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Im trying to analyse a situation where a country is using is using monetary policies to control its inflation. The policies they are using are high interest rates, and increasing the amount of money in banks (so less is loaned out). Now in the situation there is no mention that inflation is due to excess money in the economy, however it is mentioned that food inflation is very high, as well as non-food inflation. The CPI is high! My best guess is that there is demand-pull inflation, due to the fact that output can't meet demand, and thats why food prices are soo high. Not mentioned in the passage but we all know that China is experiencing rapid population increase, maybe thats why demand pull inflation, am I right? Perhaps there is also inflation due to more money in the economy ->because they are using monetary policies. I dont know if there's both type of inflation or one. 1-So, can we both types of inflation at the same time. If so, how would we get rid of inflation, or reduce inflation, what policies can the country use (also their effects in long run and short run)? I thought that contractionary fiscal policies might work, but then again high taxes not desirable by the government, since they want to get re-elected next time. 2-It is also hinted that high interest rates is not a good strategy, but I dont know why? 3- What could be the best policy? and how would it work to reduce aggregate demnad, or decrease aggregate supply. 4- Im also confused by the fact that what would each policy do, decrease AD and shift it to the left, or decrease Rhode Island (and shift it to the left)? Thanks for any help!
Inflation Policies By Catherine Capozzi, eHow Contributor If you go to the grocery store and notice the cost of staples such as bread, milk and cheese are higher, you might be noticing inflation. Economists measure inflation through the compilation of the Consumer Price Index. A basket of goods containing basic commodities such as eggs, milk and cheese is assembled and the prices of the products are compared over time. If the Federal Reserve believes prices of goods are increasing too quickly, or wants to incite a rise in prices, they use inflation policies to contract or expand the money supply. Interest Rates One tool the Federal Reserve uses to incite inflation is managing the interest rates. When interest rates are low, consumers are encouraged to take out large loans for cars, homes or other significant expenditures. When the consumer receives this loan, this amount of money is introduced into the economy and the money supply expands. In addition to the principal amount of the loan, the amount of interest on the loan is money added to the money supply. Conversely, if the Federal Reserve wants to avoid rising prices, one potential solution is raising interest rates. The Reagan administration raised interest rates to a whopping 21.5 percent to contract the money supply as a result of the hyperinflation that ravaged the economy. Quantitative Easing When interest rates are already at very low levels, the Fed then uses the inflation policy of quantitative easing. This policy is when central banks buy assets such as government securities and corporate bonds. These assets serve as an infusion of capital to financial institutions. The rise in assets for these banks promotes lending activity, which in turn increases the money supply. A 2010 Wall Street Journal article detailed how the Fed had engaged in quantitative easing by purchasing $7.26 billion in securities as means of curtailing deflation. Benefits Expanding the money supply through such policies is believed to have some benefits. When more money is available, consumers ideally buy more goods and firms hire more workers to accommodate the additional economic activity. Harvard professor and economist Gregory Mankiw explains that rising inflation levels tend to lower the unemployment rate. Thus, a primary goal of inflationary policies is to improve the level of unemployment. Warning Inflation policies must be implemented carefully to avoid disastrous consequences. For example, Zimbabwe flooded its country with cheap money and caused hyperinflation. Hyperinflation meant the costs of goods and services rose exponentially and wiped out the savings of its population. Additionally, inflationary policies do not always reduce the unemployment rate. Stagflation is an economic period when prices and the unemployment rate are both high.