How Inflation Is Controlled By Government
By Derek Beese
I had lots of requests mainly from very young people about the post: “So How Does The Government Control Inflation?” They were asking for the article to be written in a way which was easier to understand.
That is a very difficult task because Economics, which deals with inflation, is a highly complicated subject but getting right down to the basic principle here it is explained in very simple terms.
I hope it makes sense to you.
Assume an imaginary world with two people. One of them owns a tree which every year produces a good crop of lovely eating apples. The other one owns a water spring that flows at a constant rate. Both need food and water to live so have to exchange apples for water so that each of them has both food and water to survive.
Now, what is the value of the apples and what is the value of the water in this exchange?
There is no money as we know it so the value can only be expressed in terms of the other thing (called a commodity). So if the tree produces 1000 kilograms of apples in a year and the spring produces 1000 litres of water then one kilo of apples is worth one litre of water. This establishes the quantities for any exchange.
So if the apple man wants to buy 50 litres of water then he has to give (pay) 50 kilos of apples. If he wants 100 litres he pays 100 kilos. Similarly if the water man wants apples he has to pay the same quantities in water. This has now fixed a value for water and apples.
Unfortunately, whilst the spring flows at a constant rate and delivers 1000 litres of water every year, the apple tree crop varies from year to year. If this variation is very small it will not matter and both people will still be happy to keep the value the same, but let us say that the apple crop is gradually getting less each year. Both people start to worry that there might be a shortage of food.
The apple man wants to keep his apples but he must exchange some of them or he will die of thirst – he must have some water. The water man has his normal supply of water but he becomes desperate to buy some food.
Now what are the values for apples and water?
Let us say that the apple crop was only 500 kilos for the year. There are still 1000 litres of water so the value of one kilo of apples is now two litres of water and both will have to use this new value to stay alive. In other words the price for a kilo of apples has doubled from one year to the next and that is called inflation.
If the apple crop had increased then the price would have gone down and that is the opposite of inflation called disinflation. (Deflation is a word that is only used in economics for a massive dose of disinflation when prices drop dramatically and sometimes for a long period)
In the real world Governments cannot cope with wild fluctuations in values because it upsets their plans so they do everything they can to keep things as unchanged as possible, so back in our imaginary world what do we have to do to keep the values stable?
Well, when the apple crop fell to 500 kilos, the water supply would have to be cut to 500 litres thereby keeping the same values of one kilo of apples for one litre of water.
If there was a government in our imaginary world then they would have installed a tap in the spring so that the water supply could be balanced with the food supply to keep the prices constant and they would open or close this tap as necessary to do this.
Back to the real world
For the apples, substitute the whole of the things produced by the country from manufactured goods, services, mined goods, pop songs, food and everything else.
For the water substitute the monetary currency of the country (in the UK pounds sterling). The Government wants to keep prices stable and to do this it must control the supply of the currency (money) and regulate it so that it balances with the produce.
When prices start to rise too much then it chokes off the money supply by making it more expensive to borrow it.
When prices start to drop too much then it increases the supply by making it cheaper to borrow. This is like increasing or slowing the water supply in our imaginary world.
The means of doing this is the rate of interest charged to borrow money. (This is like the tap in the water supply in our imaginary world).
If interest rates rise then the supply of money is reduced and if they fall then the money supply increases.
The big problem is that when dealing with a thing as complicated as a whole country it takes a long time for the effect of any change to be seen (like six months or a year) so a Government is always trying to guess what is happening.
The Government interest rate is called the Base Rate and if they get this wrong as at present in most countries in the world then things become very unstable and difficult for the people for quite a long time.
Tags: control inflation, How inflation is controoled by the government
Money Matters | Derek Beese April 28, 2009
