Showing posts with label economics. Show all posts
Showing posts with label economics. Show all posts

Friday, December 9, 2011

Stagflation Explained

Stagflation:



Stagflation is the economic condition in which there is extremely slow economic growth and high unemployment (stagnation) accompanied by high inflation. The word itself is a portmanteau of the two words stagnation and inflation. It is a tricky situation to be in because policy measures to counter one condition could further aggravate the other – measures to stimulate growth could further raise inflation levels and measures to control inflation could further slow economic growth.

Causes:
Economists commonly state two possible causes for stagflation:
1. When the productive capacity of an economy is sharply reduced due to an unfavourable supply shock – such as a sharp increase in oil prices. This leads to both an increase in prices and a decrease in production since production is now more costly and less profitable. Hence prices rise while the economy is slowing down.
2. Conflicting macroeconomic policies – For example when the central banks allow a rapid increase in money supply by keeping interest rates low while the government causes stagnation by rigid regulation of the goods markets and/or the labour markets. Strict regulation limits economic growth while the growth in money supply drives up demand and hence prices.

The U.S. Stagflation of the 1970’s:

From 1958 to 1973, USA experienced the "Post-War Boom". The economy grew by an average of 5% annually, fuelling a slow but steady rise in prices. In this period, the Federal Reserve's monetary policy was guided by diehard Keynesians who believed in the Phillips Curve which gives the relationship between unemployment and inflation. The Fed believed that the inverse relationship between unemployment and inflation was stable and decided to use its monetary policy to increase overall demand and keep unemployment low. They believed the only trade-off would be a safely rising inflation rate.

However, the unnaturally low unemployment in the 1960s caused a wage-price spiral. The government poured money into the economy to increase demand, making prices rise. Workers, noting the rise in prices, expected their wages to rise accordingly. For a while, employers were willing to raise wages, but then inflation began to rise faster than wages. Workers weren't willing to supply labour for lower wages, so unemployment increased even as inflation continued to rise. Industry faced a scarcity of labour and the growth was slowing.

The real kicker for stagflation came in with the OPEC’s oil embargo of 1973, which brought oil prices to record new levels. Prices skyrocketed across all U.S. industries. In 1970, inflation was 5.5 percent. By 1974, it was 12.2 percent, and then it peaked at a crippling 13.3 percent in 1979. The stock market ground to a halt. The annual return on bonds dropped below inflation levels.

Further reading: http://www.businessbookmall.com/Economics_16_Stagflation_and_the_Rise_of_Supply-Side_Economics.htm

Thursday, October 27, 2011

Quantitative Easing - explained

Quantitative Easing & money supply management by central banks:
Quantitative Easing (QE) is a term very often in the news in recent times. Let us take a look at the what, why, how and when of it:
What it is:

It is a monetary policy that is used by governments to increase money supply. It is an unconventional system and is usually used only when the conventional methods of increasing money supply have become ineffective. It was first used by the Bank of Japan in early 2000’s to fight domestic deflation. More recently, it has been employed by the USA, UK and the Eurozone during the financial crisis of 2007-2010.
Why and when it is done:

Central Banks attempt to increase money supply in poor economic conditions when spending is low. There are various methods to accomplish the same, one of which is quantitative easing. Quantitative easing is sometimes viewed as a last resort measure when the more accepted methods of increasing money supply have become ineffective. It is generally employed when the interest rates are near 0% and have failed to produce the desired effect.
How it happens:

It is implemented by the central bank purchasing financial assets such as government securities or other securities from the banks and other public/private institutions with the newly generated money. This floods the targeted institutions with capital and hence increases the money supply. It is thus an attempt at driving up spending and hence consumption in situations when even a near 0% interest rate fails to elicit spending (the economy is in a liquidity trap).
Risks & Questions on effectiveness:

  • More money enters the system without a corresponding rise in the amount of goods available. This will eventually lead to higher prices i.e., inflation. This nature of generating more money without more goods leads to quantitative easing sometimes being referred to as “printing money”.
  • Increasing the money supply tends to depreciate the concerned currency’s exchange rates versus others. This directly harms creditors and holders of the currency as the real value of the currency decreases. Also, importers will be harmed as the cost of imported goods will be inflated by the depreciation of the currency. This could drive up prices of imported goods sharply.
  • There is always the risk that the new money could be used by the banks to invest abroad and in asset classes like emerging markets, commodity-based economies, commodities themselves and non-local opportunities rather than to lend to local businesses.

QE could thus prove useless unless it is combined with effective policy measures in other areas.
Illustration by the Bank of England:


Further Reading: