Updated: Jan 25
Let's conduct a thought experiment. Think of a village market. Food items are becoming expensive. You need to curb rising prices. There are two methods.
Reduce the money supply so people have less money. This is generally done by raising interest rates. If they have less money, they would demand less, which would force farmers to lower their prices.
Ask farmers how you can help them reduce costs. Do they have to buy permits and licenses? Do they have to pay high fuel costs to irrigate their lands and transport their produce to the market? Take measures to help them reduce the cost of production. A lower cost of production would yield higher margins, which may incentivize some of them, especially new players, to lower their prices to invite higher volumes. In the long run, higher margins would also attract new entrants, further adding to the total output, which would further lower prices. Eventually, the market would be brimming with more produce than before, selling at prices lower than before.
Which method is correct? Since governments always choose the first method and we know how clever they are, we can safely assume that the first method is wrong. Why? Less money would force food prices to go down. Lower prices would reduce profit margins. Some farmers would get eliminated, causing a reduction in the supply of produce. Existing farmers would cut costs by laying off workers or by reducing quality. A rise in unemployment would cause a further decline in consumption, further lowering the prices. If the money supply gets cut by a lot, our little village might face food shortages.
Let's zoom out and come to the real world.
When interest rates rise, the contraction in the money supply disincentivizes both consumption and value creation. Lower consumption causes lower profits, which means layoffs, and fewer business activities cause a decline in the supply of goods and services. Unemployment further lowers consumption and value creation. The monetary contraction also crashes over-leveraged companies and nations that can't borrow more cheap money to stay afloat. This is not to say that interest rates should not be lowered. An economy that is built on leverage is just a bubble. It has to burst, if not today then tomorrow. However, the impact of increasing interest rates can be and should be neutralized by restoring and supporting the supply side, as shown in the figure below:
If we only contract the money supply, we get EQ2, where prices have come down at the expense of a decline in aggregate supply.
If we only restore the supply side, we get EQ3, where prices have come down in addition to an increase in aggregate supply.
If we do both, we archive achieve significantly lower prices at EQ4. Whether aggregate supply increases or not depends on how drastic both measures are. So long supply-side measures restore more than monetary contraction destroys, we get a net increase in aggregate supply.
What if I show you that our governments have found out a way to be in a position far worse than all the four equilibrium points above. I will let the figure below do the explaining:
We started at EQ1. In 2020, corona measures like lockdowns and travel restrictions disrupted the supply side, hence AS2. At the same time, governments lowered interest rates, printed a ton of money, and gave away handouts to stimulate the economy, which created AD2. As we can see, prices jumped massively while the change in aggregate supply depended on the magnitude of supply-side disruptions and that of the monetary expansion. Now, as the money supply is getting tightened, the aggregate demand curve would move to the left. The further the movement, the worse the recession would get. Prices should come down unless something creates another supply shock, which would move AS2 leftwards (stagflation). But there are no reasons, besides the Russia-Ukraine conflict, to expect a supply shock.
A point worth noting
Governments around the world are acting in unison. Call it herd behaviour, conformity, or directives/pressures from a shadow government above all nations, but it makes everything much worse. If one nation is undergoing an inflationary period while its neighbour is in a deflationary period, people in the inflated nation can buy cheap goods and services from their deflated neighbour, which would ease inflation in their home country and stimulate their neighbour's economy. However, this is not how governments have behaved in the past two years. Their reaction to covid was relatively the same. Lockdowns disrupted the supply chains and initiated a recession. The supply shock caused inflation globally. Then, they all lowered interest rates at the same time, which only fueled the inflation. Now, they are raising interest rates all at once. This means the entire globe is about to suffer another recession, a much harder one. If they did it only a few countries at a time, this fate could be avoided. If countries with the high inflation went first and the next group of countries waited until their turn, the coming recession would be much more manageable.