Thursday, January 13, 2011

How We Currently Control Inflation

I laid out all the bad things about inflation and why it should be kept low and steady.  So how does our policy makers currently control inflation?  By trying to wreck the economy.  Long ago, congress entrusted the federal reserve to conduct monetary policy to promote "promote maximum employment, production, and purchasing power".  The people at the federal reserve have tried many different things to stop inflation and encourage "full employment".  In the end, the tool they use most often is by setting interest rates.

When unemployment is high, the federal reserve leaders lower interest rates.  This encourages people to borrow money to buy stuff which creates demand.  It also encourages businesses to expand and invest which increases demand and creates jobs.  Unfortunately, all that borrowed money increases the money supply and all that spending and investing can increase demand faster than supply.  All of this combines to cause the inflation rate to rise.  Once that happens, the federal reserve leaders decide to raise interest rates.  This discourages consumer borrowing and business investment.  Those two things cause unemployment to rise.

So, when I say that we control inflation by wrecking the economy.  This is such an accepted and non-controversial idea, that the federal reserve freely admits that they willingly cause unemployment.
Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.

So why do these people constantly vote to wreck our economy, and why does congress let them?  It's not because their evil.  It's not even because their stupid.  It's just that it's the only way they know how to control inflation and think it's the best way to control unemployment.  It's a way of thinking based heavily in the Monetarism school of economics.  It is pretty much the dominant economic theory in congress and government, business, and even the International Monetary Fund.

They believe that both some inflation and some unemployment is a good thing.  The belief is that having a little bit of each will keep both of them low.  It's a good theory that I think is a correct observation.  My problem is with the solution.  Causing unemployment and all the problems it causes society(poverty, loss of work ethic, disrupted families) is a very high price to pay for price stability.  Unfortunately, it's the best our mainstream thinking offers.  Given that, I understand why they do it, I just think we should be actively looking for a way to lower inflation without causing massive unemployment.

I bring this up for a reason.  When talking about other possible solutions, I think it's important to compare those solutions to what we currently do.  Right now our only solution to lowering inflation means that people must be laid off and rendered unemployed.
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