Fiscal Tools of Central Banks Essay Example | Topics and Well Written Essays - 1500 words

Fiscal Tools of Central Banks - Essay Example Since a low stable inflation is mandatory for an optimal economic growth, one of the main roles of the central bank is to control the growth of money by controlling inflation which is attained by using monetary policy tools. According to early classical theories of inflation pertaining mostly to the growth of money, an increase in the supply of money by government forces is primarily responsible for increased inflation levels. However, the growth of money is a necessary prerequisite for the growth of money but it is not adequate on its own (Mankiw & Reis, 2002). Other factors that should be considered include the velocity of money because, in the absence of money expenditure, no inflation can occur. A good example of the importance of the velocity of money impact on inflation is when people possess money but instead of spending it, they hide the money in their homes. In such scenarios, there will be no effect on the present inflation levels.   Inflation is recorded when suppliers of goods and services increase the prices of their products by responding to the effects of aggregate demand in the economy. â€Å"The increase in aggregate demand has the effect of increasing aggregate supply† (total supply of all the services and products in the economy) (Dullien, 2004). Therefore, an increase in inflation levels is as a result of an increase in the demand which is relative to supply. A cycle is created as a result because when people acquire money they proceed to spend the money on a service or product and the money is transferred to the supplier of the good/service and the supplier, in turn, spends it turn on some else and an endless cycle continues. In this case, the government creates money which is cycled throughout the population endlessly.