So How Does a Government Control Inflation?

How Does a Government Control InflationWell, a fairy godmother with her magic wand to put everything right would be marvellous, but unfortunately, real life doesn’t work like that. In real life when things get out of control they can only be brought back under control by straightforward blood, sweat and tears, and it is the people of the country who have to pay the price.

A small degree of inflation, say 1% or 2%, is used by the powers that be to keep industry and commerce rolling along nicely and to give all the people a “feel good factor”. Industry produces hard goods like tools, machines, cars, food and clothing whilst Commerce produces services like banking, transport, postal services and so on. Governments in a democracy have an immense desire to keep the people content because that means they keep their vote and stay in government. But this can influence thinking and lure them into making bad policy that as the saying goes “looked good at the time”!

A sound policy will keep inflation of the country’s money under very strict control and to do this it is necessary to keep the supply of money in balance with the product. If the money supply grows too rapidly the result is inflation, or if the product grows too quickly there is disinflation or deflation.

The difference between these two words is very important because it describes the degree of severity felt by the people. Disinflation is letting the air out of an inflated balloon slowly and in a controlled way so that nothing drastic happens, whereas deflation is letting go altogether when the balloon flies off in all directions and is totally out of control. The former is using policies which correct the situation gradually and brings everything back to the required normality over an extended timeframe and makes life easier for the people by protecting the maximum number of jobs possible. Deflation is the crash, course, kill or cure, and usually means that a large part of the population loses their jobs and their livelihood, giving great stress and anguish. If bad policies are followed for too long then the only way out is deflation – not good and normally called a “slump”. The last slump started in 1929 and continued until the late 1930′s. The result of disinflation is a “recession” which is a slowdown but not a case of falling off the edge of the precipice.

So how is this controlled?

Firstly, we have to understand that all countries want to keep expanding their output of product because that provides the people with jobs to earn a decent living. Provided there is someone to buy all of this “growth” all will be well. You will see growth factors quoted in the financial news all the time and this is what they mean. If the factor is positive then that means the product is getting bigger and if it goes negative then the output is shrinking.

Secondly, we have to keep the money supply expanding at the same rate as the product growth. There are a number of ways of doing this and some are very complex and difficult to understand but the predominant method is to persuade all of the people in the country either to use more of it (that is to spend more) or to use less of it (to spend less and save more).

If they spend more, that means a greater demand for product and if they save more that means a reduction in demand for product. When the former gets out of hand the result is not enough product to supply the demand and scarcity makes the price rocket as recently happened in house prices.

There was too much money easily available at very low cost chasing after a much more slowly growing product output. (It takes a number of years to plan, acquire land, obtain planning permission, and then build a house).

This was exaggerated to an alarming extent because the policies in the countries affected encouraged people to borrow money to do so even when those people could never pay back the loan from their income.

The lenders believed that provided the borrowers could pay the interest charges there was no problem because the house prices would keep rising and eventually take care of the repayment of the loan itself.

Another case like the “Tulip Mania” and the fable of the “Emperor’s New Clothes” where people saw what they wanted to see until someone broke the rose tinted spectacles. The method most used to control this demand is the rate of interest paid on borrowed money.

The national bank sets a rate which periodically moves up or down and this normally is taken as a guide by all financial institutions for the rates they offer to borrowers and savers. A reduction in rate encourages borrowers because they do not have to pay so much for their loans but at the same time discourages savers because they receive less on their savings.

An increase in the rate does exactly the opposite. The big problem associated with this system is that the decision has to be made after seeing what the effect of the current rate has been (that is, in hindsight) and it takes about six months for the statisticians to make their report on this. A lot of damage can be done in six months of the wrong policy when the ship is already off course.

An example of this can be seen in the current financial turmoil. Most governments kept their base rates (national interest rate guidelines ) too low for too long which encouraged people to borrow money and also made it cheaper for them (as governments ) to borrow money themselves. (That will be discussed in another blog post). The end result was an unacceptable increase in the money supply relative to product which was seen as inflation for those products home grown like houses but was offset in the overall assessment by the increasing volume of product being obtained (imported) from overseas countries like China where the prices were to our eyes phenomenally cheap. So, house values going up at 10% each year, and children’s toys, televisions, washing machines, refrigerators, cookers etc going down at 10% per annum, resulted in a net increase of around 2%. Everything looks rosy and people are happy.

BUT, wait a minute, we said earlier that in any one country the amount of money in circulation in that country must be kept in balance with its own product to control its money inflation, so whose product are all those toys, televisions, washing machines etc? The answer must be China’s and so do not reflect in the value of other countries’ currency values. So the real rate of currency inflation was the 10% affected by the indigenous housing prices! In reality it was dropping in value and would buy less and less as time progressed. The 2% net figure is another thing called the “Cost of Living index” and measures what anyone has to pay in their own currency to buy a range of goods deemed to be essential for a comfortable life regardless of where these are made.

Over the course of many years the money inflation rate is the vital one but the quickest and easiest to see is the cost of living inflation which is why more attention is paid to this. Ultimately though, it is the value of a country’s money and the confidence that people have in it that controls how much people have to pay for that acceptable standard of living.

Oh dear, where is that fairy godmother when you really need her?

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