Inflation: Causes, Effects and the Term Paper

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"..most importantly, we find that inflation has a dramatic negative impact on the profitability of banks." (2006) Boyd and Champ additionally state that: "The world has seen a dramatic decline in inflation rates in recent decades, but concerns about inflation may still be warranted, especially in some countries. Evidence is mounting that inflation is harmful to economic activity even at fairly modest rates of inflation because of the way it adversely affects the banking sector and investment." (2006) In the private sector "high interest rates have their most dramatic impact on equity investments - both stock market and private." (Understanding Inflation: So What's to Worry About, Anyway?, 2006) Additionally stated is that: "High interest rates show their effects by: (1) direct competitor for the investor's dollar. By increasing the difficulty of raising equity capital, high interest rates directly undermine financial stability and slow the growth of economic capacity needed to meet inflationary demand. They reduce price/earnings ratios; (2) High interest rates increase economic costs and risks for the individual business and the economy as a whole. In addition, high interest rates can obviously reduce incentives for long-term economic projects; (3) High interest rates reduce borrowing for consumption, production and investment purposes.

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Ultimately efforts to keep interest rates down by means of rapid money supply increases must lead to higher interest rates than would otherwise occur." (paraphrased; 2006)

III. HOW DOES THE FEDERAL RESERVE BOARD CONTROL INFLATION?

The Federal Reserve System's implementation of monetary policy is through the targeting of the federal funds rate and through directly setting the discount rate or the interest rate that banks are charged when borrowing money from the Federal Reserve. The federal funds rate and the discount rate both influence the prime rate which is the rate at which bank loans are made to their most valued customers. The lower interest rates work toward stimulation of the economy through the costs associated with borrowing being lowered which makes it much easier for consumers and businesses to attain construction and consumption loans. The economy is slowed when the higher interest rates are in effect because the costs associated with borrowing money are higher. (Wikipedia, 2006; paraphrased).....

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