Inflation has become a major political issue in both the USA and Canada. People resent the increase in cost for food, fuel for their cars and housing. Many are expecting government to act in ways that will generate lower prices in the near future.
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We should be careful what we wish for. Economists refer to an economy experiencing a wave of falling prices as experiencing deflation. It isn鈥檛 much fun for anyone.
Political leaders in both Canada and the USA are being pressured to take action to stop price increases on goods and services. Normally that would mean the central bank would both reduce the supply of money by selling government securities and restrict future issues of currency thereby allowing interest rates to rise.
When that happens, consumers find that loans, including mortgages, become more expensive and businesses find loan availability is reduced, so investment in plant and equipment also declines. At the same time, consumers begin to fear a future decline in the economysa国际传媒 rate of growth. That, in turn, causes them to cut back on expenditures. As spending by both consumers and businesses declines, supply begins to exceed demand and there is pressure on businesses to cut back costs, including by reducing labour demands. Therefore, unemployment rises.
Central banks are between a rock and a hard place. If allowed to go on too long, inflation becomes ever harder to control so the central question becomes: 鈥淲hat is the best way to restrain excessive price rises?鈥 But, if efforts to reign in inflation are too aggressive, the economy may head into a downward spiral of prices, rapidly rising unemployment and increased poverty.
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There are serious risks of both over-shooting and under-shooting the runway when trying to keep the economy both stable and growing without substantially rising prices.
If an economy falls into a deflationary cycle and action is required, the choice of policy measures depends, in part, on what is causing prices to fall.
It could be a decline in exports to foreign markets. Another factor might be a severe reduction in the demand for or production of certain goods or services, such as a prolonged strike in a key industrial sector or adverse climate impacts on major sectors such as agriculture and manufacturing.
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A market panic followed by a substantial decline in stock prices might generate fear among consumers such that they reduce their spending and wait for prices to decline further. As the value of their money balances increases, the supply of money in circulation is reduced and the buying of goods and services slows.
Effective anti-deflation strategies can involve one of the following:
The central bank reduces the money supply by either selling some of its holdings of government securities (thereby raising interest rates) and/or cutting back on purchase of government securities which could mean less federal spending or higher deficits.
Government could reduce budgetary expenditures thereby cutting back on consumption within sectors targeted by the cutbacks. The reductions will eventually result in accumulation of stocks of produced goods which in turn results in businesses laying off workers.
The essential problem with deciding which policy to use or how much of either is that, more often than not, the data central banks and government rely upon to make such decisions is both incomplete and reflects conditions that existed sometime before the decision is to be made. That time lag can result in hesitation by those making policy decision leading to a worsening situation.
Or, if the deflationary pressure is stronger than decision makers perceive, the risk is turning a decline in growth to a full-blown depression with high unemployment and rising poverty. Similarly, if the decision- makers implement too-strong actions for too long they may further constrain growth and precipitate a downward spiral in the economy.
Pierre Poilievre has discovered it is easy to criticize governments for finding it difficult to control inflation.
It is also important that governments try to avoid deflation; rising unemployment, mainly in lower income brackets, only increases inequality of incomes. Yes, it is easier to advocate for firing the central banksa国际传媒 governor than to do his job.
