Monetary Policy, Inflation, and Oil Price - Assignment Example

It was noted that Central Banks have been successful in their policies which controlled inflation particularly in controlling insulating countries from shocks such as high oil prices. This mechanism will be explained using various macroeconomic principles. The money supply is directly linked with inflation as shown in the famous Quantity Theory of Money (QTM). This model links the level of the money supply to the level of prices of goods and services sold, thus inflation. The famous equation of the TQM is MV = PT, where P is the average price level, T is the volume of transactions of goods and services, V is the velocity of circulation, and M is the money supply in the economy.

From this equation, we can see that the money supply and price level have a direct relationship. We should note that TQM assumes that V and T are constant in the short term, leaving only the M and P variable. Consequently, when the money supply doubles, the price level in the economy also doubles. Thus, Central Banks can either increase or decrease the money supply in order to do the same in inflation. In the statement being analyzed, Central Banks are able to avoid wage-price spirals (which are considered P in the TQM) by pursuing a contractionary monetary policy.

According to Mishkin (2004), lowering the money supply is done by raising discount rates which discourages bank borrowings, open market sale which tightens reserves and monetary base, and raises the reserve requirement among banks which shrinks the available funds for banks to grant as loans to borrowers.