Which statement best describes how the fed responds to high inflation? Good question…especially nowadays when there may actually be a slight hint of inflation. Over the last decade or so, we have seen absolutely zero inflation due to the horrific and stagnant economic outlook of the global economy.
Because of this stagnation, interest rates have gone crashing down near all-time lows. However, interest rates have increased over the last few months, which is a clear sign that the market believes economic growth may be in the future. And when the market believes there may be economic growth in the future, the market also believes there may be inflation.
However, sometimes too much inflation is not a good thing. The Federal Reserve likes a moderate rate of inflation, but not a rate of inflation that is anywhere above 2% a year. Fortunately, the Fed has some tricks up its sleeve to counteract inflation to keep the value of our currency (the US Dollar) from fading away.
Here we go, our answer to the question “which statement best describes how the fed responds to high inflation?”
What Is Inflation?
Inflation is the increase in prices and the subsequent fall in the purchasing power of the underlying currency. Period.
The Federal Reserve typically sets their target inflation rate at 2%, which means prices overall for goods and services should increase roughly 2% per year on average. Here is an example of what that would look like.
Let’s say for example this lovely Reese’s peanut butter cup currently costs a consumer in the United States $1.00 (full disclosure I am running to the store to buy 100 of these right now). If we have a 2% inflation rate goal, clearly the hope is that next year at this time, this Reese’s will sell for $1.02.
Now, Reese’s will not simply raise the prices by 2% a year because the Federal Reserve tells them to. It all comes down to supply and demand.
If more people have better-paying jobs and thus, more disposable income, Reese’s has a shot at being able to raise prices by 2% next year because there is sufficient demand (money from these people with better-paying jobs). If salaries are going up each year and more and more consumers are getting hired and the unemployment rate it lower, there will be more money to spend thus an environment of economic growth where consumers could easily afford the 2% increase without feeling the pain.
Recall above, our definition of inflation is the increase in prices with the subsequent decrease in the purchasing power of the underlying currency. In the scenario above, inflation is occurring due to economic strength and supply and demand. The underlying currency, or in this case the US Dollar, does not lose too much purchasing power when inflation happens because the inflation is occurring from economic strength. If the US economy is doing well, other nations will feel more confident trading with the US in dollar terms as it will be seen as a strong currency in times of economic growth.
When Is Inflation Bad?
This melted Reese’s is going to be an example of when inflation is going up without economic growth. It can happen. Things such as rising healthcare costs can create inflation because people are spending more money, however, it is not in terms of growing the economy. It is as simply as their cost of living has gone up.
Back to the food, though. Let’s say the price of Reese’s is going up 10% over the year because people are spending a lot of money on healthcare for example. In the scenario above, prices are going higher because of economic growth. People have higher paying jobs and thus more disposable income. They can pay that extra 2% because they have more money.
But in this scenario, prices are higher not because of economic growth. It becomes more challenging for consumers to buy that Reese’s for a 10% increase year over year. Prices are not rising due to economic growth so people don’t have more jobs or extra disposable income to spend.
This will make the value of the US Dollar go down as the inflation is not caused by economic growth. It will not be a more attractive trading vehicle with other nations and will lose value.
Which Statement Best Describes How the Fed Responds to High Inflation?
These guys (The Federal Reserve) have a tool to respond to inflation if it gets out of hand. Remember, inflation getting out of hand if prices moving too high too quickly without the economic growth to support it while at the same time also losing value in the nations underlying currency, making it less valuable against other currencies all over the world.
So, which statement best describes how the fed responds to high inflation? Simple!
They can raise interest rates!
According to Quora,
Higher interest rates make people cautious and encourage them to save more and borrow less. As a result, the amount of money circulating in the market reduces. Less money, of course, would mean that consumers find it more difficult to buy goods and services. The demand is less than the supply, the hike in prices stabilise, and sometimes, prices even come down.
When interest rates are raised, access to capital is more difficult when compared to interest rates being lowered. People will have less money to spend while at the same time the potential to attract a higher yield of return on savings and fixed income products. This removes the money supply that is readily available in our first example.
In that first example, the consumer had higher paying jobs and thus, more money to spend. That made the 2% price increase of Reese’s manageable. Reese’s would continue to charge higher prices because of this.
But when interest rates go up, people have less money to spend overall because there is less money in the financial system. This makes those consumers spend less and save more.
Consumers will not buy and consume at the same rate when compared to when interest rates were lower. In this scenario, they will open online savings accounts or buy US Treasury Bonds and the yields on those products will be far more attractive in higher interest rate times. They will invest that smaller amount of money they have rather than pay that extra money for the Reese’s.
This will bring prices down (and inflation) because people are spending less money.
Wrapping Up How The Fed Responds To High Inflation
Simply put, when the Fed sees inflation creeping up at a pace they are not comfortable with, they will raise interest rates in order to decrease the amount of money in the system. This means that overall, there will be less money in the system, thus, less demand for those higher prices seen by the inflated prices.