The price-level and
expectations of changes in it have a direct effect on the value of money and
demand in the economy through interest rate and interest rate expectations,
inflation/disinflation/deflation and expectations of changes in them decide
interest rate and interest rate expectations which may directly affect the
supply by adjusting the borrowing cost. Low supply and increase in inflation
and inflation expectations might increase interest rate cut and rate cut
expectations and a higher supply and disinflation or deflation and expectations
increase interest rate hike and hike expectations, in order to balance supply
with demand. But, a central bank normally try to contain demand and
unemployment to achieve a stable value of money over a period of time, when
there are inflation and expectations it tightens and when there are
disinflation/deflation and expectation it cuts interest rates. Nonetheless,
increase in the value of money is desirable in case of lower population growth
rate to increase demand and growth by lowering the price-level through lowering
the borrowing cost. The price-level falls as the economy approaches
full-employment because production might consume excess labour supply and increase
and as the economy crosses full-employment labour demand more wages to
reallocate which makes the economy lose competitiveness and demand by increasing
the wage cost which is good for the labour bargaining power, the share of wages
increase in the GDP, but as production cannot be increased due to
full-employment it results in inflation and loss in the value of money and the
share of profits or the real profit fall which also discourages supply, but
conversely when other costs and prices go down due to lower inflation, like the
borrowing cost or the raw material cost it helps increasing both, demand and
supply, because real wages increase and it also increases competitiveness and
supply. Therefore, the economic-growth increases because both demand and supply
increase, lower inflation and lower cost increase profits and also help contain
demand for wages. There are two ways to increase competitiveness and demand and
supply, either we cut nominal wages, which is hard to gain because of nominal
downward wage rigidity, as put by Paul Krugman, labour resist cuts in nominal
wages, or we cut real wages by inflation which reduces domestic demand, but may
increase demand for exports because real effective wages go down. But, as we
have noticed, in the most of the developed countries real wages have gone down
even though productivity has increased, which has made the supply outpace
demand forcing the economies in low inflation or deflation regime, lower real
wages have resulted in low demand and lower real interest rate or borrowing
costs too has increased supply, which are responsible for low inflation or
price pressures today. However, the central banks may also increase demand and
spending by lowering inflation and inflation expectations which might increase
rate cut and rate cut expectations, if the banks try to increase demand by
committing to lower borrowing cost and prices that might help balance demand
with supply to achieve the inflation target and full-employment, higher demand
and supply and investment and lower unemployment might increase the economic
growth rate…
Even though inflation
is a sign of economic-activity and cuts real wages, real interest rate and real
exchange rate, it reduces domestic demand only to achieve supply and exports
which is responsible for the deflationary forces observed in much of the
developed world, which are also responsible for low imports demand and low
exports resulting in lower global growth, but lower inflation or little or slow
deflation might increase domestic demand and demand for imports and exports
thereby increasing the both, domestic growth and global growth rates… Lower
price-level because of lower borrowing and wage costs might help
increase domestic demand and demand for imports and exports, too…
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