how does a country control/fix inflation?
In: 14
/u/jsveiga has a pretty decent explanation if your currency is inflated so far that you need to rebase it.
First, what causes inflation. One famous economist said, “Inflation is everywhere and always a monetary phenomenon.” Meaning that when money is being printed faster than the economy is growing, you have inflation. If it’s slower, then deflation.
Second, how do banks make money. Firstly they get money in deposits. They pay the depositor a small interest rate, and then they lend that money out at a higher interest rate. They always keep some money on hand to pay back depositors, this is called reserves. Generally their incentive is to have as little money in reserves as possible, that way they can put as much to work as possible. Also, banks themselves create money through lending. Suppose you deposit $10000 in the bank, and then the bank loans $5000 to Joe Schmoe for a car loan. You now have an extra $5000 in the economy, your 10k deposit, and the $5k car loan. The bank is holding the other $5k in reserve.
Ok, now on to the central bank. Nearly all countries have a central bank, the US central bank is called the Fed. Their primary tool is to adjust a lending rate called the Federal funds rate, this is a rate that banks (and credit unions) lend money to each other on an overnight basis. The Fed adjusts the federal funds rate by changing interest paid on reserves. Suppose in the last case the fed “raises the interest rate” from 0% to 5%. This means they pay money based on the $5000 reserve the bank has to the tune of $250. Suppose Joe Schmoe’s car loan was 5%. There is no risk doing business with the Fed, so after the rate hike, the bank would choose not to make a loan to him. This means the $10,000 in deposits, is not getting lent out, therefore new money is not getting created by the bank, therefore there isn’t inflation.
Obviously those numbers are made up to illustrate the case. Dang this is hard to ELI5.
Latest Answers