Introduction
Economic growth is a primary concern of every government, as it ensures high employment and political stability. There are various factors which affect economic growth; however, all these factors are interconnected. The methodical study about inflation reveals that changes in inflation could be cyclic. When the economy is on an upswing, the rate of inflation increases and when the economy is downswing, general prices level decreases (deflation). To address this issue, financial and economic institutions have devised various instruments and strategies, which keep the inflation rate at the desired level. For instance, expansionary monetary policy, in which reserve ratio is reduced, and the money supply/interest rate is increased, is implemented, when the pace of economic growth slows down and deflation sets in. In contrast, the contractionary monetary policy is emphasized when the economy is heating up (inflation is increasing at a considerable rate).
Deflation is a far more serious issue or concern than inflation. It is because deflation is more stubborn, and it dulls economic activity. In contrast, inflation does not slow down economic growth; however, it yields other long-term challenges, such as income inequality, low real wages, the small size of savings (aggregate), etc. [1]
Objectives
We will study how different economies how Britain and American economies dealt with the consequence of The Great Recession (deflation) and how these measures affected the general price level.
We will also study the impact of expansionary monetary policy, an attempt to increase investment general price level and employment, on consumption and wages.
Literature Review
Inflation is a serious concern, for which both governments and central banks devise and implement policies. However, generally, it is a central bank, which devices policy to keep inflation rate at a particular level. Studies show that the inflation rate between 2% to 3% is desired. High inflation, deflation has its own set of problems. One of the major challenges, which deflation yields, is that it takes away the incentive to invest in the economy. It is a fact that price directly affects profit and when the general price level starts to decrease the size of the profit also starts to reduce. The reduction in profit usually discourages investors, which shrinks the volume of investment in an economy. Another challenge, which deflation yields, is that large investors began to hoard money. They usually abstain from investing in the economy or in purchasing, which results in the hoarding of cash. During this period, when cash hoards, it becomes more difficult to increase the price level [2].
After The Great Recession, capitalist economies went into recession, which pushed them to employ an expansionary monetary policy. The expansion of the money supply did not work effectively, which forced many capitalist economies, such as the United States, to introduce Fiscal Stimulus. For instance, the American Recovery and Investment Act was introduced by the Obama Administration, which intended to increase government spending and reduce taxes. It addressed deflation and deflationary challenges by increasing the volume of consumption. As consumption increased, so did the investment. Similarly, the United Kingdom also emphasized on fiscal stimulus to end the recession [3].
As per projections, after a brief recovery, the deflationary trend has started to emerge. Reports suggest that inflation rate is decreasing and may dip below 2%. These projections are ominous as they can badly affect the economy that has very recently resuscitated, which why is deflationary trends are alarming [4].
Impact of Expansionary Fiscal and Monetary Policy on Inflation and Unemployment
Recent evidence suggests that deflationary trends that had appeared in the brief period were cyclic. The unemployment rate has declined gradually since the implementation of expansionary monetary and fiscal policy. The United States claims that because of fiscal stimulus (first by the Obama administration and now by Trump Administration) and expansionary monetary policy American economy is operating at full-employment level.
US Inflation Rate Graph
Source: https://tradingeconomics.com/united-states/inflation-cpi
From the graph above, which shows the inflation rate in the United States (over the years), it is quite apparent that the general price level is in desired range; a range that facilitates healthy economic progress. The Federal Reserve claims that the economy is heating up, which is why it, has to increase interest rates so that inflation may remain in the desired range.
US Unemployment Rate Graph
Source: https://tradingeconomics.com/united-states/unemployment-rate
From the unemployment graph, it is evident that the United States is operating at full employment. Economists consider 4% unemployment rate as the natural rate of employment; therefore, when investment increased in the first quarter of January, in the US, there was minor increased in employment but the evident increase in nominal wages.
Currently, the true concern of the current American administration and economic/financial institutions is wages. The wages are still low, despite an increase in investment, employment and consumption. The increase in wages may slow down further because the Federal Reserve has adopted the contractionary monetary policy.
The United Kingdom Inflation Rate Graph
Source: https://tradingeconomics.com/united-kingdom/inflation-cpi
The inflation rate in the United Kingdom is also healthy, which means that expansionary monetary and fiscal policy increased investment, which increased both employment and consumption. We also know that Britain’s government increased government spending to influence consumption directly.
United Kingdom Unemployment Rate Graph
Source: https://tradingeconomics.com/united-kingdom/unemployment-rate
As the unemployment rate is at its natural level (economy operating at full level) an increase in investment will probably translate into higher wages. Like in the United States, the unemployment rate in the United Kingdom has also dwindled significantly, which has positively affected inflation rate. However, the impact on wages remains smaller and less meaningful.
Analysis
The projection of The Economist, in which deflationary trends are emerging, was not valid. Also, the deflationary trend was not global, as it was when it appeared last time after the sub-prime mortgage crisis [5]. In fact, most of the capitalist economies, especially Britain and the United States, are operating at full employment level and as the volume of investment will increase in these countries, wages will increase. An increase in nominal wages, in the short run, will increase real wages (if the rise in nominal wages in greater than the inflation rate), which improves the quality of the economy. It may affect exports; however, the United States and the United Kingdom’s exports are technology products and services, which is why the impact on exports will not be large.
Conclusion
In the end, it is concluded that inflation is a strong economic factor, which affects the economy in both the short and long run. When the inflation rate moves up from the desired range, the size of savings reduces, real wages decline, and resources are employed recklessly. Similarly, when inflation is below the desired range, it affects not only economic growth and employment but also a political system. Therefore, keeping inflation in the desired range is the prime objective of economic and financial institutions.
One of the consequences of the sub-prime mortgage crisis was deflation. Governments and Central Banks emphasized expansionary fiscal and monetary policies respectively to address this issue. It is quite apparent that because of the expansionary strategy, the unemployment rate has declined to natural rate and inflation is around 2.5% in both the United States and Britain. Any additional investment will increase real wages in the short run, which will increase the size of consumption. We have already established that there is a positive correlation between consumption and inflation, which means that if consumption increases, the inflation rate will increase too. Currently, the concern for the United States is not deflation but rather heating up of the economy, for which it is devised and implemented contractionary fiscal policy. However, how effective that policy would be is a valid question as Trump Administration has introduced a massive fiscal stimulus package.
Bibliography
[1] The Economist. (2015, February 19). The high cost of falling prices. Retrieved from https://www.economist.com/finance-and-economics/2015/02/19/the-high-cost-of-falling-prices
[2] The Financial Times. (2009, January 29). Deflation: How concerned should we be about deflation? Should the Bank of England unleash unorthodox monetary policy weapons 2009? Retrieved from https://www.ft.com/content/e9744bce-d820-11dd-bcc0-000077b07658
[3] Reich, G. C., Feiveson, L., Liscow, Z., & Woolston, W. G. (2012). Does state fiscal relief during recessions increase employment? Evidence from the American Recovery and Reinvestment Act. American Economic Journal: Economic Policy, 4(3), 118-45.
[4] The Economist. (2015, February 19). The high cost of falling prices. Retrieved from https://www.economist.com/finance-and-economics/2015/02/19/the-high-cost-of-falling-prices
[5] The Economist. (2015, February 19). The high cost of falling prices. Retrieved from https://www.economist.com/finance-and-economics/2015/02/19/the-high-cost-of-falling-prices
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