How do governments influence markets, and How do they control inflation?
How do governments influence markets, and How do they control inflation?
Have you watched the Netflix show Money Heist? Have we ever wondered what happened to the country’s economy when such a vast sum was printed and stolen from the royal mint while enjoying the show’s pleasure?
Free markets are frequently imagined as having little to no government intervention. Governments do, however, intervene to stabilize markets, regulate transactions, establish institutional frameworks, and enforce contract law and property rights regulations. When markets fail, governments can interfere with bailouts and other emergency measures.
This article will look at how the government influences markets and businesses in ways that frequently have unintended repercussions.
India’s policymakers should be commended for averting a worsening economic disaster. Still, to maintain the country’s COVID-19 recovery, they must act aggressively to increase demand and protect supply, writes Raghbendra Jha.
India underwent the world’s most extended single shutdown during the first wave of the COVID-19 pandemic in March 2020. Naturally, the economy suffered a severe blow.
India’s gross domestic product (GDP) fell by 23% in the first quarter of the 2020-21 fiscal year, the steepest drop of any major country.
Most economists and international organizations recognized this as a demand and supply issue but only proposed demand-side answers.
All major OECD countries participated in large-scale quantitative easing – when a central bank acquires bonds or other assets on the open market to infuse money into the economy to generate growth or recovery – near-zero interest rates, and other demand-stimulating policies.
India was also encouraged to follow the same path but wisely chose to go differently. Its ‘barbell strategy,’ which centred on a combination of enlarged social safety nets for vulnerable Indians and policy modifications based on continually updated real-time data, reduced the likelihood of widespread famine and mass bankruptcy.
Despite the devastating effects of the Delta and Omicron variations, this worked, and the economy showed signs of recovery throughout 2021. This trend has persisted into this year, with strong growth projected in 2022-23. According to budget expenditure patterns, increases in public consumption and investment expenditures have aided the economic recovery.
During this era, monetary authorities should be applauded for keeping key policy indicators under control and guaranteeing appropriate liquidity. Furthermore, the Bankruptcy Act and other regulatory measures have reduced the ratio of non-performing assets in public sector banks from 21% in 1994 to 7.5 per cent in 2021. Non-performing assets are loans made to the open market that are not being repaid and are vital economic success indicators. This indicates that, despite the pandemic, India’s investment climate has substantially improved.
Inflation, on the other hand, has resurfaced as a big issue.
The current inflation rate in India is around 6%. Though it is still lower than in the United States and several other OECD countries, India’s recovery could be slowed if inflation persists.
While this is a cause for concern, consider what would have happened if the country had adopted a robust demand-boost programme during the first wave. Instead of only inflation, it would have experienced stagflation,’ which occurs when increased inflation is combined with sluggish growth (usual thanks to stagnating supply).
Still, since inflation is a problem in India, how should the issue be addressed? What is the exit strategy?
Monetary tightening should be used only as a last option. The country is dealing with a structural supply and demand issue that cannot be handled solely through economic methods.
When an economy is hit by both demand and supply shocks, targeting nominal GDP – GDP expressed in current prices without inflation adjustments – rather than the inflation rate may yield better results on average.
As a result, India should concentrate on nominal GDP targeting, for the time being, allowing inflation expectations to settle around the nominal GDP target and providing some economic stability before revisiting the topic of appropriate monetary policy in more normal circumstances.
Second, some supply-side adjustments are required. Excise duties by both the federal and state governments keep fuel prices high and exacerbate the price problem, mainly owing to geopolitical worries – this could be a place to start.
In addition, India’s income tax base must be expanded. Only a little more than 1% of the population in India pays income tax. This number must rapidly and significantly increase. One option to achieve this is to extend it to agricultural incomes. After determining the costs and applying usual exemption limitations, they would only be taxed on agricultural income over a specific threshold.
This would provide the government with enough income to reduce petroleum excise rates and possibly explore putting petroleum items under a consumption tax. This would lessen inflationary pressures, increase revenue, allow middle-class tax cuts, shrink the informal economy, reduce tax evasion, and give other benefits.
Crises give governments a once-in-a-lifetime chance to enact significant reforms. Reforms like these – nominal GDP targets, increasing the income tax base, and decreasing petrol excises – can bring immediate relief to Indians while also improving India’s prospects for better economic development and lower inflation by attacking inflation before it gets out of hand.
Inflation and Currency
Only governments have the legal authority to create their respective currencies. Governments will typically like to see currency inflation if they can get away with it. Why? Because it boosts the economy in the short term by allowing businesses to charge higher prices for their goods. It also lowers the value of government bonds issued in the inflated currency and held by investors.
For a while, inflated money seems nice, especially for investors who watch corporate earnings and stock prices soar, but the long-term effect is a loss of value. Savings and bond buyers are penalized because savings are worthless. This is excellent news for debtors because they will have to pay less to repay their loans, which will damage those who acquired bank bonds based on those debts. This makes borrowing more appealing, but interest rates quickly rise, removing that appeal.
Governments have a significant and far-reaching impact on markets because of their capacity to manage everything from monetary policy and currency to the laws and regulations that affect each industry.
Rates of Interest
Even though they are frequently employed to combat inflation, interest rates are another popular weapon. This is because they can boost the economy by lowering the cost of borrowing. Rather than raising interest rates, the Federal Reserve lowers them, encouraging businesses and individuals to borrow and buy more.
Unfortunately, unlike the steady erosion of inflation, this can lead to asset bubbles. Massive quantities of capital are destroyed, which takes us nicely to the following way the government can influence the market.
It’s no secret that the US government wants to bail out sectors that have run into trouble since the financial crisis of 2008-2010. This was known before the crisis. The savings and loan crisis of 1989 was eerily similar to the 2008 bank bailout, but the government has previously bailed out non-financial companies, including Chrysler (1980), Penn Central Railroad (1970), and Lockheed Martin (1970). (1971).
These bailouts were in the form of loan guarantees instead of direct investments under the Troubled Asset Relief Program (TARP).
Bailouts can skew the market by allowing poorly operated businesses to thrive by modifying the rules. These bailouts frequently harm the rescued company’s stockholders and its lenders. These businesses would go out of operation under normal market conditions, and their assets would be sold to more efficient companies to pay creditors and, if feasible, shareholders. Thankfully, the government only utilizes its power to defend the most systemically important companies, such as banks, insurance, airlines, and automobile manufacturers.
Tariffs and Subsidies
From the taxpayer’s standpoint, subsidies and tariffs are the same. A donation is when the government levies a tax on the general population and then sends the money to a specific industry to help it become more profitable. When the government imposes tariffs on imported items, the government raises the price of those products, allowing domestic suppliers to raise their prices. Both of these activities have an immediate market impact.
Government assistance for a business is a significant motivator for banks and other financial institutions to provide advantageous conditions to that business. Even if the only comparative advantage is government assistance, this preferential treatment and financing mean more money and resources will be spent in that industry. Other, more globally competitive industries are now having to work harder to acquire access to capital due to this resource drain. When the government serves as the primary client for particular businesses, this impact can be amplified, resulting in well-known cases of overcharging contractors and chronically delayed projects.
Corporate Taxation and Regulations
The corporate world rarely complains about bailouts for specific industries, maybe because they know that their industry may want assistance in the future. When it comes to rules and taxes, though, Wall Street is adamant. Because although subsidies and tariffs might provide the industry with a competitive advantage, regulations and taxes can reduce earnings.
During the first bailout, Lee Iacocca was the CEO of Chrysler. One of the main reasons Chrysler needed the bailout, according to Iacocca’s book, Iacocca: An Autobiography, was the rising expenses of ever-increasing safety rules. Other industries are following this pattern. As laws become more stringent, the more giant corporations’ economies of scale force out some smaller providers. As a result, a highly regulated industry with a few big corporations inextricably linked to the government may emerge.
High corporate profit taxes have a different effect in that they may deter businesses from setting up shop in the country. Low-tax states can entice enterprises away from their neighbours, and low-tax countries will likely attract any mobile companies. Worse yet, enterprises that cannot relocate must pay a higher tax, putting them at a competitive disadvantage in business and obtaining investment money.
Which country has the most open economy?
Singapore is ranked top in the Heritage Foundation’s Index of Economic Freedom for having markets free of government involvement.
Switzerland, Ireland, New Zealand, and Luxembourg are the following countries. The United States is ranked 25th in the world.
What Does Libertarianism Say About Government’s Role in Markets?
Libertarianism is a political and economic philosophy that promotes free markets, minimal taxes, and a small government. Following Adam Smith’s teachings, strict libertarians believe that the government has only a few essential functions:
- to ensure that private property rights are protected and enforced
- to keep a domestic police force in place to protect citizens
- to keep a standing army to guard the country’s borders and interests
- to construct public infrastructure (such as schools and parks) that would benefit society but would not otherwise be motivated by the free market
Why is it necessary for governments to impose specific regulations?
Free markets can only function effectively if all players, including buyers and sellers, producers and consumers, have complete information (what economists call “perfect information”). However, some merchants may be con artists, and businesses may cut corners to offer inferior goods. An information asymmetry is what this is called. While the market may eventually discover and discipline such unethical actors, consumers may suffer considerable economic and other consequences. As a result, laws are enacted to address the knowledge imbalance and protect consumers.
What effect do government policies have on inflation?
We cannot print more money to compensate when we run out. This will result in even higher inflation rates.
Inflation can be beneficial. Inflation can be detrimental. Although there is no official inflation objective, experts agree that a rate of 2% or less is reasonable and healthy.
The annual inflation rate in India has been above 6% for the past 70 months. This appears to be a long way from the “established aim” of 2%.
Inflation can be controlled in a variety of ways. While some may prove beneficial, others may cause chaos. For example, if the government decides to manage inflation by wage and price regulations, it may result in employment losses.
Inflation Control Techniques
Inflation can be managed in three ways by government policies and decisions. They are-
- The first of many steps taken by the government is to raise interest rates. Borrowing money gets more complex when interest rates rise. As a result, demand in the economy declines, resulting in slower economic growth. As a result, the inflation rate falls.
- This takes us to our second point: the direct relationship between money supply and inflation. If the money supply in the economy is regulated, inflation can be kept under control.
- The central bank might potentially begin offering government bonds and securities to commercial banks, incentivizing them to purchase them.
- When banks purchase securities, they have less money to lend to the broader population. The money supply in the economy is reduced, and the inflation rate falls.
This includes revenue and expenditure measures for the government.
- The government can raise tax rates to produce more income while discouraging public spending.
- During demand-pull inflation, inflation can be controlled by limiting government spending.
- However, during cost-push inflation, the government directly affects the general population by freezing workers’ pay and setting upper and lower price limits on critical utility products such as electricity and coal.
Price regulation refers to establishing minimum and maximum limitations for specific items. It is done to make those things more affordable. They are primarily used in consumer essentials such as rent and fuel. When used for a long time, it causes various issues such as shortages, deterioration in product quality, rationing issues, and illicit markets for such commodities.
Other government efforts to keep inflation under control
Aside from these efforts, the government intervenes with some programmes to keep inflation rates from growing. Because inflation occurs when spending increases faster than projected, the government implements the following actions to control the economy’s money supply.
Operations on the open market
Open market operations are when the central bank engages in available market purchases and sales of government assets to affect the money supply in the economy. When an economy experiences inflation, the central bank sells more securities to shrink the money supply.
The buyers pay for these securities with their money in their accounts, usually with commercial banks. This limits how much money commercial banks may lend to individuals.
The rate of rediscount
This is the bank rate, often known as the discount rate, which the central bank charges commercial banks and other financial intermediaries for reserve fund loans. This rate determines how much it costs banks to add more significant reserves. The central bank raises this bank rate as inflation rises. This is passed on to bank clients in the form of higher-interest loans. Thus, the money supply is reduced.
This is probably the simplest to comprehend and apply. People will have to spend more money to get the same number of things they could go before for a lower price. This decreases regular people’s spending while also controlling the money supply.
Reserve requirements should be increased.
The reserve requirement is the amount of money commercial banks must set aside with the central bank. The central bank hopes to restrict commercial banks’ lending capacity by increasing this amount.
Savings have increased.
People are encouraged to save more and spend more when the government creates appealing savings plans. This reduces the money supply once more.
Inflation is a given. Without inflation, the economy would stop growing, which we don’t want, do we?
However, we should be aware of the efforts taken by the government to raise interest rates so that we may better manage our finances.
In the financial world, governments play a significant influence. Regulations, subsidies, and taxes can have immediate and long-term consequences for businesses and sectors. As a result, Fisher, Price, and other well-known investors considered a legislative risk a critical consideration when analyzing stocks. If a fantastic investment is at risk of losing its competitive advantage and profitability, it may not be that wonderful.
edited and proofread by nikita sharma