Most people understand that inflation is a major factor in the economy, but many aren’t entirely sure what is is or how central banks attempt to control it.
Inflation is an important element in economic performance, so it’s worth understanding how central banks try to keep it under control.
How Central Banks Control Inflation
The most common way central banks attempt to control inflation is by deciding monetary policy. Basically, this means the central bank, which is called the Federal Reserve Bank in the U.S., determines how much of currency will be available for use. If the central bank determines that the economy needs more inflation, it will increase the supply of currency. If it wants to rein in inflation, it will begin cutting the monetary supply.
Let’s look at a real-life example of how this happened recently.
In an effort to help the economy bounce back from the Great Recession, the Federal Reserve introduced something called quantitative easing, which increased the amount of money available to the economy. The Federal Reserve did this by buying securities from other banks, increasing the market’s liquidity.
Quantitative easing made it easier for banks to borrow money, which also made it easier for them to lend to businesses and consumers. Lending to companies means those companies can potentially purchase more and employ more people–both of which can be good for the economy.
Other Ways the Central Banks Can Control Inflation
Aside from controlling the supply of money, there are a number of other ways that central banks can increase or decrease the rate of inflation.
Perhaps the most infamous method is through price controls.That essentially means attempting to curb price increases by fixing the rate of currency.
Often, runaway inflation gets so bad that a country’s central bank will turn to price controls, which is arguably worse than the initial problem.
Venezuela has been an example of attempting to combat high inflation through price controls
The idea behind price controls is simple: if people can’t buy more with their money, it keeps businesses from charging more.
Unfortunately, there are just too many essential products that, by their very nature, just can’t be controlled for a sustained amount of time. For example, the price of most farm commodities is affected by weather. Raw materials are affected by international prices. The list goes on and on.
How the Market Controls Inflation
Central banks don’t hold all of the control over inflation, though.
The market itself has a lot of power to sway inflation, too.
Consumer confidence plays a major role.
Again, think about quantitative easing. The Federal Reserve’s plan was aimed at building consumers’ confidence levels until people felt comfortable spending money again. Until then, consumers would continue holding onto their money, afraid that another recession could strike.
You Can’t Control Inflation but You Can Control Your Investments
While central banks have the best of intentions when controlling inflation, that doesn’t always mean it’s going to work out for you, at least in the short term.
As the rate of inflation goes up, your money’s purchasing power can go down.
That’s why investing is so important. You can’t simply hope to save your money because inflation will, slowly but surely, reduce how much it’s able to purchase.
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