Tejvan Pettinger - Economics Help

Canadian Monetary Policy and Inflation

10 March 20202 April 2008 by Tejvan Pettinger

Readers Question: suppose you are the governor of the bank of Canada .. and that inflation has been high and roughly constant for a number of years. you have two policy choices: you can attempt to eliminate the sustained inflation. Outline the issues involved when making this choice. list and explain the costs of ongoing inflation, and also the costs of a potential disinflation. explain how you make your policy decision.

There is only one choice in this question – eliminate sustained inflation. I guess the alternative is to allow the inflation to continue and target higher economic growth.

Costs of Inflation

If Canada has high and sustained inflation it will have the following costs:

Discourages investment. High levels of inflation create uncertainty and lead to lower investment levels. Countries with higher inflation rates tend to have lower rates of economic growth in the long term.
Falling International Competitiveness. If Canada has a high rate of inflation then it is likely that they will be losing international competitiveness. This will cause lower exports and potentially higher unemployment.
Menu costs / Shoe leather Costs. These may not be too high in a modern economy, but, they involve the costs of changing price lists and looking for the best-valued prices.

See: costs of inflation

Therefore these costs suggest there is a good reason for the Bank of Canada to use monetary policy to try and reduce inflationary pressures. This will involve increasing interest rates. Higher interest rates will

Make borrowing more expensive
Reduce the disposable income of those with mortgages
Make saving more attractive
Lead to an appreciation in the Canadian currency (because of attracting hot money flows)

This has the effect of reducing investment, consumer spending, AD and economic growth. This will reduce inflation but at the cost of lower growth, higher unemployment and possibly a recession. The slowdown in growth will also lead to higher government borrowing because people will pay lower tax and the government spend more on benefits.

Exporters will be adversely affected by the rise in the exchange rates as it makes exports less competitive.

The only benefit is that it will improve the current account because it reduces import spending.

Question on American Banking History

15 January 20201 April 2008 by Tejvan Pettinger

Readers Question: In early American banking history, banks would issue banknotes to patrons that were supposed to be backed by gold and silver. My questions is, what did the patrons give the banks to get the bank notes, and why were many banks unable to make payment on demand when the patrons tried to exchange their notes?

Banknotes have evolved over time. Initially bank notes were issues in lieu of precious metals and were essentially I O U’s. A more technical term is that bank notes were ‘promissory’ – Rather than give gold to customers, banks gave a credit note saying they promised to exchange this credit note for an equivalent sum of gold or silver.

Over time, gold and silver were no longer used in the monetary system, thus bank notes became effective credit notes.

It was the banks who were most keen to use promissory notes rather than deal in precious metals. Bank notes had the advantage that is was easier to transport, lower costs and, most importantly, enabled the banks to make better use of their assets.

Question on Electicity Price Increases

15 January 202031 March 2008 by Tejvan Pettinger

Readers Question Am I correct in assuming that electricity is an inelastic supply? Oil is in short demand, there are not many green/low emission replenishable supplies and in the short run this would explain the continued increase in prices for the consumer.

I think that in the short term electricity supply is quite inelastic. When the price rises it is not easy for electricity generators to immediately increase the supply. They may have some spare capacity, but, mostly supply is fixed by the number and size of electricity power stations.

In the long term, the government and power companies could invest in new sources of electricity generation, but, this could take a long time to occur. Therefore, over time supply will be more elastic. But, are the price increases temporary or permanent?

Because supply is inelastic, when there is an increase in demand we tend to get a significant increase in price. In recent years global demand for energy has risen because of economic growth in countries such as China and India. There large economies are growing at a fast rate and this is a major factor in causing rising demand and therefore rising prices.

Interest Rates 2009

17 March 201731 March 2008 by Tejvan Pettinger

Readers Question: with economic scare, do you advise to invest? how do you predict inflation and interest rates will affect business? In the UK, interest rates have only fallen slightly since the start of the global credit crisis. The Bank of England has reduced rates from 5.75% to 5.25%. The Bank is still worried about …

To what extent is Bank of England responsible for low inflation?

12 November 202529 March 2008 by Tejvan Pettinger

Readers Question: What credit can the adoption of central bank independence take for the relative stability of the UK business cycle since 1997?

The MPC, Bank of England, are responsible for setting interest rates and determining UK monetary policy. They seek to keep inflation close to the government’s target of CPI 2% +/-1 %

Between 1997 and 2007, the UK enjoyed a period of unbroken economic growth and low inflation. It appears that the UK has been able to avoid the ‘boom and bust‘ economic cycles that characterised the boost way period – most notably the Lawson boom of the late 80s and following recession.

The statistics on inflation and economic growth were impressive, especially when put in historical context. It is a good question to ask how much we can credit the independence of the Bank of England?

Why the MPC has helped keep inflation on target

1. They are independent. They are not subject to political pressures. E.g. they are not tempted to cut interest rates just before an election. This used to be a problem for UK economy, with many experiences of boom and bust economic cycles.

2. Monetary Policy is pre-emptive. They try to prevent inflation before it occurs. They predict future inflation trends. If inflation looks to be increasing above the target of 2%+/-1 then they can increase interest rates to reduce consumer spending and keep inflation on track.

Housing Spending and Urban Development

27 March 2008 by Tejvan Pettinger

Readers Question: Will an extra $20 billion per year spent on housing have the same impact on the economy as an extra $20 billion spent on interstate highways?

It depends on the state of the economy.

At the moment, 2008, one of the biggest threats to the US economy is falling house prices. Data released for last month showed a record fall in house prices. Lower house prices are undermining consumer confidence and leading to lower consumer spending. This is one of the main causes of lower economic growth.

Falling house prices are being driven by two factors

Rise in mortgage defaults
Excess Supply.

Building more houses at this particular time would not help, it would exacerbate the glut in house prices and cause a further fall in prices. Therefore, this could cause further problems in the economy.

Economic Impact of Beijing Olympics

24 March 2008 by Tejvan Pettinger

Readers Question: Use the ideas and theories you have encountered in your study of the macroeconomic business environment to assess the possible impacts on China of holding the Olympic games in Beijing in 2008.

The Olympic Games will effect the Chinese economy in the following way.

Increase in Tourism. This is a short term effect but will help increase spending in the economy. It will come from the athletes, spectators and media who will travel to Beijin. It is argued the Olympics will also provide a long term boost in repeat tourism; this could be quite significant for China as the tourist industry is largely underdeveloped.

Increased Investment in Infrastructure. To prepare the economy for the Olympics, the Chinese authorities have attempted to improved infrastructure and transport links, these will have some effect in increasing the productive capacity.

Readers Questions on Exchange Rates UK

15 January 202024 March 2008 by Tejvan Pettinger

1) You say depreciation causes inflation for the three reasons you mention, but later, that in the long run, a higher rate of inflation will cause depreciation. So my first question is how are these two phenomena linked? Is ‘long run’ the key; i.e. it takes a prolonged high inflation to cause a devaluation, but devaluation causes inflation sooner? How long does it take for those three reasons to really kick in?

It depends, there is no straight answer. The two phenomena may occur simultaneously. Also it is complicated by the fact that many factors affect the exchange rate apart from just inflation. (e.g. short term interest rates)

2) My next question is that I’m aware that factors such as rising commodity prices can exert upward inflationary pressure, but are there any other factors that affect the devaluation of a currency – or is it purely down to inflation?

Many factors can affect exchange rates. These include:

Interest Rates – lower interest rates cause less hot money flows and depreciation.
Expectations – If investors expect a currency to devalue they will sell less. Confidence and market expectations are important in determining exchange rate
Current account deficit. A large current account deficit may put downward pressure on exchange rates
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