Question

5. Problems and Applications Q5

The inflation rate is 12 percent, and the central bank is considering slowing the rate of money growth to reduce inflation to 8 percent. Economist Carlos believes that expectations of inflation change quickly in response to new policies, whereas economist Felix believes that expectations are very sluggish.

True or False: Economist Felix is more likely to favor using contractionary policy to reduce inflation than economist Carlos.

True

False

Answer 1

Inflation usually occurs when an economy grows due to increased spending. Thus the prices rise and the currency is worth less than it was before. The buying power of the currency also reduces. When a currency is worth less, its exchange rate weakens when compared to other currencies.

There are many ways by which inflation can be controlled, one of which is the Contractionary Monetary Policy. The most important goal of a contractionary policy is to reduce the money supply within an economy by decreasing bond prices and increasing interest rates. This reduces spending as there is less money and people prefer to save it rather than sending. The less available credit also reduces sending. Reducing spending is very important during inflation as it halts economic growth and the rate of inflation as well.

There are three important tools for a contractionary policy:

1. Increasing the Interest rates- When the rate of interest are increased by the Central Banks, the commercial banks do not have any option but to raise the rate of interest as well. Thus fewer people want to borrow money as it costs more. This helps in reducing spending and thus ultimately inflation.
2. The second tool is to increase the reserve requirements on the amounts of money banks are legally required to keep In hand. The more money banks are required to hold back, the less they have to lend to consumers. If they have less to lend, consumers will borrow less, which will decrease spending.
3. Reducing the Money Supply- The third method is to directly or indirectly reduce the money supply by enacting policies that encourage the reduction of money supply. Two examples of this include calling in debts that are owed to the government and increasing the interest paid on bonds so that more investors will buy them. Both these policies will reduce the amount of money in circulation as the money will be going from the banks and investors to the government.    

Thus the statement of Economist Felix is more likely to favor using contractionary policy to reduce inflation than economist Carlos is True.