IN economics, inflation means that the general level of prices of goods and services is increasing. When inflation is rapid, prices of goods and services can increase faster than consumers’ income, and that means less amount of goods and services that consumers are able to purchase.
With inflation, a peso buys less and less over time. That’s why the Bangko Sentral (Central Bank) tries to keep inflation low and stable in the long run because that helps the economy grow over long periods of time.
Besides, people can make better spending and investment plans if inflation is low and stable because they do not have to worry about high inflation decreasing the purchasing power of their money.
Problems of inflation
IF it’s high, there are three main problems it can cause:
1. People on a fixed income (e.g., pensioners, students) will be worse off in real terms due to higher prices as before, and this will lead to a reduction in their purchasing power.
2. Rising inflation can encourage trade unions to demand higher wages, and this can cause a wage spiral. If strikes occur, say in an important industry with a comparative advantage, the nation may see a serious reduction in productivity and unemployment.
3. If inflation is high, exports will become more expensive for other countries to buy, and this will create a deficit on the current account.
Controlling inflation
The Bangko Sentral, now under newly appointed Gov. Benjamin Diokno, a noted economist, is not only mandated to determine the nation’s monetary policy but it is also tasked to look at inflation.
The Bangko Sentral holds regular meetings to review the country’s economic and financial conditions and set monetary policies. The term “monetary policy” refers to the actions taken by the Bangko Sentral to help encourage a healthy economy. The actions taken influence the availability and cost of money and credit, which affect a range of economic variables, including output, employment, and prices of goods and services.
Interest rates have frequently been proposed as a guide to policy, not only because of the role they play in a wide variety of spending decisions but also because information on interest rates is available on a real-time basis.
The appropriate level of interest rates will vary with the stance on fiscal policy, changes in the pattern of household and business spending, productivity growth and economic developments abroad. It’s not easy to gauge the strength of these forces and translate them into a path for interest rates.
The slope of the yield curve (that is, the difference between the interest rate on longer-term and shorter-term instruments) has also been suggested as a guide to monetary policy. Short-term interest rates are strongly influenced by the current setting of the policy instrument, while longer-term interest rates are influenced by expectations of future short-term interest rates, and thus by the longer-term effects of monetary policy on inflation and output.
For example, a yield curve with a steeply positive slope (that is, longer-term interest rates far above short-term rates) may be a signal that participants in the bond market believe that monetary policy has become too expansive and thus, without a monetary policy correction, more inflationary.
Conversely, a yield curve with a downward slope (short-term rates above longer rates) may be an indication that policy is too restrictive, perhaps risking an unwanted loss of output and employment.
However, the yield curve is also influenced by other factors, including prospective fiscal policy, developments in foreign-exchange markets, and expectations about the future path of monetary policy. Thus, signals from the yield curve must be interpreted carefully.
The Taylor Rule
The “Taylor Rule,” named after the prominent economist John Brian Taylor of Stanford University and former US undersecretary of treasury for international affairs, is another guide to assessing the proper stance on monetary policy. It relates the setting of the national funds rate to the primary objectives of monetary policy—that is, the extent to which inflation may be departing from something approximating price stability and the extent to which output and employment may be departing from their maximum sustainable levels.
For example, one version of the Rule calls for the Bangko Sentral’s funds rate to be set equal to the rate thought to be consistent in the long run with the achievement of full employment and price stability plus a component based on the gap between current inflation and the inflation objective, less a component based on the shortfall of actual output from the full-employment level.
If inflation is picking up, the Taylor Rule prescribes the amount by which the Bangko Sentral funds rate would need to be raised or, if output and employment are weakening, the amount by which it would need to be lowered.
The specific parameters of the formula are set to describe actual monetary policy behavior over a period when policy is thought to have been fairly successful in achieving its basic goals.
To reach the writer, e-mail cecilio.arillo@gmail.com.