Inflation And Monetary Policy

By: EconomyWatch   Date: 13 October 2010

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Inflation and monetary policy are closely related concepts wherein the latter can be used efficiently to reduce the effect of the former. Inflation is thought of as the rise in prices and wages that reduces the purchasing power of money. Monetary policy is the regulation adopted by the central bank, currency board or other regulatory authority which stabilizes the prices and maximizes production and employment of the country.
Inflation
Inflation is characterized by an increase in the general level of prices for goods and services. As a consequence, the purchasing power of money will fall. Most of the countries in the world try to sustain an inflation rate between 2 and 3 percent. Inflation lowers the rate of savings and diminishes the purchasing power. Inflation takes place, when too much money is in circulation in comparison with the production of goods and services.

Measurement of Inflation
Inflation is evaluated by changes in the CPI (Consumer Price Index). It is essential to know the changes of absolute price and relative price, at the time of determining the inflation rate. The GNP (Gross National Product) is also considered while evaluating the inflation of a country.
Causes of Inflation
The main cause behind inflation is the increase of money supply than the demand for money. Alternatively, it can be said that when the supply of money per unit of output increases, inflation occurs. The supply of money per unit of output increases, when "velocity" of money circulation increases. The demand for money depends on the overall economic activities of a country.
Relationship between Monetary policy and Inflation
The Fisher's equation depicts that proportional relation that exists between money supply and the price level.Monetary policy is a regulation of a central bank or any regulatory authority, that ascertains the size and growth rate of the money supply. Monetary policy directly influence the interest rates which in turn has a negative relation with the price level. In the face of inflation the central bank of the country generally resorts to a rise in the cash reserve ratio, repo rate and reverse repo rate. So the basic idea is to reduce the money supply in the economy. To this end government securities are also issued so as to mop up the excess money supply from the mass. This would reduce aggregate demand . This reduction would again help reduce the price level.

Monetary policy is adopted with an objective to make the most of production and employment and consequently stabilize the price level of a country. Monetary policy also regulates the interest rate, availability of credit and at the same time promotes the overall economic growth of a country. Monetary policy facilitates establishing trade relationships with other countries.

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