When faced with an overheated economy, that is, when inflation is rising over the bank’s target level, the central bank will typically increase interest rates says Peter Decaprio. This causes people to spend less on consumption and more on savings (which increases the supply of money) since there is now a higher return on saving than spending. The reduced consumption also curtails demand in the economy (since people are buying fewer goods), which in turn decreases prices in the economy. All these factors cause inflation to fall back down below its original target level.
You can find more information on this link. When inflation is out of control, the central bank will increase interest rates to curb spending and decrease demand. I kept it simple for you here.
Here is how to use monetary policy to control an overheated economy:
- Additionally, monetary policy needs to be conducted in coordination with fiscal policy (i.e., government expenditures). For example, if there is a budget surplus, the central bank may need to cut interest rates because people are holding onto their money instead of spending it. Similarly, government actions that reduce prices of imported goods play an important role in maintaining price stability as well because this reduces cost-push inflation. The dollar’s buying power comes into play too where countries with weaker currencies will have higher inflation. To read about implications of different economic policies for emerging markets, please check out this article.
- How would a central bank change its money supply in response to an increase in consumer spending? By increasing the money supply. The Federal Reserve controls the country’s monetary policy and it implemented quantitative easing after the 2008 financial crisis. Peter Decaprio says if you’re interested, here’s a link that discusses the effects of quantitative easing: Effects of Quantitative Easing.
- So what is the connection between interest rates, inflation and exchange rates? Interest rate increases will typically cause a currency to appreciate because capital flows out of low-yielding investments in countries with lower interest rates into countries where they can get a better return. The increased demand for that currency causes its price (the exchange rate) to increase. However, expansionary monetary policy also causes inflation by increasing the money supply, which will weaken demand for the currency and cause it to depreciate. Here’s an article on how interest rates affect currencies: How do Interest Rates Affect Currency Exchange Rates
- You said “an overheated economy,” does this mean it’s at its capacity limits? Capacity limits refer to when an economy has exhausted all resources such as labor, raw materials and capital. At this point, factors of production are fully utilized and there is no room for any more growth without inflation occurs or a recession occurring due to a decrease in output.
- It seems that the economy being “overheated” would mean it’s not at its capacity limits? If an economy is overheating, it means there is excess demand (i.e., more people looking to buy than sell), but it does not necessarily mean the resources of the country have been exhausting; overheating typically happens before an economy hits its capacity limit because prices begin rising which creates incentives for businesses to expand and invest in new technology and capital equipment with lower costs per unit explains Peter Decaprio.
- According to the Federal Reserve Bank of Cleveland’s inflation glossary, inflation is “an increase in the overall level of prices”. Prices will go up because more money is chasing after a limited number of goods and services. So there will be upward pressure on prices.
- We’ve gone through some key terms related to inflation and GDP growth. Real gross domestic product (GDP), nominal GDP and the GDP deflator and what they mean; aggregate demand, aggregate supply, cost-push vs. demand pull inflation and how central banks control money supply; interest rates, inflation targeting, quantitative easing and how it affects exchange rates; overheated economy/capacity limits/demand side of the economy vs. the supply side of the economy; and inflation is an increase in prices.
Conclusion:
Inflation is an increase in the overall level of prices says Peter Decaprio. Central banks control inflation by adjusting the money supply to ensure. There isn’t excess demand (i.e., more people looking to buy than sell). If there is too much demand, prices will rise which creates an incentive for businesses. To expand and invest in new technologies with lower costs per unit. If you have any questions or would like us to address something specific about how central banks control inflation.
