Question

What impacts on the economy and the financial system would inflation rates well above the Fed's 2% target have on the economy and financial system? Similarly, why is the Fed so concerned about the prospects for disinflation or even deflation?

Answer 1

Answer - The main aim of the federal reserve bank is to stabalise the economy of US by controlling the supply of money in economy. It sets up the target rate of inflation . The actual rates above the rate of inflation or the falling rates of inflation below target create disturbances in the economy.

The rise in the rates of inflation overheat the economy , this makes the value of currency cheaper and reduces the purchasing power of currency. Even in the foreign exchange market the reducing value of currency or inflation leads to the rise in the exchange rate or the currency suffers depreciation. People have more money , but on the other side , they have to spend greater than before because of rise in price of goods and services. Thus , this becomes problematic for fed to control and it must implement policies to stabalise the economy.

On the other hand , deflation or disinflation , slows down the economy . The economic activities including the production slow down , the firms start cutting down on cost due to which many workers are laid off. This causes the rise in the rate of unemployment leading to loss of income , decrease in real GDP and decreased demand in economy . If this is not controlled on time , it will lead to sluggish economy with below potential performance.