Central bank\'s limits to containing of inflation
Abu Ahmed | Published:
March 23, 2016 22:00:45
October 20, 2017 13:47:58
There was no bank in the old past nor was there any money as we see them today. But there were transactions among the people; transactions were carried through exchange of real goods and services. That is, real goods and services were used as medium of exchanges and economists called that type of transactions as barter system. The limitations of barter mode in transactions were that it was not fast and it was localised. The exchanges through barter system were uneven. Later, with the growth of innovations and businesses, people felt the need for a common unit of exchange of goods and services.
The common units of exchanges were initially gold or silver coins. The main reason for choosing gold and silver coins as the medium of exchange was that these two metals were inheritenly valuable to the people since long past. Later, gold coins or any other metallic coins were replaced by paper notes but with a gold standard. The bearers of notes could claim gold inscribed on them by returning them to the issuers. The issuers of the paper notes were the banks, and they were obligated to pay the bearers with gold on demand. Later, to facilitate transactions of all types-even very small ones---banks issued various types of notes in different denominations with inscribed gold value. The reality was that very few people returned those paper notes to the issuing banks for gold. Rather the paper notes got changed among the people again and again through transaction. That is, overtime the paper notes became the main vehicle or medium of exchange in transactions.
Money in one form or other was there since people started transactions with one another. But the form of money or protecting its value was evolutionary. After doing away with the gold standard, the paper money became fiat money, that is, these money did not have any value by themselves, but carried the values as declared by the issuers. Meanwhile, even when the gold standard was in vogue, the responsibility of issuing paper money or any other money was taken over by the central banks of the nation-states. Now there are as many paper moneys, which are called currencies, as the number of central banks or the countries is. With detachment of paper money from the gold standard, the important questions which came before the issuers or the central banks were inflation. Inflation is defined as erosion of purchasing power of the paper notes or money which are used as the medium of exchange. Modern money is not only used as the medium of exchange, but also as a store of value. Inflation or price surge in the economy erodes the trust of the users of the paper money, specially when they would be wanting them to use as the store of value. Precisely, for this reason, currency traders globally switch their holdings from one currency to another. Overtime, some paper notes or currencies gained confidence worldwide and they were declared as fully convertible currencies and could be held as reserve currencies by any country of the world. The US dollar occupied the most prominent position in global transactions since the end of the World War II though this currency is no more related to gold with regard to protecting its value. The other convertible and declared reserve currencies are British Pound, Europe's Euro, Japanese Yen and Chinese Yuan. However, inflation has always remained as the number one concern locally for every central bank. The main reason for such concern was that as the central banks, which are differently named in various countries, they are to protect the value of the money they issue. Still many countries experienced surging inflation but many others faced just the opposite-one kind of price decrease or deflation.
Economists say both inflation and deflation are bad; they favour a gradual rise in prices. Inflation impairs trust in the currency, hampers portfolio management with the currency and alternately drives the people to hold real goods. Simple economic reasoning says, inflation or erosion of value of the currency comes from either excessive or inflating issue of the currency or because of big fall in the supply chain of goods and services. Now-a-days, banks also create money through multiple expansion of credits. That is, one unit of money may perform a number of transactions in a given period. In some sense, the central bank, which issues paper money, does not have absolute control over money supply. A variable called money multiplier is very important in calculating how much money is actually available in the market place of an economy. Multiple factors determine the value of money multiplier including interest rates and people's wish to hold cash money. The central bank cannot control these factors fully.
Though the central bank can control its own reserve money fully, it cannot control money's use in the economy or inflation. Inflation can also originate from external source over which the central bank of a country does not have any control. Inflation is seen by the economists as a cost-pushed and demand-pulled phenomenon. A central bank can only partly control and better influence demand-pulled inflation by making a variation in money supply, but controlling of cost-pushed inflation remains out of the purview of the central bank, at least in the short run.
The writer is Professor of Economics University of Dhaka.