Term Paper: Inflation and Deflation

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[. . .] This is done through control of the money supply and the availability of credit in the economy. In times of deflation and depressed demand, the Fed attempts to increase the money supply and in times of inflation it tries to decrease it.

For example, if the Fed wants to put more money into the economy, it does not do so by asking the treasury to print more dollar bills but by using the reserves in checking and saving accounts of institutions such as commercial banks, saving banks, savings and loan associations. The Federal Reserve sets the reserve requirements for these institutions (presently between 3-10% of their funds. ("Monetary Policy.." p.18,19) In times of inflation, Fed can raise the reserve requirements to tighten money supplies and lower such limits to increase the money supply during deflation. Another tool available with the Fed to control the money supply is by changing the discount rate (the rate it charges banks when they borrow money from the Federal Reserve System). When the discount rate goes down, the banks borrow money from the Federal Reserve System, to cover their reserve requirements and support more loans to borrowers. Such loans result in increasing the nation's money supply. Conversely, an increase in the discount rate results in a decrease in the money supply.

In practice, however, banks rarely borrow money from the Federal Reserve, and changes in the discount rate are more important as a signal of whether the Fed wants to increase or decrease the money supply. For example, raising the discount rate may alert banks that the Fed might take other actions, such as increasing the reserve requirement. That signal can lead banks to reduce the amount of loans they are making. Hence the most important part of a change in discount rate is its "announcement" effect. ("What are the Tools.." para on Discount Rates)

Another way by which the Fed controls the supply of reserves in the banking system is done through Open Market Operations. This is done by the buying and selling of government securities or government bonds on the open market. The U.S. government borrows money by issuing bonds that are regularly auctioned on the bond market in New York. The Fed is one of the largest purchasers of those bonds, and the bank's open market operations have a significant effect on the amount of money in the economy when it buys or sells bonds.

Limitations of Fed's Role in Regulating the Economy

Although the control of Monetary Policy by the Fed is very important, it has its limitations. This is because the monetary policy is not the only factor affecting the economy or the inflationary or deflationary trends. Other factors such as government fiscal policies and unforeseen events are equally important. Government fiscal policies may include measures on taxation and spending programs that are beyond the purview of the Federal Reserve. While an alert Fed may anticipate and cater for the government policies unforeseen events, by their very nature, are near-impossible to predict. ("Monetary Policy.." p.25)

Another reason why the policies of the Federal Reserve do not always have the desired effect in achieving price stability is the problem of time lag. The effects of changes in the monetary policies by the Fed are not felt immediately and there is a significant time lag between the policy change and its result. It has been observed that the time lag between a change in policy and its effect on growth of production of goods and services are usually felt within three months to two years. And the effects on inflation tend to involve even longer lags, perhaps one to three years, or more. Due to this time lag, it becomes difficult to monitor the effects of a policy move. (Ibid.)

The situation is further complicated if the unpredictability of human response to policy changes is factored in. In order to counter these difficulties the policy makers at the Fed have to anticipate future developments. In order to do an adequate job, the Fed looks at a range of economic indicators such as the money supply, real interest rates, the unemployment rate, nominal and real GDP growth, commodity prices, exchange rates, various interest rate spreads, and inflation expectations surveys. ("Monetary Policy.." p.25, 26) The economic data, however, is not always accurate or up-to-date which again limits the effectiveness of the Fed Monetary Policies.


As we saw in this paper, maintaining price stability in a capitalist economy is one of the major concerns. This is because both sustained inflation and deflation are generally harmful for the economy and need to be controlled. In the United States, this job of maintaining price stability is performed by the Federal Reserve Bank. It does so by implementing a monetary policy that controls the supply of money in the economy. Despite its wide-ranging powers and ability to do so, the Fed also has its limitations in controlling the inflation and deflation. This is because there are many factors in play that affect the economy of a country, some of which are beyond the control of the Fed.

Works Cited

Buiter, Willem H. "Deflation: Prevention and Cure?." European Bank for Reconstruction and Development. 12-05-2003. February 10, 2004.


Christiano, Lawrence J. And Terry J. Fitzgerald. "Inflation and Monetary Policy in the Twentieth Century." Economic Perspectives. 27. 1. (2003): 22+.

Makinen, Gail. "Inflation: Causes, Costs, and Current Status." Report for Congress

Congressional Research Service: The Library of Congress. Updated May 20, 2003. http://www.policyalmanac.org/economic/archive/inflation.pdf

Moffatt, Mike. "What is deflation and how can it be prevented?" Economics at About.com. n.d.

'Monetary Policy and the Economy." Federal Reserve System: Purposes & Functions: PDF Document. Federal Reserve Board Web site. February 10, 2004.

Skene, G. Leigh. Cycles of Inflation and Deflation: Money, Debt, and the 1990s. Westport, CT: Praeger Publishers, 1992

'What are the Tools of Monetary Policy?" Federal Reserve Bank of San Francisco Web site. February 10, 2004.

Wilson, George W. Inflation -- Causes, Consequences and Cures. Bloomington" Indiana University Press, 1982.

Plus or minus 2% or less is often taken to be equivalent to price stability (Makinen p. 1)

There is no precise measure of a "longer period." Makinen defines it as a period "longer than a day, week, or month" (p. 1) while Wilson links it to the expectations about the persistence of inflation (pp. 2-4).

measures the price of a selection of goods purchased by a "typical consumer" and is the most commonly reported inflation figure.

measures the change in price of a selection of goods at wholesale (i.e., typically prior to sales taxes)

measures the change in price of a selection of commodities

Followers of the influential the British economist John Maynard Keynes

Named after the British economist, Alan W. Philips

Keynes termed a major consequence of inflation as the "euthanasia of the rentier" -- the mercy killing of all those living on a fixed income. (Quoted by [END OF PREVIEW]

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