Wednesday, 16 December 2020

Measuring and Monitoring Overheating economy and Slowing economy

Interest rates and Money supply

Interest rates and money supply are the major tools the Fed and other central banks have traditionally used to control economic growth; the key is in how the tools are applied.

A country's economy is regulated by its money supply, which determines interest rates.  And each country's money supply is controlled by its central bank.  These quasi-public institutions are set up by governments but are then given the independence to keep an economy under control without undue interference from dabbling politicians.

How to measure and monitor growth and inflation in an economy?

Despite the tendency of the media to concentrate on the latest major economic statistic, such as GDP growth or unemployment, there is no one single indicator that tells us 

  • how fast an economy is growing or 
  • if that growth will lead to inflation down the road.

In addition, there is no way to know how quickly an economy will respond to changes in monetary policy.  

  • If a country's central bank allows the economy to expand too rapidly - by keeping too much money in circulation, for example - it may cause bubbles and rampant inflation.  
  • But if it slows down the economy too much, an economic recession can result, bringing financial turmoil and severe unemployment.  
  • When economic stagnation coincides with high inflation, sometimes referred to as stagflation, a worst-case scenario is created.

Central bankers, therefore, need to be prescient and extremely careful - keeping 

  • one eye on inflation, which is usually a product of an overheating economy, and 
  • one eye on unemployment, which is almost always the product of a slowing economy.

In the twenty first century, with the amount of capital flowing around the world dwarfing many countries' money supplies, it is almost impossible to know with certainty what the effect of any one monetary decision will have on a local economy, let alone on the world.

Fiscal policy or Massive deficit spending

Given the extremely low inflation rates in the 2010s, some have called for alternative methods for controlling economic growth.  Instead of using the central banks' authority to raise tor lower interest rates, referred to as "monetary policy," another solution would be to use "fiscal policy" to alter the money supply - essentially allowing governments to circumvent central banks by printing massive amounts of money to increase the money supply, for example.  

The use of a government's ability to issue new currency to influence economic growth, commonly referred to as Modern Monetary Theory (MMT), is not unproblematic in that inflation can come roaring back at a moment's notice.  

Many governments may misuse the power of MMT to pay for massive deficit spending in ways that lack the prudent guidance provided by the world's central banks.

Unforeseen and unpredictable events

Sometimes financial crises are caused by - and sometimes solved by forces -  entirely unconnected to the original problem.  

Most of the recent financial meltdowns, 

  • from the stock market crash of 1987, 
  • to the bursting of the dot-com bubble in 2000, 
  • to the market collapse following the terrorist attacks of September 11, 2001, 

were exacerbated by economic and sociopolitical forces well outside the control of any one country and greatly affected markets around the world.

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