Consumer Price Index - Essay Example

Topic: Macroeconomic/Fiscal Policy Paper The Following Outline Provides the Basis for my Analysis on the above Topic. “Consumer Price Index (CPI), the Producer Price Index (PPI) and money supply have been of considerable concern to the macroeconomic policy makers, governments and the Federal Reserve for quite a long time. The CPI, which measures average weighted prices of a commonly purchased basket of commodities by the average consumer, has remained below 5% annually since 1991 in the US economy. The PPI measures the change in the average selling price of goods entering the market for the first time. The PPI tends to be a lead indicator of inflation. Economists suggest that money supply plays a major role in determining the level of interest rates, inflation and real growth rates in the economy. Because money is used in virtually all economic transactions, it has a powerful effect on economic activity. An increase in the supply of money puts more money in the hands of consumers, making them feel wealthier, thus stimulating increased spending or what’s called in economic parlance, “demand-pull inflation”. My analysis will also focus on the phenomenon of deflation and seek to address such connected issues as Fed’s policy levers in expenditure-switching and expenditure-dampening strategies. Finally, I will provide empirical evidence to support the correlation between macroeconomic policy and quantitative changes in macroeconomic variables within limits”. 1. Theoretical Outline Macroeconomic policies, such as fiscal policy, monetary policy, supply side policy, national minimum wage policy and the connected host of strategic alternatives (e.g. government borrowings) have been used by the Federal Reserve and the successive US governments in order to bring about an ever elusive equilibrium in the overall macroeconomic scenario of the country. Fiscal policy consists of a series of tax related measures and is divided into (a).Expansive or Inflationary fiscal policy and (b). Contractive or Deflationary fiscal policy. Expansive fiscal policy, as the name implies, is adopted in order to buoy up aggregate demand in the economy so that it will stimulate economic growth, both in real and nominal terms. On the other hand, Contractive fiscal policy is adopted, in the first instance, to control inflation. As we are aware inflation is defined as “a persistent rise in the general level of prices in the economy over a period of time, usually a year”. This is the crux of the matter because both CPI and PPI are influenced by the level of inflation. In other words, CPI and PPI are used as measures of inflation. If one or both of them rise from one year to the other it is a clear indicator of inflationary tendencies in the economy. The vignette above refers to the fact that in the US economy CPI has not risen above 5% in any year since 1991, i.e. approximately two whole decades. Does this mean that the US economy has been experiencing deflationary pressures? The answer is ‘no’. Because the price level has not been negative; in fact, it has been rising but at a lesser rate. If CPI has not risen much it is due to the fact that aggregate demand in the US economy has been rising at a less faster rate. However, there is an economic fallacy here. We are not talking about all the goods and services. We are talking about only a selected basket of goods and services. “The conceptual and definitional distinctions of PPI and CPI are consistent with the uses of these two major economic indicators. PPI is used to deflate revenue to measure real growth in output while CPI is used to adjust income and expenditures for changes in the cost of living”, (US Department of Labor, Bureau of Labor Statistics, 2008, pp.1-2). As this conceptual differentiation points out there is very little, if any, in common between CPI and PPI. In the same way they are not expected to be positively correlated at any given time. This means they may differ in values to a greater extent. 2. Macroeconomic Policy and Money Supply Next, I shall consider how and why macroeconomic policies of the US government will be put in place to reverse any undesirable and predictable growth in money supply. The term ‘inflation’ is regarded as a euphemism for money supply because when all technicalities associated with the money supply equation are removed, what will be left out is inflation. Money supply has a number of monetary aggregates such as M1, M2, M3 and L. It must be noted here that while fiscal policy is concerned with demand management, money supply, which is primarily determined by interest rates, is a monetary policy related phenomenon. Therefore it is essential to be sure as to what monetary aggregate of the above four, has a greater impact on the money supply. It isn’t difficult to imagine that M1, being the most liquid monetary aggregate, has the most palpable impact on money supply in the economy. M1 consists of currency held by the public, demand deposits, NOW accounts, ATS accounts, travelers’ checks and credit union share drafts. As the vignette states “Economists suggest that money supply plays a major role in determining the interest rates, inflation and real growth rates in the economy”. However it can be argued that money supply is mostly influenced by the demand for and supply of money (Rousseas, 1986, p.80) As of consequence, therefore, we may argue that interest rates are determined by the demand for and supply of money. Businesses and people borrow more money when interest rates are lower and vice versa. Now we have come to our next phase of the macroeconomic problem, viz. how an increase in money supply is caused in the first instance and how it causes inflation in turn? Cheap credit drives the economic machine (Moore, 1988, p.238). The sub-prime mortgage crisis in the USA is the latest manifestation of this hydra-headed phenomenon called cheap credit. When the credit history of borrowers is too heavily biased against prime lending, there is little or no alternative but to rely on the compromised stand of the borrower to be provided with a loan. However, in the USA, the cheap credit phenomenon has fuelled not inflation but a mortgage crisis. Again it reminds us how lower interest rates attract people to finance mortgages that have no real financial strength. The money supply equation given below helps us to understand the equilibrium level of money stock in the economy. It is also known as the Fisher equation. MV=PT Where: M = The money stock in circulation. V= Velocity of money. P = The average price level in the economy. T = Number of transactions. The importance of this equation lies in the Federal Reserve’s ability to influence it by selling and buying Treasury securities. For example, when the Fed sells Treasury securities in the open market, both individual and institutional investors like banks, buy them by using their reserves. This, in turn, reduces the lending capacity of banks. In other words, there will be less money in circulation. Therefore should M fall and V is constant, inflation in the economy would be less (Graziano, 1987, p.207). Quantity Theory of Money, as the theoretical approach on this subject is known, has been questioned by many post-Friedman writers. It is not difficult to see the correlation between not only money supply and inflation but also a host of other aspects that underlie the phenomenon. In conclusion, I hope to establish the all too important correlation between macroeconomic policy or strategy of the government and the quantitative changes in both endogenous and exogenous variables. Every successive administration in Washington after the early 1980’s has made a conscious effort to achieve economic growth in real terms by manipulating either monetary aggregates directly or a policy variant obviously analogous to supply-side theory. Supply-side theory depends on aggregate supply as against aggregate demand, to bring about economic welfare to the population as a whole. Its basic premise is that lower corporate taxes will stimulate aggregate supply, thus looking after aggregate demand on its own without the need for government intervention. It is beyond the scope of this paper to examine the success or failure of these ad hoc policy measures of the government. Neither do I propose to comment on the structural changes in the economy resulting from such policies, though quantitative changes in macroeconomic variables such as employment, inflation and economic growth can be cited as the results of these policies. But they cannot be exclusively attributed to these policies. There can be more invisible influences on them than what we can see. References 1. Bureau of Labor Statistics, US Department of Labor, Consumer and Producer Price Indexes, 2008, Retrieved: May 24, 2008, from http;//www.bls.gov/news. release/ppi.nr0.htm 2. Graziano, L, (1987), Interpreting the Money Supply; Institutional and Human Factors, New York, Quorum Books. 3. Moore, B.J, (1988), Horizontalists and Verticalists, New York, Cambridge University Press. 4. Rousseas, S, (1986), Post-Keynesian Monetary Economics, Armonk, New York, M.E Sharpe Inc. Read More