The transmission mechanism and the inflation rate.
Abstract
The point of this essay is to show the link between all components of the transmission mechanism, how interest rates, inflation, the GDP, inflation and unemployment are affected by the control of money supply and demand and what can offset inflationary measures in making adjustments. The other point is to explain the forces that are at play within an open economy and how different countries are affected by the decisions of a country’s policies.
Introduction
According to Lipsey et al.(1994:616),”The mechanism by which the demand and supply for money changes and affect aggregate demand is called the transmission mechanism”, there are a number of components that are affected by the way in which the demand and supply of money is changed.
“The components have an effect on each other and there is a reaction moving through a monetary policy whereby a monetary disequilibrium occurs, moving to a fall or rise in interest rates and due to the level of interest rates changing from the selling and buying of bonds, the next step arises from an increase or decrease in investment expenditure, creating a shift in aggregate expenditure and eventually the way that aggregate demand changes” (Lipsey et.al, 1999:616).
The inflation outlook changes and there is a frustration of the adjustment mechanisms that can increase prices and inflation when it wasn’t intended (Tracer2, 2002:2).
The Essay on Push Inflation Money Demand Causes
Inflation is the general upward trend in the level of prices. Inflation causes the purchasing power of money to fall. Inflation is categorised in two types being demand-pull inflation and cost-push inflation. One of the main causes of inflation is excess demand. If demand is growing faster than the level of supply, then prices will increase. Output will increase as well, as there is a shift along ...
The transmission mechanism and decreasing the interest rate.
In order for there to be a decrease in the interest rate there needs to first be money disequilibrium where by the money supply is increased by the South African Reserve Bank and this causes a fall in interest rates relative to other countries (Lipsey et.al, 1999:616).
This also makes the interest earning assets less attractive than the assets in other countries and so the demand for South African assets decreases. By doing so, the Rand will depreciate on the foreign exchange market (Lipsey et.al, 1999:616).
By increasing the supply of money, the excess supply of money leads firms and households to buy bonds and so the interest rate falls. This will cause foreigners and citizens to start to sell the financial assets and buy foreign assets because the foreign assets are earning more at higher interest rates than in our own country and this causes the interest rate to change because as we sell our financial assets, bond prices start to go down and interest rates start to go up and so people who have sold their own financial assets will wish to sell their Rands in order to buy foreign financial assets, depreciating the rand (CCSO, 1996:30).
This now paves the way for a new channel for the monetary policy because as the Rand is depreciated, it makes our locally produced products more competitive in an open market and so our exports increase and our imports decrease helping our GDP improve in the long run with inflation decreasing with lower locally produced prices until the phenomena reoccurs in the long run (Lipsey et.al, 1999:618).
(Lipsey et.al, 1999:618)
The situation where there is an impact in employment comes in whereby Mboweni (20004:SARB) stated “it was argued that at a low level of inflation, real economic growth can be stimulated through an expansionary monetary policy even if this policy should lead to higher inflation. There may be some truth in this analysis over the short term, but such a policy will not achieve long-term sustainable high economic growth and employment creation.”
The Review on Currency And Interest Rate Swap
Business transactions occur on the international front and there are laws and regulations regarding the pricing of the long-term forward exchange contracts. It is noted that the violation of the traditionally covered interest arbitrage pricing relation has been rampant and that the activity in the international currency and interest rate swap markets offers a substantial explanation for the ...
The explanation is that if there is a low inflation, Aggregate demand for business output falls, causing the demand for labour to fall, creating an excess supply of labour and so according to the Phillips curve, there is a trade off in that a lower level of inflation means an increase in unemployment (Tracer2, 2002:2)
(Econlib, 2001:12)
Inflation outlook regarding rising oil prices
The global economy began to recover at an accelerated pace during the course of 2003 and the first quarter of 2004 but then started to slow down in the second quarter and this is because of slower growth in the economy in the United States and in China. The Situation in the United States is based on the increase in oil prices which affects consumer expenditure (SARB, 2004:27/11).
The increase in prices of oil, increased consumer price inflation in South Africa and other industrial countries thereby increasing aggregate expenditure. The Reserve Bank are made to tighten and reduce money supply so there is a decrease in the short run aggregate demand curve up and to the left and rising the price level. This moves the economy along the short run aggregate demand curve so as to reduce aggregate demand. In the long run inflationary outlook, they may want to increase the money supply thereby increasing aggregate demand and if the two different monetary forces balance each other by the time the price level has risen again, potential output will still be in the same at the new aggregate demand level and at an even higher price.
(Lipsey et.al, 1999:617)
Other factors that could increase inflation beyond the target range.
One factor that results in inflation rates exceeding the target range could be the price of gold and other financial reserves, increasing in certain markets due to say geographical tension or isolation. This would hamper the financial infrastructure, creating uncomfortable financial markets and institutions and causing boycotts of investment by foreign investors and so increasing inflation as prices increase. (SARB, 2004:22/11).
The Term Paper on Price Level Unemployment Inflation Demand
... inflation in the Extended AS- AD model: An increase in the aggregate demands from AD 1 to AD 2 drives up the price level and increase ... have the power to administer prices rather than accept the dictates of the market forces of supply and demand - To the degree that ... don't fall properly or are sticky downwards to clear the market. This is shown in the diagram below: Wages are initially ...
Another factor could be the economic slowdown or certain business cycle of a major industrial country determining on the policies determined by their own authorities. When the Chinese Government had their recent slowdown based on the deliberate policy decisions to cool down the rapid growth that they had experienced over the years, they also slowed their energy, steel and chemical commodity production and this influenced the demand in the international market for these commodities and especially the Asian markets. This doesn’t help our economy seeing as China is our fifth largest trading partner (Tracer2, 2002:2).
Conclusion
With there being a frustration of adjustment in the transmission mechanism, it is difficult to make accurate self-correcting decisions for removing an inflationary gap and so it is difficult to decide what open market forces are going to affect other countries and it is difficult to determine how the other countries are going to self-correct the effects of these open market forces (Tracer2, 2002:2).
The level of GDP, inflation and unemployment are negatively imposed by a decrease in interest rates because the money supply is unemployment is in exact conjunction with inflation and the CPIX increases with lower investment and interest rates (Econlib, 2001:12).
References
1) LIPSEY, R.G, COURANT, P.N. and RAGAN, C.T.S., 1999. Economics (12e).
Reading Mass: Addison-Wesley Longman
2) TRACER2 2002: What is the relationship between price inflation and the unemployment rate? [online]. Available: http://www.tracer2.com/admin/uploadedPublications/180_tlmrexpert0211.pdf . [Accessed 29 September 2004]
3) CCSO 1996: Macroeconomics in data stream. [online]. Available: [Accessed 29 September 2004]
SARB 2004: The restructured South African economy. [online]. Available: [Accessed: 29 September 2004].
4) ECONLIB 2001: The concise encyclopaedia of economics. [online]. Available: http://www.econlib.org/library/Enc/PhillipsCurve.html [Accessed: 29 September 2004]
