Question

OPEC raises the price of oil for a year but then an increase in the supply of oil from Russia bids oil prices back down again. Contrast the evolution of the economy if monetary policy follows: (a) a fixed interest rate or (b) flexible inflation targeting.

Short answer

A flexible inflation-targeting policy manages economic stability better by actively adjusting interest rates.

Step-by-step solution

Understanding the Fixed Interest Rate Scenario

If the Central Bank follows a fixed interest rate policy, it maintains a constant nominal interest rate despite changes in economic conditions. When OPEC raises oil prices, the increased cost of oil will lead to higher overall prices in the economy, causing inflation. Under a fixed interest rate, the Central Bank does not respond to this inflation. Later, when the Russian oil supply increase causes oil prices to fall, the inflation pressures ease, but the interest rate remains unchanged throughout.

Analyzing Economic Effects with Fixed Interest Rate

The economy will initially experience higher inflation due to the oil price increase without any monetary policy response to mitigate this. Consumers and businesses will face higher prices, potentially reducing consumption and investment. When oil prices fall, inflation pressures will reduce, but the fixed interest rate might result in slower adjustments back to stability, possibly prolonging any inflation-induced economic slowdown.

Understanding Flexible Inflation Targeting

Under a flexible inflation targeting policy, the Central Bank actively adjusts interest rates in response to inflation deviations from the targeted level. When oil prices rise, leading to cost-push inflation, the Central Bank may choose to increase interest rates to combat this inflation, acknowledging potential short-term impacts on output and employment.

Analyzing Economic Effects with Flexible Inflation Targeting

With flexible inflation targeting, the Central Bank responds to oil-induced inflation by adjusting interest rates, likely increasing them to manage inflation expectations. Later, as oil prices drop due to increased Russian supply, the Central Bank can lower interest rates to support economic activity and stabilize inflation back to target, providing a more balanced economic adjustment.

Key concepts

Fixed Interest Rate

A fixed interest rate policy means that the Central Bank keeps the nominal interest rate constant, regardless of economic changes. This can lead to varying impacts on the economy during different economic phases. With OPEC's decision to raise oil prices, an economy with a fixed interest rate may see higher inflation because the cost of goods, influenced by the cost of oil, rises. The Central Bank does not adjust the interest rate, leaving the inflation unchecked, potentially leading to reduced consumer spending and investments as prices rise.

For example, when the oil supply increases from Russia and prices fall, although the inflation pressure decreases, the nominal interest rate remains unchanged. The economy might take longer to adjust back to stable conditions because the fixed interest rate does not help mitigate the temporary inflation-induced slowdowns. This lack of response illustrates both the advantage and risk of fixed interest rates: stability in interest rates, but with possible prolonged economic disturbances.

Flexible Inflation Targeting

Flexible inflation targeting allows the Central Bank to actively change interest rates in response to deviations from its inflation goals. This policy adapts to current economic conditions, making it a dynamic approach to managing the economy. When inflation deviates from the target due to something like OPEC's oil price hikes, the central authority might raise interest rates to discourage excessive spending and bring inflation back down.

As oil prices later decrease because of an increase in supply from Russia, the Central Bank can lower interest rates to encourage economic activity, promoting spending and investment. This policy accommodates short-term fluctuations in inflation and stabilizes it over time. The proactive adjustment in rates ensures that inflation remains close to the central bank’s target, helping mitigate negative impacts on output and employment. Flexible inflation targeting offers a more nuanced method of steering the economy through immediate inflationary pressures.

Cost-Push Inflation

Cost-push inflation is driven by increased costs of production which cause overall prices to rise. A critical example is when OPEC raises oil prices, thus directly increasing the costs for industries dependent on oil. Since oil is a crucial input for many products and services, its higher price leads to widespread price hikes across the economy. As a result, consumers face higher living costs and businesses face increased operating expenses.

This type of inflation is challenging because it can lead to stagflation, where inflation remains high while economic growth is slow. Cost-push inflation requires careful monetary policy to balance the inflation with economic activity, such as might be managed through flexible inflation targeting. Managing cost-push inflation entails addressing both immediate inflationary concerns and longer-term economic impacts.

Central Bank

A central bank plays a critical role in managing a nation’s monetary policy. It is responsible for ensuring economic stability through interest rate policies and other monetary tools. The central bank influences inflation and economic activity with these tools. In the context of our exercise, whether the central bank adopts a fixed interest rate or flexible inflation targeting will define how effectively it responds to oil price changes by OPEC and Russia.

By keeping interest rates fixed, the central bank may promote interest rate stability but at the cost of potentially extended inflationary periods. In contrast, flexible inflation targeting allows the central bank to step in with interventions as needed. The central bank’s decision to raise or lower interest rates directly impacts consumer and business spending, inflation expectations, and overall economic health. Central banks balance these factors to foster a stable economic environment and react appropriately to both domestic and international market changes.