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Home Automotive

Conventional monetary policy in unconventional scenarios

by souhaib
May 2, 2022
in Automotive
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Due to the pandemic, most central banks implemented an expansionary monetary policy with the aim of stimulating economic activities as a result of the effects caused by the total and partial closures. By lowering interest rates, the monetary authorities sought to encourage direct investment and household consumption. In parallel, most economies applied an expansionary fiscal policy based on tax exemptions, transfers, and public spending seeking the same results. Conventional actions to face a conventional economic recession. However, the economic crisis unleashed by the pandemic has been anything but conventional.

With the control of the pandemic, the reopening of economic activities deepened the negative impacts on the markets due to the alteration in the supply chains as a result of the contraction in supply and the growing demand driven by the stimuli granted to households. The result? A continuous inflationary process, present in most of the world’s economies for almost a year, which clearly shows that the problem is not temporary.

Faced with the onset of inflation, the conventional response of central banks has been to raise interest rates. By doing so, investment and consumption are discouraged, despite the economic recovery. Direct investment is the one that is suffering the most, since market conditions are highly fluctuating and there is no economic certainty for companies; coupled with the high cost of credit. The foregoing represents greater obstacles so that the offer can be leveled with the objective of satisfying the demands of the market, thus exacerbating inflationary pressures.

Central banks have also acted in the same way with the monetary base during this time of inflationary pressures. One of the main functions of money is to be a medium of exchange, therefore, central banks must put enough money in circulation to ensure that all goods and services produced within an economy can be marketed. In other words, the value of the gross domestic product must be supported by the monetary base. This relationship between the real economy and money is often very little analyzed and much less understood.

For an economy to grow in economic terms, it means that there is a greater physical quantity of goods and services produced per unit of time, especially with constant inflation or growing at a slower pace than the rate of economic growth. When an economy grows and its inflation rate is controlled, then the amount of money required to be able to market goods and services will increase in parallel and at the same rate as the growth rate, without generating greater inflationary pressures. The latter because income is growing.

But what happens when there is false growth? That is, when it is the prices that are growing and not the physical quantity of goods and services produced domestically. Under these conditions, the amount of money needed to market the product must also grow because it is essential to facilitate transactions. Since the number of goods and services produced is not growing, then neither is national income. Which implies that inflation is being supported only by the monetary base.

When a central bank increases the amount of money in circulation, it generates an increase in the speed of money, in such a way that economic agents perceive a false increase in their purchasing power; this drives them to increase their demand. Therefore, inflationary pressures rise even more. As the objective of any central bank is to maintain the stability of the payment system, when there are expectations of inflation, the monetary base will immediately tend to rise. However, such an increase in money actually makes the expectation of inflation true. In other words, it is the central banks that continue to feed back the pre-existing inflationary pressures by increasing the monetary base. In Mexico, from June 2019 to February 2022, the monetary base grew 24% according to Banxico figures. This positive trend in the quantity of money is also present in economies such as the United States, Canada and the European Union, which is exacerbating the levels of inflation in these countries.

*The author is Research Secretary of the Faculty of Economic and Business Sciences of the Universidad Panamericana.


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