Money multiplier
The monetary multiplier is a measurement of the potency of central bank stimulus in the economy. It is a metric that is closely watched by governmental agencies and their economists. Every time the government thinks that it needs to kick-start the economy, it looks to the multiplier to help decide how much stimulus should be applied and in what way.
The money multiplier is a key element of the fractional banking system.
- There is an initial increase in bank deposits (monetary base)
- The bank holds a fraction of this deposit in reserves and then lends out the rest.
- This bank loan will, in turn, be re-deposited in banks allowing a further increase in bank lending and a further increase in the money supply.
Monetary and non-monetary theories of inflation
Monetary Theory of Inflation
The monetary theory of inflation asserts that money supply growth is the cause of inflation. Faster money supply growth causes faster inflation. In particular, 1% faster money supply growth causes 1% more inflation.
With other things constant, the price level is proportional to the money supply. Doubling the money supply would double prices.
In other words, inflationary pressures originate with supply rather than demand and spread throughout the economy. Inflation of the cost-push type originate in industries which are relatively concentrated and in which sellers can exercise considerable discretion in the formulation of both prices and wages. Cost-push inflation may not be possible in an economy characterized by pure competition.
Since this inflation is due to the forces of cost and supply, it is not subject to easy treatment because fiscal and monetary measures may cure a cost inflation only at the expense of increasing unemployment and slower growth. That is why many cost-push inflation experts advocate mitigation rather than elimination of inflation.
Non-monetary theories of inflation
Demand-Pull Effect
The demand-pull effect states that as wages increase within an economic system (often the case in a growing economy with low unemployment), people will have more money to spend on consumer goods. This increase in liquidity and demand for consumer goods results in an increase in demand for products. As a result of the increased demand, companies will raise prices to the level the consumer will bear in order to balance supply and demand.
An example would be a huge increase in consumer demand for a product or service that the public determines to be cheap. For instance, when hourly wages increase, many people may determine to undertake home improvement projects. This increased demand for home improvement goods and services will result in price increases by house-painters, electricians, and other general contractors in order to offset the increased demand. This will in turn drive up prices across the board.
Cost-Push Effect
Another factor in driving up prices of consumer goods and services is explained by an economic theory known as the cost-push effect. Essentially, this theory states that when companies are faced with increased input costs like raw goods and materials or wages, they will preserve their profitability by passing this increased cost of production onto the consumer in the form of higher prices.
A simple example would be an increase in milk prices, which would undoubtedly drive up the price of a cappuccino at your local Starbucks since each cup of coffee is now more expensive for Starbucks to make.
Exchange Rates
Inflation can be made worse by our increasing exposure to foreign marketplaces. In America, we function on a basis of the value of the dollar. On a day-to-day basis, we as consumers may not care what the exchange rates between our foreign trade partners are, but in an increasingly global economy, exchange rates are one of the most important factors in determining our rate of inflation.
When the exchange rate suffers such that the U.S. currency has become less valuable relative to foreign currency, this makes foreign commodities and goods more expensive to American consumers while simultaneously making U.S. goods, services, and exports cheaper to consumers overseas.
Rise in taxes
A rise in taxes will cause businesses to react by raising their prices to offset the increased corporate tax rate. Alternatively, should the government choose the latter option, printing more money will lead directly to an increase in the money supply, which will in turn lead to the devaluation of the currency and increased prices.
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