China’s Inflation eases due to the tightening measures

This BBC News article of May 24, 2011 reports that annual inflation rate in China has started to decrease in the month of April from a year earlier due to the government efforts mainly from monetary tightening measures.

Inflation is a rise in general prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also affects the purchasing power of money – a loss of real value in the internal medium of exchange and unit of account in the economy. High inflation in China has been mainly caused by the rapidly growing economy in the past few years due to the excessive money supply in the market encouraging investment and spending. Rising food, fuel, housing prices have been identified as serious problems.

Today, most mainstream economists favor a low, steady rate of inflation. Keeping low (below 2-3%) inflation is vital because it may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn and reduce the risk of a liquidity trap in order to stabilize the economy.

Government can control inflation by using monetary or fiscal policy but the Chinese government has focused mainly on tightening monetary policy. Generally, central banks in most countries are the monetary authorities that control the size of the money supply through the setting of interest rates through open market operations and through the setting of banking reserve requirements. China’s Central Bank has continuously raising interest rates and at the same time allowing Yuan currency to strengthen further against the US dollar. Raising interest rates causes higher borrowing costs which will discourage excessive investment. Also, government controls banks to hold more money through higher reserve requirement policy instead of lending it out. Results show that industrial output in China started to slow down from the month of April from a year ago, mush less than economists’ forecasts. Allowing Yuan currency to strengthen against US dollar brings down the cost of imported items such as fuel and food. Even though pressures in the rising price of food and fuel still remain, government believes that the inflation will gradually fall in a short term to mid term.

Most economists in this article view Chinese government monetary policy as positive. Even though inflation is still too high as of today, there are some signs that policy measures put in place over the last six months are showing impact from the data announced by the government. Chinese government needs to further monitor the situation closely on inflation to avoid possible economic recession and at the same time avoid possible deflation. If successful, the overall economy could then be stabilized in a long term.

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