Chinese Government Reduced Inflation

Chinese government reduced inflation by intervening in the economy. Previously, China experienced rapid economic growth which led to the economy getting cheap money which therefore resulted in higher inflation. This commentary will study the causes of inflation and assess the government’s policy in terms of advantages and disadvantages among stakeholders.

Inflation is a continuing rise in general price level. In theory, there are two types of inflation: demand-pull and cost-push. Demand-pull inflation occurs when aggregate demand (AD) total of all planned expenditure in an economy at each level of prices exceeds aggregate supply (AS) total of all planned production at each level of prices. Cost-push inflation occurs when the cost of production increases and firms put up prices to maintain profits.

It can be assumed that China’s inflation was demand-pull. The economic growth shifted AD rightward, as shown below:

As AD shifted from AD 1to AD 2, average price level measures of overall prices for goods and services in a given interval that has increased from PL 1 to PL 2. Along with price level increased real gross domestic product a measure of the level of economic activity adjusted for inflation from Y 1 to Y 2.

Actually, the price level increased when the rising food, fuel, and housing prices have been identified as serious problems. Together with this, the cost of production has increased which brought about cost-push inflation as illustrated below:

When AS shifted leftward, the average price level increased from PL 1 to PL 2 while real GDP decreased from Y 1 to Y 2. With two types of inflation working together, China grieved with high inflation cause of the increase in price levels.

In theory, there are two macroeconomic policies intended to influence principal macroeconomic targets that can improve inflation: contractionary fiscal policy and contractionary monetary policies.

Fiscal policy changes in the level of taxation and government expenditure.

Monetary policy changes in the supply of money and interest rates.

The contractionary monetary policy is a form of economic policy used to fight inflation which involves decreasing the money supply in order to increase the cost of borrowing which in turn decreases GDP and reduces inflation.

The contractionary fiscal policy is when the government either cuts spending or raises taxes. It reduces the amount of money available for businesses and consumers to spend.
In order to ease inflation, the government can higher taxation and decrease government expenditure using contractionary fiscal policy or decrease money supply and increase interest rate using contractionary monetary policy.

China implemented only contractionary monetary policy, as it brings about result rapidly and allows the government to reasonably adjust to its best interest. According to the article, the government raised the cost of borrowing four times so that the government can get more money in the economy to avoid the currency from getting useless on the international market or exchange markets. With this government eased annual inflation rate by 0.1%, depicted below:

With the increase in interest rate, AD shifted to leftward from AD 1 to AD 2, bringing about the decrease in the average price level from PL 1 to PL 2 and in real GDP from Y 1 to Y 2. Because government increased the interest rate, there was a leakage in the economy which was slowing down money flow and therefore collapsing inflation.
According to the article, “China’s central bank will continue to raise borrowing costs”. There are advantages and disadvantages to this among stakeholders: savers and borrowers, domestic firms, foreign investors, and the government.

For savers, a rise in interest rate is advantageous because it will increase the money received from the interest-bearing bank. On the other hand, an increase in interest rate is disadvantageous to borrowers and people with loans, since they would have to pay higher interest rates.

As of domestic firms, they will agonize because with rising saving, consumption and investment will likely decrease. This means demand for the firm’s products and their efficiency will decrease; bring about in a decrease in profit, which leads to a fall in the value of the stock.

Foreign investors, on the other hand, will benefit from a rise in interest rate because as investors are attracted to the higher first-rates of interest, foreigners are likely to increase the number of funds into China. As the article mentioned, this will “allow the Yuan currency to strengthen,” taking down the cost of imported items.

Lastly, the Chinese government will likely be worried about an increase in unemployment as a result of an increase in interest rate. Because the inflation rate and unemployment rate have opposite relationships, as inflation rate decrease due to the contractionary monetary policy, the unemployment rate might increase.

In general, the Chinese government has made a right choice: to tighten monetary policy. Unless rising inflation was dealt with, China might have experienced economic bubble: a phenomenon characterized by surges in asset prices to levels significantly above the fundamental value of that asset.