In our last post, we talked about how an increase in potential GDP is effectively economic growth. This growth, however, is not always a smooth ride, with real GDP fluctuating around potential GDP, since supply and demand for GDP are always changing. This is essentially the business cycle.
What does the government do to stabilize the business cycle? It enacts fiscal policy, which involves setting tax rates and government expenditures. One example is using tax cuts (to increase consumption) and/or government expenditures to increase demand for GDP. Such measures are used to bring real GDP back to potential GDP levels.
Another issue that arises with fluctuating real GDP is inflation. We define inflation as an increase in prices.
Why do prices change? There are two main causes, one from the demand side and one from the supply side.
Demand-pull inflation happens when demand for GDP increases, pushing real GDP beyond potential GDP. While this may seem like a good thing, eventually wages rise because of a shortage of labor (ie, low unemployment rate). As a result, supply of GDP decreases, bringing real GDP back to potential GDP levels. Demand-pull inflation could be a one-time event, but the only way for it to happen persistently is as a result of monetary policy (which we explain below), where the government increases the supply of money.
Cost-push inflation occurs due to two main reasons:
- Wages increase, or
- The price of raw materials increase
A good example of the effects of changes in the price of raw materials is the case of oil. If oil prices continually increase, supply of GDP decreases (because costs for firms are higher), pulling real GDP below potential GDP levels. The combination of decreasing real GDP and inflation is known as stagflation.
It’s important to note that the problem of fluctuating GDP is absent when inflation is expected. This is because demand for GDP is accurately forecasted, and as a result wages change to keep supply matched with demand of GDP.
Since inflation involves fluctuating real GDP, it is interrelated with the business cycle and unemployment. As a result, being able to forecast inflation is a very important task for economists.
That’s not a particularly easy job. In the case where inflation does go awry, the central bank steps in to resolve the situation, by enacting monetary policy, where it changes the country’s interest rates to influence GDP. This is achieved in the following manner:
A central bank is essentially the banks’ bank. All banks keep a deposit (also known as reserves) with the central bank. What the central bank does is, depending on the situation, buy or sell government securities (for example, government bonds) from or to banks or the public. It does so by increasing reserves (borrowing from banks) to pay for these bonds, or decreasing reserves by selling these bonds to the banks. This sets off a ripple effect that leads to a change in interest rates and eventually a change in GDP, which we explain below:
Although all major central banks function in a similar fashion, let’s take a look at the US Fed (the central bank of the US) for a clear example.
- When the Fed buys government securities (also known as an open market purchase), banks end up with excess reserves.
- These banks lend the excess reserves to earn interest. Because of the law of supply and demand, the interest rate on these reserves fall, since the supply of them is now larger.
- Next, bank deposits increase because of the reserves being loaned. This increase in deposits means a further increase in loans, since banks lend these deposits out. Essentially, the supply of money increases.
- Since there are a lot more loans in the market, interest rates fall.
- Since interest rates fall, businesses borrow more, and GDP increases.
When the Fed wants to hike interest rates, it does the reverse action, starting with an open market sale, which causes a ripple effect that is the reverse of what we’ve outlined above.
Phew! That was a lot to cover. And these are just the basics! Hopefully this series of articles provides you with a framework to understand what happens when you here about inflation, interest rates, central banks, et cetera et cetera.
I would like to end this series with a few caveats:
- What we’ve just gone over is mainstream economic theory. Look around and you’re bound to find people who disagree with some (or all) of what we’ve just gone through.
- Hopefully I haven’t made fiscal and monetary policy seem too simplistic, because their mandates and actions are much more complex. These are just the bare essentials!
See you in the next post!
Ramon Rodrigo Cuenca, CFA
CFA Program Curriculum Level I, 2009, volume 2: Economics, pp. 360-362, 384-386, 388-389, 391-392, 454-457