Why might a government want to establish credibility with regard to fighting inflation? LO5

Name: Problem 11, Chapter 12: Macroeconomics
Uploaded: 2021-04-29T01:58:17-08:00
Duration: 7 min 25 s
Channel: Sandile Ndlovu
Description: Why might a government want to establish credibility with regard to fighting inflation? LO5

Why might a government want to establish credibility with...

Key Concepts

Government Credibility

This concept refers to the trust and confidence that economic agents, such as consumers, investors, and international bodies, have in a government's commitment and ability to implement policies effectively. In the context of fighting inflation, a government with strong credibility can anchor inflation expectations, thereby stabilizing the economy. It signals that the government is serious about curbing inflation, which can lead to more favorable outcomes in terms of investment, consumption, and overall economic performance.

Inflation Expectations

Inflation expectations are the anticipations of future inflation levels by businesses, consumers, and investors. When a government establishes credibility in fighting inflation, it can help anchor these expectations to lower levels, reducing the likelihood of self-fulfilling prophecies where workers demand higher wages and firms raise prices. Stable inflation expectations are crucial because they influence actual inflation and economic decision-making, helping to maintain economic stability.

Policy Effectiveness

Policy effectiveness refers to the degree to which implemented economic policies achieve their intended outcomes. Establishing credibility is fundamental to the effectiveness of policies aimed at controlling inflation. When the public believes in the government's commitment to fighting inflation, the policies enacted—whether fiscal or monetary—are more likely to change behavior in ways that lead to lower inflation, thereby enhancing the overall effectiveness of the policy measures.

Transcript

00:01 Problem 19 says how can monetary authorities target any inflation rate they wish? so monetary authorities or the central bank will first announce its inflation targets.

00:12 So maybe the inflation target is 4 % or maybe it's a band of 6 % to 3%.

00:20 So inflation targets or announcing the inflation target rather helps to control inflation expectations as they have a direct impact on the inflation because if individuals expect the inflation rate to be high they will buy in the present moment which will increase inflation so inflation expectations are really important and the central bank the central bank makes these announcements to control these expectations so after after announcing the inflation rate target the central bank has mainly four monetary tools monetary policy tools, which is the control of money supply, which is basically quantitative easing, the control of repo rates, which is basically the commercial banks lending, sorry, the commercial banks borrowing from the central bank, open market operations, which is basically the central bank buying and selling bonds in the open market, sorry, in the local financial.

01:31 Market and the required reserve ratio which is basically the value of reserves that commercial banks are supposed to reserve in the central bank in case the individuals who have their deposits at the bank decide to withdraw all their funds right so that's the required reserves of the commercial banks.

02:06 So all these tools basically help increase or decrease economic activity which is an impact on the inflation rate.

02:16 So let's start with money supply which is the vertical line in this graph.

02:24 So if the economy is doing really well, that is output is increasing and employment is high, which indicates high inflation the central bank will decrease money supply this will increase interest rates increase the cost of borrowing and decrease investments and that in turn will lower economic activity and decrease inflation all right and the converse is true that is during a recession the central bank will increase money supply lowering interest rates which will increase investment and then increase outputs and then slowly increase inflation okay and moving on to repo rates so repo rates is basically the interest rate that is charged to commercial banks for borrowing at the central bank and when the repo rates increases the cost of borrowing for banks for commercial banks will increase right and that in turn will lead to an increase in the interest rates of loans because banks will pass the increase in the cost of borrowing to the borrowers in the economy so they will have to also pay a larger interest for their loans all right and that will basically lead to a higher cost of borrowing for borrowers or investors that will lead to lower investment and that will lead to a lower economic activity and lower inflation.

04:17 So a higher repo rate leads to lower economic activity and a lower inflation rate.

04:26 All right.

04:30 Excuse me.

04:32 And moving on to open market operation...

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