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The Relationship Between Monetary Policy

and Inflation

By: Daniel Workman

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In todays world we hear words like inflation and monetary policy swirling around, but

what do they really mean. How are they related? We see rising prices in different markets, does

this constitute inflation or are other forces at work? What is the governments roll with

inflation? Monetary policy is one of the tools governments have to combat inflation.

Governments use monetary policies to limit inflation growth.

The fear of inflation is based on the price pressures that accompany capacity

production. When the economy presses against its production possibilities, idle resources are

hard to find. An imbalance between the demand and supply of goods may cause prices to start

rising. The resulting inflation may cause a whole new type of pain. Even a low level of inflation

pinches family pocketbooks, upsets financial markets, and ignites a storm of political protest.

Runaway inflations do even more harm; they crush whole economies and topple governments1.

Inflation is defined as a general increase in prices and fall in the purchasing value of

money2. By this definition, fluctuations in price of specific goods does not mean inflation is

growing. Other factors might be playing a role, such as fluctuating prices of raw materials and

supply and demand. Inflation is an increase in average price. Some prices may rise and others

may fall. Just because some prices rise, it does not mean that inflation is rising as well. Inflation

has 2 main causes: Demand-pull inflation and Cost-push inflation3.

1 Schiller, B. R. (n.d.). Essentials of Economics(10th ed.).

2 Inflation. (n.d.). Retrieved from https://www.dictionary.com/browse/inflation
3Causes of inflation. (n.d.). Retrieved from
https://www.economicshelp.org/macroeconomics/inflation/causes-inflation/
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Demand-pull inflation is caused by demand rising faster than supply can keep up. With

limited supply and excess demand prices rise. Prices rise because they can. Aggregate demand

shifts to the right meaning that more is demanded at a specific price. If the economy is at or

close to full employment, then an increase in AD leads to an increase in the price level. As firms

reach full capacity, they respond by putting up prices leading to inflation. Also, near full

employment with labor shortages, workers can get higher wages which increase their spending

power4.

Cost-Push inflation is caused by rising prices in conducting business. As the prices of the

factors of production (land, labor, capital, and entrepreneurship) rise the costs are passed on to

the consumer. As taxes rise so do prices. When taxes are increased on property and sales the

additional money has to come from somewhere. The object of businesses is to maximize profit

so the business will raise prices to cover the additional costs. The same concept applies to

labor. The more educated and skilled the work force, the higher the wage they expect to be

paid for their time. The increased salaries are passed on to the consumer as well.

Now that inflation has been examined, what is monetary policy? There is wide

agreement about the major goals of economic policy: high employment, stable prices, and

rapid growth. There is less agreement that these goals are mutually compatible or, among

those who regard them as incompatible, about the terms at which they can and should be

substituted for one another. There is least agreement about the role that various instruments

4Causes of inflation. (n.d.). Retrieved from

https://www.economicshelp.org/macroeconomics/inflation/causes-inflation/
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of policy can and should play in achieving the several goals5. Monetary policy uses the control

of money to obtain these goals. So how does it do it?

The biggest controlling factor is the Federal Reserve or Fed. The Fed has 3 tools to

control the money supply: reserve requirements, discount rates, and open market operations6.

The Fed requires banks to keep a minimum percent of deposits in reserve. Meaning that only a

fraction of the money banks have on hand can be leant out. This allows the Fed to control the

rate of inflation. If inflation is growing rapidly then the Fed will raise the required reserve to

decrease the amount of money leant out with the hopes of slowing the economy.

Discount rates have to opposite affects. When inflation is low, or we are even in times of

deflation, discount rates can be used to induce spending. The Fed can lend money to banks at

discount rates to increase their amount of deposits so they can lend more. The higher the rate

of inflation the higher the discount rate. Banks won’t borrow money from the Fed if their

interest rate is higher than interest rate they earn from lending it out.

Lastly, open market operations are the issue of government bonds. To increase the

money supply, the Fed raises the paid interest rate on bonds, encouraging the population to

invest more. This money can then be leant to banks increase their amount of deposits. The

combination of these three are used to control the rate of inflation.

5Yurtoğlu, N. (2018). Http://www.historystudies.net/dergi//birinci-dunya-savasinda-bir-asayis-

sorunu-sebinkarahisar-ermeni-isyani20181092a4a8f.pdf. History Studies International Journal
of History,10(7), 241-264. doi:10.9737/hist.2018.658
6 Schiller, B. R. (n.d.). Essentials of Economics(10th ed.).
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While these tools seem fairly simple it is important to remember that the U.S. economy

is composed of trillions of dollars, there is a multiplier effect, and monetary policy needs to

avoid sharp changes. The size of the U.S. economy can make it difficult to know how to make

changes to improve. With some markets thriving and others failing it is not an easy choice to

decide what is best overall. Improvements can be achieved with small changes and but one

must proceed with caution.

Every time there is an injection of new demand into the circular flow of income, there is

likely to be a multiplier effect. This is because an injection of extra income leads to more

spending, which creates more income, and so on. The multiplier effect refers to the increase in

final income arising from any new injection of spending7. Each dollar change caused by changes

in monetary policy may be 3, 5, or even 10 times greater than the original value. It all depends

on how much the population is saving.

The previous two points brings me to the final precaution, monetary policy needs to

avoid sharp changes. Each change in interest rates or required reserves can make significant

changes. These changes may take time to occur and patience is required. Drastic changes can

make you over shoot your goal.

“For example, in early 1966, it was the right policy for the Federal Re- serve to move in a less

expansionary direction-though it should have done so at least a year earlier. But when it

moved, it went too far, producing the sharpest change in the rate of monetary growth of the

post- war era. Again, having gone too far, it was the right policy for the Fed to reverse course at

7The multiplier. (n.d.). Retrieved from

https://www.economicsonline.co.uk/Managing_the_economy/The_multiplier_effect.html
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the end of 1966. But again, it went too far, not only restoring but exceeding the earlier

excessive rate of monetary growth. And this episode is no exception. Time and again this has

been the course followed-as in 1919 and 1920, in 1937 and 1938, in 1953 and 1954, in 1959 and

1960. The reason for the propensity to overreact seems clear: the failure of monetary

authorities to allow for the delay between their actions and the subsequent effects on the

economy. They tend to determine their actions by today's conditions-but their actions will

affect the economy only six or nine or twelve or fifteen months later. Hence, they feel impelled

to step on the brake, or the accelerator, as the case may be, too hard8.”

In conclusion, inflation can be caused by different reasons. Monetary policy is the

governments means of controlling money, and can be used to control the rate of inflation. The

theories behind monetary policy can seem very simple but it is important to keep in mind that

our economy is very complex and there is a multiplier effect. With this, the smallest changes

can have drastic outcomes. When dealing with monetary policy and inflation it is important to

proceed with caution.

8Yurtoğlu, N. (2018). Http://www.historystudies.net/dergi//birinci-dunya-savasinda-bir-asayis-

sorunu-sebinkarahisar-ermeni-isyani20181092a4a8f.pdf. History Studies International Journal
of History,10(7), 241-264. doi:10.9737/hist.2018.658
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