Tuesday, August 08, 2006

Economics 202

Okay, today the Federal Reserve Board decided to keep the Federal Funds rate (the interest rate that banks charge each other for overnight short-term transfers) the same as it has been since the last increase.
If you got lost in the middle of that last sentence, try this – they decided to do nothing.
This is a good thing.

The Fed has been increasing interest rates for almost two years.
Seventeen times in a row.
The motive for this is to keep inflation under control.

In theory, if you increase interest rates, you cause less money to be borrowed by business, this, in turn, causes the businesses cut back on expansion plans, which, reduces the need to raise prices to finance the repayment of the money borrowed for the expansion. (pant, pant)
Got all that?

Now, your Econ 101 textbook will tell you that “inflation” is a general increase in prices of goods and services in the economy.
It is usually expressed as a percentage in a given time period – usually a month, a quarter, or a year.

If you have been paying attention to the news people in the last few months, you would have heard about how much the price of houses, and the price of gasoline has increased.
And some companies – airlines, FedEx, UPS, transportation companies - were raising prices to reflect the increased cost of fuel.
So there was some inflation in some areas of the economy.

Interestingly, these increases were isolated and did not spread to the rest of the economy.

As the price of gas increased, sales of big SUVs fell off, and sales of smaller, more fuel effecient cars increased,– a logical result – people continued to buy gas the same rate.
Many complained but did not cut back on their purchases of gas.

Here is a question that has occurred to me – in the definition of “inflation”, interest rates are never mentioned.

But if the Federal Reserve Board is raising interest rates every four or five weeks by policy changes, isn’t that inflation, too?
In other words, the US Government is taking steps to reduce inflation in private industry by creating inflation in the banking industry.

Here is another wrinkle:
One of the things that economists look at in accessing the progress/health of the US economy is the rate of growth.
Growth is measured by a number of things – job creation, average wage rates, company sales growth compared to a past period, productivity of workers, etc.
Many times – but not always – fast economic growth is accompanied by increasing inflation.
But this is not always the case.
Many times, increasing economic growth is not the cause – and does not create – inflation.
But one of the things that the Fed looks at in making its assessment of the economy is rate of growth.
And one of the effects of the actions of the Federal Reserve Board is to reduce economic growth.
While the reduction of economic growth is never stated as the goal of the Federal Reserve Board actions, it is always the result.
Always.

And if the Fed overdoes the reduction in economic growth rate – you get a recession – negative growth.
Which is the way economists say “contraction”.
What word would you use to mean the opposite of “growth”?

Question: Why can’t the government come up with a method to reduce inflation without reducing the growth rate?
Difficult to do.

The capitalist/free enterprise system is the most efficient and productive economic system in the history of the world.
It is also the most messy and most difficult to control.

Because any economy is the result of billions of economic decisions of individual people every day, it is difficult to predict the effect of just one change.

Any questions?

Class dismissed.

1 comment:

J. No said...

Shrinkage. That's the word I'd use.

All this economy talk makes me want to return to CCC and learn at the feet of Mr. Jim Payne once again.