Thursday, October 7, 2010

To inflate or not to inflate---We all have a "Real" "Interest" in the outcome...

    The Federal Reserve continues to contemplate an unusual strategy to get the economy moving forward:.

 Fed Officials Mull Inflation as a Fix
""The Federal Reserve spent the past three decades getting inflation low and keeping it there. But as the U.S. economy struggles and flirts with the prospect of deflation, some central bank officials are publicly broaching a controversial idea: lifting inflation above the Fed's informal target.
    The reasoning takes aim at an AP students best friend when it comes to the AP Macroeconomics test in  May.  A simple math formula that can be used to figure several parts of the AP test.  From memory, I would say it helps with two or three parts of the FRQ's. The formula is: Real Interest Rate = Nominal Interest Rate minus Inflation.  That is it! Simple enough.  This is how the Federal Reserve looks at manipulating this equation:
""The rationale is that getting inflation up even temporarily would push "real" interest rates—nominal rates minus inflation—down, encouraging consumers and businesses to save less and to spend or invest more.""
   Essentially they are looking to increase the opportunity cost of saving money.  Let's say you have $100 in a savings account earning a 10% simple interest rate (the "nominal interest rate").  After a period of time you will have the original $100 plus an additional $10 in your account. Assume during the time you had your money in the bank there was NO inflation.  The $10 your earned has the full purchasing power of $10 because none of the purchasing power was eroded away by inflation.  Your Real Interest Rate is 10% (10% nominal interest rate minus 0% inflation rate)  
   Now assume instead during your period of saving money, the Federal Reserve increased the money supply so much that the inflation rate increased to 10%. Now all the things you might have bought with the original $100 now cost $110.  Your earnings from the 10% nominal interest rate given to you by the bank is REDUCED by the 10% inflation rate.  In other words, your $10 in interest earned was met by a $10 increase in the things you might purchase so you have neither gained nor lost (10% nominal interest rate minus 10% inflation rate equals a 0% REAL interest rate). 
     The Federal Reserve is banking on (forgive the pun) you coming to the conclusion that it is not worth it to save (you did not come out ahead by saving) so you will spend the $100 instead.  Spend the money today, it increases Personal Consumption Expenditures, businesses have to replace inventory, factories have to produce more, and more people will be hired to produce those new goods. A very nice story indeed!! But will it work? What do you think? A good strategy or not? What might be some of the pitfalls of this strategy?  Extra credit for good responses!
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