Monetary Policy and Inflation

Inflation is a quantitative measure of how the average price of selected goods and services have increased in price over a specified period. Monetary policy is able to increase and decrease inflation through contractionary or expansionary policy.

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Contractionary policy:

An increase in the cash rate leads to an increase in saving and investments as their assets will be able to appreciate in value and be worth more in the future. Likewise, people will be less willing to take out loans to purchase a home or liquidate their assets. As this method reduces spending as it is more difficult to take out funds this will decrease demand and is known as contractionary policy.

Expansionary Policy:

Alternatively, we have what we see currently, expansionary policy, this is commonly seen when the economy is weaker, and we need to increase demand and inflation. It does this in the opposite way where a lower cash rates provides an incentive to borrow more cash and save less as it gains less interest from sitting in the bank.

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*Note: Inflation is usually seen as a pernicious force which we must fight against, however, the truth is slightly different. While indeed, overly high rates result in the devaluation of currency inflation remains a necessary function of the economy. Keynes (famous economist) we have the Paradox of Thrift who argues that if prices deflate then consumers will delay their purchases as they will know that the price of the product will be cheaper in the future.