Understanding the Monetary Policy

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In the first three parts of our inflation series, we explored the effects of supply and demand imbalances, globalization, and technological advancements on inflation. We also examined how these forces shape the economic landscape and influence inflation's trajectory.

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Central banks, like the Federal Reserve, attempt to control inflation through monetary policy. This policy enables central banks to manage the money supply by:

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1. Creating or destroying money within the system
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2. Raising or lowering interest rates (i.e., adjusting the benchmark overnight interest rate)

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Monetary Policy Origins

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To give you some context, these powers originated in the US in 1971 when the dollar's gold backing was removed. This significant transition was driven by various factors, most notably by the lessons learned from the 1929 Great Depression. During this economic crisis, wealth and capital flowed out of productive assets and into "safe haven" assets like cash and gold. Consequently, the value of both the USD and gold (being linked at the time) increased while the value of goods, investment assets, and capital decreased. This deflation led to a vicious cycle where wealth holders were further incentivized to move their capital towards unproductive assets like gold, exacerbating the problem.

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Liquidity Trap

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This phenomenon, later defined as a "liquidity trap," occurs when an entire economy can be halted due to limited liquidity in the system driving economic activity (production of goods and services, hiring, project investment, etc.). To address this issue, economies transitioned away from the gold standard, allowing central banks to counteract deflation by printing money or lowering interest rates to increase liquidity. As a result, central banks target inflation to ensure that wealth holders invest in productive assets such as factories, real estate, and equities or lend to others owning productive assets (e.g., bonds). Inflation, by definition, is a tax on unproductive capital.

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Over time, interest rates have followed a downward trajectory, with near-zero interest rates persisting since 2008 due to a continuous outcome of low inflation. This has necessitated the use of quantitative easing, described as the steps taken to meet an inflation target by central banks to avoid deflation. This phenomenon can be explained by the deflationary pressures exerted by globalization and technological advancements, as discussed in Parts 2 and 3 of this series.

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Conclusion: Inflation, A Look Ahead

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Despite recent surges in inflation due to supply and demand imbalances and worldwide economic disruptions, deflationary forces, mainly driven by technological advancements reducing costs of labor, intelligence, manufacturing, and energy, will continue in the long run. As a result, we expect interest rates to decline again eventually.

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In conclusion, understanding the interplay between monetary policy, supply and demand dynamics, globalization, and technology is crucial for predicting future inflation trends. As we navigate this complex economic landscape, staying informed will ensure you’re investing responsibly.