defined. Such lack of clarity can serve to lead policy away from what is believed to be the most beneficial. For example, capability to serve the public interest is one definition of credibility often associated with central banks. The reliability with which a central bank keeps its promises is also a common definition. While everyone most likely agrees a central bank should not lie to the public, wide disagreement exists on how a central bank can best serve the public interest. Therefore, lack of definition can lead people to believe they are supporting one particular policy of credibility when they are really supporting another.[3]
[edit] History of monetary policy
Monetary policy is primarily associated with interest rate and credit. For many centuries there were only two forms of monetary policy: (i) Decisions about coinage; (ii) Decisions to print paper money to create credit. Interest rates, while now thought of as part of monetary authority, were not generally coordinated with the other forms of monetary policy during this time. Monetary policy was seen as an executive decision, and was generally in the hands of the authority with seigniorage, or the power to coin. With the advent of larger trading networks came the ability to set the price between gold and silver, and the price of the local currency to foreign currencies. This official price could be enforced by law, even if it varied from the market price.
With the creation of the Bank of England in 1694, which acquired the responsibility to print notes and back them with gold, the idea of monetary policy as independent of executive action began to be established.[4] The goal of monetary policy was to maintain the value of the coinage, print notes which would trade at par to specie, and prevent coins from leaving circulation. The establishment of central banks by industrializing nations was associated then with the desire to maintain the nation's peg to the gold standard, and to trade in a narrow band with other gold-backed currencies. To accomplish this end, central banks as part of the gold standard began setting the interest rates that they charged, both their own borrowers, and other banks who required liquidity. The maintenance of a gold standard required almost monthly adjustments of interest rates.
During the 1870-1920 period the industrialized nations set up central banking systems, with one of the last being the Federal Reserve in 1913.[5] By this point the role of the central bank as the "lender of last resort" was understood. It was also increasingly understood that interest rates had an effect on the entire economy, in no small part because of the marginal revolution in economics, which focused on how many more, or how many fewer, people would make a decision based on a change in the economic trade-offs. It also became clear that there was a business cycle, and economic theory began understanding the relationship of interest rates to that cycle. (Nevertheless, steering a whole economy by influencing the interest rate has often been described as trying to steer an oil tanker with a canoe paddle.) Research by Cass Business School has also suggested that perhaps it is the central bank policies of expansionary and contractionary policies that are causing the economic cycle; evidence can be found by looking at the lack of cycles in economies before central banking policies existed.
Monetarist macroeconomists have sometimes advocated simply increasing the monetary supply at a low, constant rate, as the best way of maintaining low inflation and stable output growth.[6] However, when U.S. Federal Reserve Chairman Paul Volcker tried this policy, starting in October 1979, it was found to be impractical, because of the highly unstable relationship between monetary aggregates and other macroeconomic variables.[7] Even Milton Friedman acknowledged that money supply targeting was less successful than he had hoped, in an interview with the Financial Times on June 7, 2003.[8][9][10] Therefore, monetary decisions today take into account a wider range of factors, such as:
short term interest rates;
long term interest rates;
velocity of money through the economy;
exchange rates;
credit quality;
bonds and equities (corporate ownership and debt);
government versus private sector spending/savings;
international capital flows of money on large scales;
financial derivatives such as options, swaps, futures contracts, etc.
A small but vocal group of people advocate for a return to the gold standard (the elimination of the dollar's fiat currency status and even of the Federal Reserve Bank). Their argument is basically that monetary policy is fraught with risk and these risks will result in drastic harm to the populace should monetary policy fail. Others see another problem with our current monetary policy. The problem for them is not that our money has nothing physical to define its value, but that fractional reserve lending of that money as a debt to the recipient, rather than a credit, causes all but a small proportion of society (including all governments) to be perpetually in debt.
In fact, many economists disagree with returning to a gold standard. They argue that doing so would drastically limit the money supply, and throw away 100 years of advancement in monetary policy. The sometimes complex financial transactions that make big business (especially international business) easier and safer would be much more difficult if not impossible. Moreover, shifting risk to different people/companies that specialize in monitoring and using risk can turn any financial risk into a known dollar amount and therefore make business predictable and more profitable for everyone involved.
[edit] Trends in central banking
The central bank influences interest rates by expanding or contracting the monetary base, which consists of currency in circulation and banks' reserves on deposit at the central bank. The primary way that the central bank can affect the monetary base is by open market operations or sales and purchases of second hand government debt, or by changing the reserve requirements. If the central bank wishes to lower interest rates, it purchases government debt, thereby increasing the amount of cash in circulation or crediting banks' reserve accounts. Alternatively, it can lower the interest rate on discounts or overdrafts (loans to banks secured by suitable collateral, specified by the central bank). If the interest rate on such transactions is sufficiently low, commercial banks can borrow from the central bank to meet reserve requirements and use the additional liquidity to expand their balance sheets, increasing the credit available to the economy. Lowering reserve requirements has a similar effect, freeing up funds for banks to increase loans or buy other profitable assets.
A central bank can only operate a truly independent monetary policy when the exchange rate is floating.[11] If the exchange rate is pegged or managed in any way, the central bank will have to purchase or sell foreign exchange. These transactions in foreign exchange will have an effect on the monetary base analogous to open market purchases and sales of government debt; if the central bank buys foreign exchange, the monetary base expands, and vice versa. But even in the case of a pure floating exchange rate, central banks and monetary authorities can at best "lean against the wind" in a world where capital is mobile.
Accordingly, the management of the exchange rate will influence domestic monetary conditions. In order to maintain its monetary policy target, the central bank will have to sterilize or offset its foreign exchange operations. For example, if a central bank buys foreign exchange (to counteract appreciation of the exchange rate), base money will increase. Therefore, to sterilize that increase, the central bank must also sell government debt to contract the monetary base by an equal amount. It follows that turbulent activity in foreign exchange markets can cause a central bank to lose control of domestic monetary policy when it is also managing the exchange rate.
In the 1980s, many economists began to believe that making a nation's central bank independent of the rest of executive government is the best way to ensure an optimal monetary policy, and those central banks which did not have independence began to gain it. This is to avoid overt manipulation of the tools of monetary policies to effect political goals, such as re-electing the current government. Independence typically means that the members of the committee which conducts monetary policy have long, fixed terms. Obviously, this is a somewhat limited independence.
In the 1990s, central banks began adopting formal, public inflation targets with the goal of making the outcomes, if not the process, of monetary policy more transparent. In other words, a central bank may have an inflation target of 2% for a given year, and if inflation turns out to be 5%, then the central bank will typically have to submit an explanation.
The Bank of England exemplifies both these trends. It became independent of government through the Bank of England Act 1998 and adopted an inflation target of 2.5% RPI (now 2% of CPI).
The debate rages on about whether monetary policy can smooth business cycles or not. A central conjecture of Keynesian economics is that the central bank can stimulate aggregate demand in the short run, because a significant number of prices in the economy are fixed in the short run and firms will produce as many goods and services as are demanded (in the long run, however, money is neutral, as in the neoclassical model). There is also the Austrian school of economics, which includes Friedrich von Hayek and Ludwig von Mises's arguments, but most economists fall into either the Keynesian or neoclassical camps on this issue.
[edit] Developing countries
Developing countries may have problems establishing an effective operating monetary policy. The primary difficulty is that few developing countries have deep markets in government debt. The matter is further complicated by the difficulties in forecasting money demand and fiscal pressure to levy the inflation tax by expanding the monetary base rapidly. In general, the central banks in many developing countries have poor records in managing monetary policy. This is often because the monetary authority in a developing country is not independent of government, so good monetary policy takes a backseat to the political desires of the government or are used to pursue other non-monetary goals. For this and other reasons, developing countries that want to establish credible monetary policy may institute a currency board or adopt dollarization. Such forms of monetary institutions thus essentially tie the hands of the government from interference and, it is hoped, that such policies will import the monetary policy of the anchor nation.
Recent attempts at liberalizing and reforming the financial markets (particularly the recapitalization of banks and other financial institutions in Nigeria and elsewhere) are gradually providing the latitude required in order to implement monetary policy frameworks by the relevant central banks.
[edit] Types of monetary policy
In practice, all types of monetary policy involve modifying the amount of base currency (M0) in circulation. This process of changing the liquidity of base currency through the open sales and purchases of (government-issued) debt and credit instruments is called open market operations.
Constant market transactions by the monetary authority modify the supply of currency and this impacts other market variables such as short term interest rates and the exchange rate.
The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals.
Monetary Policy:
Target Market Variable:
Long Term Objective:
Inflation Targeting
Interest rate on overnight debt
A given rate of change in the CPI
Price Level Targeting
Interest rate on overnight debt
A specific CPI number
Monetary Aggregates
The growth in money supply
A given rate of change in the CPI
Fixed Exchange Rate
The spot price of the currency
The spot price of the currency
Gold Standard
The spot price of gold
Low inflation as measured by the gold price
Mixed Policy
Usually interest rates
Usually unemployment + CPI change
The different types of policy are also called monetary regimes, in parallel to exchange rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking the exact same variables (such as a harmonized consumer price index).
[edit] Inflation targeting
Main article: Inflation targeting
Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index, within a desired range.
The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate at which banks lend to each other overnight for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar.
The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee.
Changes to the interest rate target are made in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards achieving the defined inflation target. For example, one simple method of inflation targeting called the Taylor rule adjusts the interest rate in response to changes in the inflation rate and the output gap. The rule was proposed by John B. Taylor of Stanford University.[12]
The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It is currently used in Australia, Canada, Chile, the Eurozone, New Zealand, Norway, Iceland, Philippines, Poland, Sweden, South Africa, Turkey, and the United Kingdom.
[edit] Price level targeting
Price level targeting is similar to inflation targeting except that CPI growth in one year is offset in subsequent years such that over time the price level on aggregate does not move.
Something similar to price level targeting was tried by Sweden in the 1930s, and seems to have contributed to the relatively good performance of the Swedish economy during the Great Depression. As of 2004, no country operates monetary policy based on a price level target.
[edit] Monetary aggregates
In the 1980s, several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc). In the USA this approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed Chairman.
This approach is also sometimes called monetarism.
While most monetary policy focuses on a price signal of one form or another, this approach is focused on monetary quantities.
[edit] Fixed exchange rate
This policy is based on maintaining a fixed exchange rate with a foreign currency. There are varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the fixed exchange rate is with the anchor nation.
Under a system of fiat fixed rates, the local government or monetary authority declares a fixed exchange rate but does not actively buy or sell currency to maintain the rate. Instead, the rate is enforced by non-convertibility measures (e.g. capital controls, import/export licenses, etc.). In this case there is a black market exchange rate where the currency trades at its market/unofficial rate.
Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to buy or sell as necessary to maintain the exchange rate within the band. (In this case, the fixed exchange rate with a fixed level can be seen as a special case of the fixed exchange rate with bands where the bands are set to zero.)
Under a system of fixed exchange rates maintained by a currency board every unit of local currency must be backed by a unit of foreign currency (correcting for the exchange rate). This ensures that the local monetary base does not inflate without being backed by hard currency and eliminates any worries about a run on the local currency by those wishing to convert the local currency to the hard (anchor) currency.
Under dollarization, foreign currency (usually the US dollar, hence the term "dollarization") is used freely as the medium of exchange either exclusively or in parallel with local currency. This outcome can come about because the local population has lost all faith in the local currency, or it may also be a policy of the government (usually to rein in inflation and import credible monetary policy).
These policies often abdicate monetary policy to the foreign monetary authority or government as monetary policy in the pegging nation must align with monetary policy in the anchor nation to maintain the exchange rate. The degree to which local monetary policy becomes dependent on the anchor nation depends on factors such as capital mobility, openness, credit channels and other economic factors.
See also: List of fixed currencies
[edit] Gold standard
Main article: Gold standard
The gold standard is a system in which the price of the national currency as measured in units of gold bars and is kept constant by the daily buying and selling of base currency to other countries and nationals. (i.e. open market operations, cf. above). The selling of gold is very important for economic growth and stability.
The gold standard might be regarded as a special case of the "Fixed Exchange Rate" policy. And the gold price might be regarded as a special type of "Commodity Price Index".
Today this type of monetary policy is not used anywhere in the world, although a form of gold standard was used widely across the world prior to 1971. For details see the Bretton Woods system. Its major advantages were simplicity and transparency.
[edit] Policy of various nations
Australia - Inflation targeting
Brazil - Inflation targeting
Canada - Inflation targeting
Chile - Inflation targeting
China - Monetary Targeting and targets a currency basket
Eurozone - Inflation Targeting
Hong Kong - Currency board (fixed to US dollar)
India - Inflation Targeting
New Zealand - Inflation targeting
Singapore - Exchange rate targeting
South Africa - Inflation targeting
Turkey - Inflation targeting
United Kingdom[13] - Inflation Targeting, alongside secondary targets on 'output and employment'.
United States[14] - Mixed policy (and since the 1980s it is well fitted/described by the "Taylor rule" which shows that the Fed funds rate responds to shocks in inflation and output)
Further information: Monetary policy of the USA
[edit] Monetary policy tools
[edit] Monetary base
Monetary policy can be implemented by changing the size of the monetary base. This directly changes the total amount of money circulating in the economy. A central bank can use open market operations to change the monetary base. The central bank would buy/sell bonds in exchange for hard currency. When the central bank disburses/collects this hard currency payment, it alters the amount of currency in the economy, thus altering the monetary base.
[edit] Reserve requirements
The monetary authority exerts regulatory control over banks. Monetary policy can be implemented by changing the proportion of total assets that banks must hold in reserve with the central bank. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes the availability of loanable funds. This acts as a change in the money supply. Banks typically do not change the reserve requirements often because it creates very volatile changes in the money supply due to the lending multiplier.
[edit] Discount window lending
Many central banks or finance ministries have the authority to lend funds to financial institutions within their country. By calling in existing loans or extending new loans, the monetary authority can directly change the size of the money supply.
[edit] Interest rates
The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest rates. Monetary authorities in different nations have differing levels of control of economy-wide interest rates. In the United States, the Federal Reserve can set the discount rate, as well as achieve the desired Federal funds rate by open market operations. This rate has significant effect on other market interest rates, but there is no perfect relationship. In the United States open market operations are a relatively small part of the total volume in the bond market. One cannot set independent targets for both the monetary base and the interest rate because they are both modified by a single tool — open market operations; one must choose which one to control.
In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By raising the interest rate(s) under its control, a monetary authority can contract the money supply, because higher interest rates encourage savings and discourage borrowing. Both of these effects reduce the size of the money supply.
[edit] Currency board
Main article: currency board
A currency board is a monetary arrangement which pegs the monetary base of a country to that of an anchor nation. As such, it essentially operates as a hard fixed exchange rate, whereby local currency in circulation is backed by foreign currency from the anchor nation at a fixed rate. Thus, to grow the local monetary base an equivalent amount of foreign currency must be held in reserves with the currency board. This limits the possibility for the local monetary authority to inflate or pursue other objectives. The principal rationales behind a currency board are three-fold:
To import monetary credibility of the anchor nation;
To maintain a fixed exchange rate with the anchor nation;
To establish credibility with the exchange rate (the currency board arrangement is the hardest form of fixed exchange rates outside of dollarization).
In theory, it is possible that a country may peg the local currency to more than one foreign currency; although, in practice this has never happened (and it would be a more complicated to run than a simple single-currency currency board). A gold standard is a special case of a currency board where the value of the national currency is linked to the value of gold instead of a foreign currency.
The currency board in question will no longer issue fiat money but instead will only issue a set number of units of local currency for each unit of foreign currency it has in its vault. The surplus on the balance of payments of that country is reflected by higher deposits local banks hold at the central bank as well as (initially) higher deposits of the (net) exporting firms at their local banks. The growth of the domestic money supply can now be coupled to the additional deposits of the banks at the central bank that equals additional hard foreign exchange reserves in the hands of the central bank. The virtue of this system is that questions of currency stability no longer apply. The drawbacks are that the country no longer has the ability to set monetary policy according to other domestic considerations, and that the fixed exchange rate will, to a large extent, also fix a country's terms of trade, irrespective of economic differences between it and its trading partners.
Hong Kong operates a currency board, as does Bulgaria. Estonia established a currency board pegged to the Deutschmark in 1992 after gaining independence, and this policy is seen as a mainstay of that country's subsequent economic success (see Economy of Estonia for a detailed description of the Estonian currency board). Argentina abandoned its currency board in January 2002 after a severe recession. This emphasized the fact that currency boards are not irrevocable, and hence may be abandoned in the face of speculation by foreign exchange traders. Following the signing of the Dayton Peace Agreement in 1995, Bosnia and Herzegovina established a currency board pegged to the Deutschmark (since 2002 replaced by the Euro).
Currency boards have advantages for small, open economies which would find independent monetary policy difficult to sustain. They can also form a credible commitment to low inflation.
Monetary policy is referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates in order to combat inflation. Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation.[2]
Contents
1 Overview
1.1 Theory
2 History of monetary policy
2.1 Trends in central banking
2.2 Developing countries
3 Types of monetary policy
3.1 Inflation targeting
3.2 Price level targeting
3.3 Monetary aggregates
3.4 Fixed exchange rate
3.5 Gold standard
3.6 Policy of various nations
4 Monetary policy tools
4.1 Monetary base
4.2 Reserve requirements
4.3 Discount window lending
4.4 Interest rates
4.5 Currency board
5 See also
6 References
//
[edit] Overview
Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (in order to achieve policy goals). The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard.
A policy is referred to as contractionary if it reduces the size of the money supply or raises the interest rate. An expansionary policy increases the size of the money supply, or decreases the interest rate. Furthermore, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation.
There are several monetary policy tools available to achieve these ends: increasing interest rates by fiat; reducing the monetary base; and increasing reserve requirements. All have the effect of contracting the money supply; and, if reversed, expand the money supply. Since the 1970s, monetary policy has generally been formed separately from fiscal policy. Even prior to the 1970s, the Bretton Woods system still ensured that most nations would form the two policies separately.
Within almost all modern nations, special institutions (such as the Bank of England, the European Central Bank, Reserve Bank of India, the Federal Reserve System in the United States, the Bank of Japan, the Bank of Canada or the Reserve Bank of Australia) exist which have the task of executing the monetary policy and often independently of the executive. In general, these institutions are called central banks and often have other responsibilities such as supervising the smooth operation of the financial system.
The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various credit instruments, foreign currencies or commodities. All of these purchases or sales result in more or less base currency entering or leaving market circulation.
Usually, the short term goal of open market operations is to achieve a specific short term interest rate target. In other instances, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency or else relative to gold. For example, in the case of the USA the Federal Reserve targets the federal funds rate, the rate at which member banks lend to one another overnight; however, the monetary policy of China is to target the exchange rate between the Chinese renminbi and a basket of foreign currencies.
The other primary means of conducting monetary policy include: (i) Discount window lending (lender of last resort); (ii) Fractional deposit lending (changes in the reserve requirement); (iii) Moral suasion (cajoling certain market players to achieve specified outcomes); (iv) "Open mouth operations" (talking monetary policy with the market).
[edit] Theory
Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy.[1] Monetary theory provides insight into how to craft optimal monetary policy.
Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (in order to achieve policy goals). The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard. A policy is referred to as contractionary if it reduces the size of the money supply or raises the interest rate. An expansionary policy increases the size of the money supply, or decreases the interest rate. Furthermore, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation.
It is important for policymakers to make credible announcements and degrade interest rates as they are non-important and irrelevant in regarding to monetary policies. If private agents (consumers and firms) believe that policymakers are committed to lowering inflation, they will anticipate future prices to be lower than otherwise (how those expectations are formed is an entirely different matter; compare for instance rational expectations with adaptive expectations). If an employee expects prices to be high in the future, he or she will draw up a wage contract with a high wage to match these prices. Hence, the expectation of lower wages is reflected in wage-setting behavior between employees and employers (lower wages since prices are expected to be lower) and since wages are in fact lower there is no demand pull inflation because employees are receiving a smaller wage and there is no cost push inflation because employers are paying out less in wages.
In order to achieve this low level of inflation, policymakers must have credible announcements; that is, private agents must believe that these announcements will reflect actual future policy. If an announcement about low-level inflation targets is made but not believed by private agents, wage-setting will anticipate high-level inflation and so wages will be higher and inflation will rise. A high wage will increase a consumer's demand (demand pull inflation) and a firm's costs (cost push inflation), so inflation rises. Hence, if a policymaker's announcements regarding monetary policy are not credible, policy will not have the desired effect.
If policymakers believe that private agents anticipate low inflation, they have an incentive to adopt an expansionist monetary policy (where the marginal benefit of increasing economic output outweighs the marginal cost of inflation); however, assuming private agents have rational expectations, they know that policymakers have this incentive. Hence, private agents know that if they anticipate low inflation, an expansionist policy will be adopted that causes a rise in inflation. Consequently, (unless policymakers can make their announcement of low inflation credible), private agents expect high inflation. This anticipation is fulfilled through adaptive expectation (wage-setting behavior);so, there is higher inflation (without the benefit of increased output). Hence, unless credible announcements can be made, expansionary monetary policy will fail.
Announcements can be made credible in various ways. One is to establish an independent central bank with low inflation targets (but no output targets). Hence, private agents know that inflation will be low because it is set by an independent body. Central banks can be given incentives to meet their targets (for example, larger budgets, a wage bonus for the head of the bank) in order to increase their reputation and signal a strong commitment to a policy goal. Reputation is an important element in monetary policy implementation. But the idea of reputation should not be confused with commitment. While a central bank might have a favorable reputation due to good performance in conducting monetary policy, the same central bank might not have chosen any particular form of commitment (such as targeting a certain range for inflation). Reputation plays a crucial role in determining how much would markets believe the announcement of a particular commitment to a policy goal but both concepts should not be assimilated. Also, note that under rational expectations, it is not necessary for the policymaker to have established its reputation through past policy actions; as an example, the reputation of the head of the central bank might be derived entirely from his or her ideology, professional background, public statements, etc. In fact it has been argued (add citation to Kenneth Rogoff, 1985. "The Optimal Commitment to an Intermediate Monetary Target" in 'Quarterly Journal of Economics' #100, pp. 1169-1189) that in order to prevent some pathologies related to the time-inconsistency of monetary policy implementation (in particular excessive inflation), the head of a central bank should have a larger distaste for inflation than the rest of the economy on average. Hence the reputation of a particular central bank is not necessary tied to past performance, but rather to particular institutional arrangements that the markets can use to form inflation expectations.
Despite the frequent discussion of credibility as it relates to monetary policy, the exact meaning of credibility is rarely defined. Such lack of clarity can serve to lead policy away from what is believed to be the most beneficial. For example, capability to serve the public interest is one definition of credibility often associated with central banks. The reliability with which a central bank keeps its promises is also a common definition. While everyone most likely agrees a central bank should not lie to the public, wide disagreement exists on how a central bank can best serve the public interest. Therefore, lack of definition can lead people to believe they are supporting one particular policy of credibility when they are really supporting another.[3]
[edit] History of monetary policy
Monetary policy is primarily associated with interest rate and credit. For many centuries there were only two forms of monetary policy: (i) Decisions about coinage; (ii) Decisions to print paper money to create credit. Interest rates, while now thought of as part of monetary authority, were not generally coordinated with the other forms of monetary policy during this time. Monetary policy was seen as an executive decision, and was generally in the hands of the authority with seigniorage, or the power to coin. With the advent of larger trading networks came the ability to set the price between gold and silver, and the price of the local currency to foreign currencies. This official price could be enforced by law, even if it varied from the market price.
With the creation of the Bank of England in 1694, which acquired the responsibility to print notes and back them with gold, the idea of monetary policy as independent of executive action began to be established.[4] The goal of monetary policy was to maintain the value of the coinage, print notes which would trade at par to specie, and prevent coins from leaving circulation. The establishment of central banks by industrializing nations was associated then with the desire to maintain the nation's peg to the gold standard, and to trade in a narrow band with other gold-backed currencies. To accomplish this end, central banks as part of the gold standard began setting the interest rates that they charged, both their own borrowers, and other banks who required liquidity. The maintenance of a gold standard required almost monthly adjustments of interest rates.
During the 1870-1920 period the industrialized nations set up central banking systems, with one of the last being the Federal Reserve in 1913.[5] By this point the role of the central bank as the "lender of last resort" was understood. It was also increasingly understood that interest rates had an effect on the entire economy, in no small part because of the marginal revolution in economics, which focused on how many more, or how many fewer, people would make a decision based on a change in the economic trade-offs. It also became clear that there was a business cycle, and economic theory began understanding the relationship of interest rates to that cycle. (Nevertheless, steering a whole economy by influencing the interest rate has often been described as trying to steer an oil tanker with a canoe paddle.) Research by Cass Business School has also suggested that perhaps it is the central bank policies of expansionary and contractionary policies that are causing the economic cycle; evidence can be found by looking at the lack of cycles in economies before central banking policies existed.
Monetarist macroeconomists have sometimes advocated simply increasing the monetary supply at a low, constant rate, as the best way of maintaining low inflation and stable output growth.[6] However, when U.S. Federal Reserve Chairman Paul Volcker tried this policy, starting in October 1979, it was found to be impractical, because of the highly unstable relationship between monetary aggregates and other macroeconomic variables.[7] Even Milton Friedman acknowledged that money supply targeting was less successful than he had hoped, in an interview with the Financial Times on June 7, 2003.[8][9][10] Therefore, monetary decisions today take into account a wider range of factors, such as:
short term interest rates;
long term interest rates;
velocity of money through the economy;
exchange rates;
credit quality;
bonds and equities (corporate ownership and debt);
government versus private sector spending/savings;
international capital flows of money on large scales;
financial derivatives such as options, swaps, futures contracts, etc.
A small but vocal group of people advocate for a return to the gold standard (the elimination of the dollar's fiat currency status and even of the Federal Reserve Bank). Their argument is basically that monetary policy is fraught with risk and these risks will result in drastic harm to the populace should monetary policy fail. Others see another problem with our current monetary policy. The problem for them is not that our money has nothing physical to define its value, but that fractional reserve lending of that money as a debt to the recipient, rather than a credit, causes all but a small proportion of society (including all governments) to be perpetually in debt.
In fact, many economists disagree with returning to a gold standard. They argue that doing so would drastically limit the money supply, and throw away 100 years of advancement in monetary policy. The sometimes complex financial transactions that make big business (especially international business) easier and safer would be much more difficult if not impossible. Moreover, shifting risk to different people/companies that specialize in monitoring and using risk can turn any financial risk into a known dollar amount and therefore make business predictable and more profitable for everyone involved.
[edit] Trends in central banking
The central bank influences interest rates by expanding or contracting the monetary base, which consists of currency in circulation and banks' reserves on deposit at the central bank. The primary way that the central bank can affect the monetary base is by open market operations or sales and purchases of second hand government debt, or by changing the reserve requirements. If the central bank wishes to lower interest rates, it purchases government debt, thereby increasing the amount of cash in circulation or crediting banks' reserve accounts. Alternatively, it can lower the interest rate on discounts or overdrafts (loans to banks secured by suitable collateral, specified by the central bank). If the interest rate on such transactions is sufficiently low, commercial banks can borrow from the central bank to meet reserve requirements and use the additional liquidity to expand their balance sheets, increasing the credit available to the economy. Lowering reserve requirements has a similar effect, freeing up funds for banks to increase loans or buy other profitable assets.
A central bank can only operate a truly independent monetary policy when the exchange rate is floating.[11] If the exchange rate is pegged or managed in any way, the central bank will have to purchase or sell foreign exchange. These transactions in foreign exchange will have an effect on the monetary base analogous to open market purchases and sales of government debt; if the central bank buys foreign exchange, the monetary base expands, and vice versa. But even in the case of a pure floating exchange rate, central banks and monetary authorities can at best "lean against the wind" in a world where capital is mobile.
Accordingly, the management of the exchange rate will influence domestic monetary conditions. In order to maintain its monetary policy target, the central bank will have to sterilize or offset its foreign exchange operations. For example, if a central bank buys foreign exchange (to counteract appreciation of the exchange rate), base money will increase. Therefore, to sterilize that increase, the central bank must also sell government debt to contract the monetary base by an equal amount. It follows that turbulent activity in foreign exchange markets can cause a central bank to lose control of domestic monetary policy when it is also managing the exchange rate.
In the 1980s, many economists began to believe that making a nation's central bank independent of the rest of executive government is the best way to ensure an optimal monetary policy, and those central banks which did not have independence began to gain it. This is to avoid overt manipulation of the tools of monetary policies to effect political goals, such as re-electing the current government. Independence typically means that the members of the committee which conducts monetary policy have long, fixed terms. Obviously, this is a somewhat limited independence.
In the 1990s, central banks began adopting formal, public inflation targets with the goal of making the outcomes, if not the process, of monetary policy more transparent. In other words, a central bank may have an inflation target of 2% for a given year, and if inflation turns out to be 5%, then the central bank will typically have to submit an explanation.
The Bank of England exemplifies both these trends. It became independent of government through the Bank of England Act 1998 and adopted an inflation target of 2.5% RPI (now 2% of CPI).
The debate rages on about whether monetary policy can smooth business cycles or not. A central conjecture of Keynesian economics is that the central bank can stimulate aggregate demand in the short run, because a significant number of prices in the economy are fixed in the short run and firms will produce as many goods and services as are demanded (in the long run, however, money is neutral, as in the neoclassical model). There is also the Austrian school of economics, which includes Friedrich von Hayek and Ludwig von Mises's arguments, but most economists fall into either the Keynesian or neoclassical camps on this issue.
[edit] Developing countries
Developing countries may have problems establishing an effective operating monetary policy. The primary difficulty is that few developing countries have deep markets in government debt. The matter is further complicated by the difficulties in forecasting money demand and fiscal pressure to levy the inflation tax by expanding the monetary base rapidly. In general, the central banks in many developing countries have poor records in managing monetary policy. This is often because the monetary authority in a developing country is not independent of government, so good monetary policy takes a backseat to the political desires of the government or are used to pursue other non-monetary goals. For this and other reasons, developing countries that want to establish credible monetary policy may institute a currency board or adopt dollarization. Such forms of monetary institutions thus essentially tie the hands of the government from interference and, it is hoped, that such policies will import the monetary policy of the anchor nation.
Recent attempts at liberalizing and reforming the financial markets (particularly the recapitalization of banks and other financial institutions in Nigeria and elsewhere) are gradually providing the latitude required in order to implement monetary policy frameworks by the relevant central banks.
[edit] Types of monetary policy
In practice, all types of monetary policy involve modifying the amount of base currency (M0) in circulation. This process of changing the liquidity of base currency through the open sales and purchases of (government-issued) debt and credit instruments is called open market operations.
Constant market transactions by the monetary authority modify the supply of currency and this impacts other market variables such as short term interest rates and the exchange rate.
The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals.
Monetary Policy:
Target Market Variable:
Long Term Objective:
Inflation Targeting
Interest rate on overnight debt
A given rate of change in the CPI
Price Level Targeting
Interest rate on overnight debt
A specific CPI number
Monetary Aggregates
The growth in money supply
A given rate of change in the CPI
Fixed Exchange Rate
The spot price of the currency
The spot price of the currency
Gold Standard
The spot price of gold
Low inflation as measured by the gold price
Mixed Policy
Usually interest rates
Usually unemployment + CPI change
The different types of policy are also called monetary regimes, in parallel to exchange rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking the exact same variables (such as a harmonized consumer price index).
[edit] Inflation targeting
Main article: Inflation targeting
Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index, within a desired range.
The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate at which banks lend to each other overnight for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar.
The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee.
Changes to the interest rate target are made in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards achieving the defined inflation target. For example, one simple method of inflation targeting called the Taylor rule adjusts the interest rate in response to changes in the inflation rate and the output gap. The rule was proposed by John B. Taylor of Stanford University.[12]
The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It is currently used in Australia, Canada, Chile, the Eurozone, New Zealand, Norway, Iceland, Philippines, Poland, Sweden, South Africa, Turkey, and the United Kingdom.
[edit] Price level targeting
Price level targeting is similar to inflation targeting except that CPI growth in one year is offset in subsequent years such that over time the price level on aggregate does not move.
Something similar to price level targeting was tried by Sweden in the 1930s, and seems to have contributed to the relatively good performance of the Swedish economy during the Great Depression. As of 2004, no country operates monetary policy based on a price level target.
[edit] Monetary aggregates
In the 1980s, several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc). In the USA this approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed Chairman.
This approach is also sometimes called monetarism.
While most monetary policy focuses on a price signal of one form or another, this approach is focused on monetary quantities.
[edit] Fixed exchange rate
This policy is based on maintaining a fixed exchange rate with a foreign currency. There are varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the fixed exchange rate is with the anchor nation.
Under a system of fiat fixed rates, the local government or monetary authority declares a fixed exchange rate but does not actively buy or sell currency to maintain the rate. Instead, the rate is enforced by non-convertibility measures (e.g. capital controls, import/export licenses, etc.). In this case there is a black market exchange rate where the currency trades at its market/unofficial rate.
Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to buy or sell as necessary to maintain the exchange rate within the band. (In this case, the fixed exchange rate with a fixed level can be seen as a special case of the fixed exchange rate with bands where the bands are set to zero.)
Under a system of fixed exchange rates maintained by a currency board every unit of local currency must be backed by a unit of foreign currency (correcting for the exchange rate). This ensures that the local monetary base does not inflate without being backed by hard currency and eliminates any worries about a run on the local currency by those wishing to convert the local currency to the hard (anchor) currency.
Under dollarization, foreign currency (usually the US dollar, hence the term "dollarization") is used freely as the medium of exchange either exclusively or in parallel with local currency. This outcome can come about because the local population has lost all faith in the local currency, or it may also be a policy of the government (usually to rein in inflation and import credible monetary policy).
These policies often abdicate monetary policy to the foreign monetary authority or government as monetary policy in the pegging nation must align with monetary policy in the anchor nation to maintain the exchange rate. The degree to which local monetary policy becomes dependent on the anchor nation depends on factors such as capital mobility, openness, credit channels and other economic factors.
See also: List of fixed currencies
[edit] Gold standard
Main article: Gold standard
The gold standard is a system in which the price of the national currency as measured in units of gold bars and is kept constant by the daily buying and selling of base currency to other countries and nationals. (i.e. open market operations, cf. above). The selling of gold is very important for economic growth and stability.
The gold standard might be regarded as a special case of the "Fixed Exchange Rate" policy. And the gold price might be regarded as a special type of "Commodity Price Index".
Today this type of monetary policy is not used anywhere in the world, although a form of gold standard was used widely across the world prior to 1971. For details see the Bretton Woods system. Its major advantages were simplicity and transparency.
[edit] Policy of various nations
Australia - Inflation targeting
Brazil - Inflation targeting
Canada - Inflation targeting
Chile - Inflation targeting
China - Monetary Targeting and targets a currency basket
Eurozone - Inflation Targeting
Hong Kong - Currency board (fixed to US dollar)
India - Inflation Targeting
New Zealand - Inflation targeting
Singapore - Exchange rate targeting
South Africa - Inflation targeting
Turkey - Inflation targeting
United Kingdom[13] - Inflation Targeting, alongside secondary targets on 'output and employment'.
United States[14] - Mixed policy (and since the 1980s it is well fitted/described by the "Taylor rule" which shows that the Fed funds rate responds to shocks in inflation and output)
Further information: Monetary policy of the USA
[edit] Monetary policy tools
[edit] Monetary base
Monetary policy can be implemented by changing the size of the monetary base. This directly changes the total amount of money circulating in the economy. A central bank can use open market operations to change the monetary base. The central bank would buy/sell bonds in exchange for hard currency. When the central bank disburses/collects this hard currency payment, it alters the amount of currency in the economy, thus altering the monetary base.
[edit] Reserve requirements
The monetary authority exerts regulatory control over banks. Monetary policy can be implemented by changing the proportion of total assets that banks must hold in reserve with the central bank. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes the availability of loanable funds. This acts as a change in the money supply. Banks typically do not change the reserve requirements often because it creates very volatile changes in the money supply due to the lending multiplier.
[edit] Discount window lending
Many central banks or finance ministries have the authority to lend funds to financial institutions within their country. By calling in existing loans or extending new loans, the monetary authority can directly change the size of the money supply.
[edit] Interest rates
The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest rates. Monetary authorities in different nations have differing levels of control of economy-wide interest rates. In the United States, the Federal Reserve can set the discount rate, as well as achieve the desired Federal funds rate by open market operations. This rate has significant effect on other market interest rates, but there is no perfect relationship. In the United States open market operations are a relatively small part of the total volume in the bond market. One cannot set independent targets for both the monetary base and the interest rate because they are both modified by a single tool — open market operations; one must choose which one to control.
In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By raising the interest rate(s) under its control, a monetary authority can contract the money supply, because higher interest rates encourage savings and discourage borrowing. Both of these effects reduce the size of the money supply.
[edit] Currency board
Main article: currency board
A currency board is a monetary arrangement which pegs the monetary base of a country to that of an anchor nation. As such, it essentially operates as a hard fixed exchange rate, whereby local currency in circulation is backed by foreign currency from the anchor nation at a fixed rate. Thus, to grow the local monetary base an equivalent amount of foreign currency must be held in reserves with the currency board. This limits the possibility for the local monetary authority to inflate or pursue other objectives. The principal rationales behind a currency board are three-fold:
To import monetary credibility of the anchor nation;
To maintain a fixed exchange rate with the anchor nation;
To establish credibility with the exchange rate (the currency board arrangement is the hardest form of fixed exchange rates outside of dollarization).
In theory, it is possible that a country may peg the local currency to more than one foreign currency; although, in practice this has never happened (and it would be a more complicated to run than a simple single-currency currency board). A gold standard is a special case of a currency board where the value of the national currency is linked to the value of gold instead of a foreign currency.
The currency board in question will no longer issue fiat money but instead will only issue a set number of units of local currency for each unit of foreign currency it has in its vault. The surplus on the balance of payments of that country is reflected by higher deposits local banks hold at the central bank as well as (initially) higher deposits of the (net) exporting firms at their local banks. The growth of the domestic money supply can now be coupled to the additional deposits of the banks at the central bank that equals additional hard foreign exchange reserves in the hands of the central bank. The virtue of this system is that questions of currency stability no longer apply. The drawbacks are that the country no longer has the ability to set monetary policy according to other domestic considerations, and that the fixed exchange rate will, to a large extent, also fix a country's terms of trade, irrespective of economic differences between it and its trading partners.
Hong Kong operates a currency board, as does Bulgaria. Estonia established a currency board pegged to the Deutschmark in 1992 after gaining independence, and this policy is seen as a mainstay of that country's subsequent economic success (see Economy of Estonia for a detailed description of the Estonian currency board). Argentina abandoned its currency board in January 2002 after a severe recession. This emphasized the fact that currency boards are not irrevocable, and hence may be abandoned in the face of speculation by foreign exchange traders. Following the signing of the Dayton Peace Agreement in 1995, Bosnia and Herzegovina established a currency board pegged to the Deutschmark (since 2002 replaced by the Euro).
Currency boards have advantages for small, open economies which would find independent monetary policy difficult to sustain. They can also form a credible commitment to low inflation.
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