Fed’s Involvement in Inflation Part 2

Apr 14, 2022 | Finconomics 101

Following-up on our explanation about the first cause of inflation (supply & demand for goods), we continue here with the second cause of inflation. 

Inflation can also be caused by the Fed’s money creation efforts. The Fed may try to prop-up a troubled economy by flooding the banks with money to lend to consumers and businesses, which results in lower interest rates. The hope is that this will stimulate consumers and businesses to borrow and spend sufficiently to restore economic growth. The problem comes when the Fed lets this go on for too long and the easy money remains available after the crisis has passed. This results in consumers and businesses borrowing more than they should (because they are human) and buying more on credit than they would if interest rates were higher. In this case, debt funded demand exceeds supply, driving prices higher (inflation). The easiest way to understand this is to notice what happens to home prices when mortgage rates are low. People qualify to borrow more than they would if interest rates were higher, and they bid up home prices. Imagine how cheap home prices would be if everyone had to pay cash???

More recently, the Fed has worked at propping-up a troubled economy by sending money directly to consumers (i.e. government stimulus checks) rather than by solely flooding the banks with money. The Fed can do this indirectly by buying government debt that is used to fund “stimulus” checks. This reflects that sometimes lower interest rates are insufficient to prompt more borrowing and spending so the Fed floods consumers with money directly hoping that they spend (as opposed to save) to jump-start the economy.

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